THE GREAT INFLATION--Part 1 The Nature of Money
By James J. Puplava
What is money? Money means different things to different people. On Main Street it may mean the dollar bills in a wallet or the cash balance in a checking account. On Wall Street it represents the electronic digits in the interbank settlement system. To others money represents credit, the ability to buy a home with a mortgage, access cash through a credit line, or the ability to purchase goods with a credit card. Ask different people what money represents and you will get a wide variety of answers.
In todays complex financial world the concept of money gets lost in translation in the day-to-day affairs of commerce and living. Somewhere along the road of history as complex societies evolved mankind shifted from direct to indirect exchange in order to expand and conduct trade. The basic problem with direct exchange (barter) is that it lacked indivisibility and coincidence of wants. Under direct exchange you could only conduct trade if both parties to a trade desired the other's goods. Because commerce needed a system of payment that transcended direct exchange, money was invented as a medium of exchange. As societies evolved and the division of labor became more complex, the diverse needs and wants of the economic system became more refined. The invention of money allowed a market to develop for the trading of goods and services that was able to meet the needs of developing societies.
Gradually money developed into a medium of exchange used in trade. The invention of money allowed society to expand and extend beyond the limits of an individual household to that of a nation and indeed the whole world. Money solved the two basic problems created by barter, which were indivisibility and the coincidence of wants. Money became a unique commodity used to transact trade and commerce between diverse cultures and nations. A secondary function of money was that it also facilitated credit transactions which were simply the exchange of present goods for future goods.
What we learn about money is that it was a commodity in its own right, with its own unique properties. As Rothbard states, "Money is not an abstract unit of account, divorceable from a concrete good: it is not a useless token only good for exchanging: it is not a 'claim on society': it is not a guarantee of a fixed price level. It is simply a commodity. It differs from other commodities in being demanded mainly as a medium of exchange. But aside from this, it is a commodityand like all commodities, it has an existing stock, it faces demands by people to buy and hold it, etc. Like all commodities, its 'price'in terms of other goods--- is determined by the interaction of its total supply, or stock, and the total demand by people to buy and hold it."  [Emphasis added]
The best explanation of the origin and role of money is given by the Austrian school of economics. For we have no definitive or historical event as to its origin. No king issued an edict that created money nor is there some inventor who is credited with its invention. The Austrian economists Carl Menger and Ludwig von Mises have given us the best explanation as to the origin and development of money. According to Menger, moneys origination was spontaneous. No king, government, or person created it. The origin and development of money came into being through barter. Eventually, as trade developed, one particular commodity became more desirable to own than another. Items such as wheat may be more desirable than a ceramic vase, and a metal that was durable might be more desirable than a bushel of grain.
Before there was money, there was credit. Credit preceded the coining of money. Historical documents dating back to the Sumerian civilization, circa 3000 B.C., reveal that the ancient world had developed a formalized system of credit based on two major commodities, grain and silver. Before there were coins, metal loans were based on weight. Archaeologists have uncovered pieces of metal that were used in trade in Troy, Minoan and Mycenaean civilizations, Babylonia, Assyria, Egypt and Persia. Before money loans came into existence loans of grain and silver served to facilitate trade. Silver was used in town economies, while grain was used in the country. For nearly 2,500 years throughout Sumerian and Babylonian history, the rate of interest on grain and silver loans remained constant. The customary rate of interest on a barley loan was 33 1/3% and for a loan of silver it was 20%. 
Although interest rates would occasionally vary, the legal maxima embodied in the Code of Hammurabi, established 33 1/3% per annum on loans of grain and 20% on loans of silver. These rates lasted for more than 2,500 years.
Eventually, the demand for a certain type of good outstripped the demand for other commodities. In matters of trade certain type of commodities were in high demand and became universally accepted in trade between buyers and sellers. As explained above, loans of silver and base metals were already used as a means of facilitating credit. Eventually precious metals emerged as the commodity of choice. At this point money came into existence as a commodity used as a medium of exchange.
The official birth of coined money was around the first millennium B.C. It is believed to have originated in Lydia in the seventh century B.C. King Croesus of Lydia (560-546 B.C.) has been credited with coining gold and silver ingots. Eventually, the innovation of stamped metal coins spread to the Greek world. Because the Greeks developed an urban economic system based on commerce a money commodity became necessary to facilitate trade. From this point forward, the use of precious metals as money used to conduct commerce was institutionalized between the developed societies of that day and has been used ever since. In matters of commerce, silver was used for smaller exchanges, while gold was used for larger transactions.
The reason that silver and gold began to be used as money was based on their unique characteristics. The use of money required several properties. It had to be divisible. It had to have utilitarian value separate from the whims of any king, emperor, or government. It had to be durable. It couldnt perish or be consumed. It also had to be relatively scarce to maintain its value. Finally, it had to be made of material that was ductile and malleable. Both silver and gold held these properties, which is why they began to be used as money. Ludwig von Mises tells us, "For hundreds, even thousands, of years the choice of mankind has wavered undecided between gold and silver. The chief cause of this remarkable phenomenon is to be found in the natural qualities of the two metals. Being physically and chemically very similar, they are almost equally serviceable for the satisfaction of human wants.
Universal Standards of Value
Because of the necessities of trade, standardized weights and measures had to be developed. Here again Ludwig von Mises clarifies through his theories on money that the reason why individuals began to value money was because they expected money to hold its value. This meant purchasing power. People would only surrender goods or provide services in the present only if that money unit could be expected to purchase the same goods and services in the future. Money functioned as a medium of exchange only if it maintained its purchasing power. A standard weight and measure had to be maintained or else money ceased to function as a medium of exchange.
Eventually, standardized weights and measures were developed for the coins of each country. The shape and size of the coin made no difference. What mattered was its content. Various coins of different nations were valued on the basis of their silver and gold content. The coins that maintained their silver and gold content became the coins of preference used in commerce. Any nation that expected to grow and expand its economy needed to maintain the standard of its money.
THE DEBASEMENT OF MONEY
As the use of money became widely used in commerce, standards of value were established trade and commerce flourished. As long as honest weights and measures were used, trade between nations and between peoples went on unencumbered. However, eventually kings, emperors and their governments began to debase their money. In order to finance a war, build monuments or palaces, or fund welfare programs, rulers required larger amounts of money. Wars were costly and could not always be funded through taxes. The money required to pay soldiers, buy armaments, and finance a campaign often required additional methods of financing. If the government couldnt raise the money through additional taxes on its people, governments learned the art of debasing their currency. In the ancient world before the invention of printing presses, emperors and kings resorted to nefarious ways to fool their own people. The common measure used to debase their own currency was through coin clipping and mixing inferior base metals into gold and silver coins. The government would simply chip away a part of a silver or gold coin and appropriate the shavings for itself. The shavings would then be melted down and made into new coins, which would increase the supply of money without having to mine more of it.
Another measure used was reissuing new coins that had lower amounts of silver and gold content. Lesser valued base metals such as copper would be mixed in with the silver and gold. Governments would also issue smaller size coins and declare they had the same value as the larger coins. Clipping, shaving, mixing base metals in coins became the standard method used by governments to inflate the money supply. No matter the method used to debase the currency, governments tried to fool the people hoping that nobody would notice. Eventually the populace caught on. The additional supply of money eventually drove up the price of goods. The price of everything went up as a result of additional demand brought on by an artificial increase in the supply of money.
An important concept to understand as it relates to money unlike other commodities is that an artificial increase in its supply confers no social benefit. The price of moneylike any other commodityis by eternal laws of supply and demand. Like any other commodity an increase in its supply lowers it price. Conversely an increase in demand raises its price. As Rothbard reminds us, What makes us rich is an abundance of goods, and what limits that abundance is a scarcity of resources: namely land, labor, and capital. Multiplying coin will not whisk these resources into being. We may feel rich for the moment, but clearly all we are doing is diluting the money supply Thus we see that while an increase in the money supply, like an increase in the supply of any good, lowers its price, the change does notunlike other goodsconfer a social benefit. Whereas new consumer or capital goods add to standards of living, new money only raises pricesi.e. dilutes its own purchasing power. The reason for this puzzle is that money is only useful for its exchange value its utility lies in its exchange value, or purchasing power.
What is even more important is that when money is depreciated, it leads to the moral and economic decay of a country. In the final days of the Roman Empire, its currency was depreciated repeatedly by successive emperors. During the first century A.D. the metal content of Roman coins was reduced by 25%, and during the second century A.D. it was reduced substantially more. Silver coins were reduced to the status of token coins. In the third century A.D. monetary inflation on a grand scale accompanied a succession of revolutions and civil wars The chaotic years, fifty years before Diocletian, 284-305 A.D. were, in the opinion of Tenney Frank, the period when Rome fell. There was anarchy and looting. Provincials lost faith in Rome. Industry and trade disintegrated, and even the Latin speech decayed. As a reminder of this truth I have on my desk at home a collection of Roman coins from the 3rd and 4th centuries. The coins feature the portraits of the last twenty Roman emperors. The coins are all bronze.
Debasement and Inflation: Modern Methods
These warehouse receipts eventually evolved as money substitutes and the modern era of banking was born. Eventually, paper money backed by gold and silver served as money in transacting commerce on a larger scale. Silver and gold coins still functioned and were used as money in day-to-day transactions by the common man, but in matters of commercial trade letters of credit, claims on bank deposits became commonplace. Instead of the transfer of paper receipts, the transfer of title or a book claim on the bank took their place. The owner of the claim had an ownership right in the stored gold at the bank. Thus the modern era of paper money and banking came into existence. As long as depositors had faith in the bank or currency of a country and a standard of value was maintained, the system functioned and prospered.
Standards of value erode over time.
Fractional Reserve Banking System
By its very nature, a fractional reserve banking system is inherently an inflationary institution. Banks as shown in the example above can expand the money supply by creating money out of thin air. They enjoy a unique privilege under our present economic system not available to you and me. As individuals the only way we can expand our bank accounts is through savings.
As mentioned above, the government has three ways of obtaining money. Unfortunately increasing taxes is not a popular choice. Taxation is unpopular with the people. The last two presidents to raise taxes in the U. S. were George Bush senior and Bill Clinton. Bush Senior lost his reelection bid over the tax issue and Clinton lost Democratic control over Congress. Because taxes are unpopular with the people, governments resort to an indirect means of taxation. It is what we know as inflation. If the government can find a means of expropriating resources without the direct knowledge of its subjects, they will do so. In effect what the government resorts to is a form of counterfeiting. By creating money "out of thin air, the government is creating its own money that wasnt appropriated directly through taxation. Counterfeiting is simply another name for inflation.
As I mentioned earlier, inflation creates no social benefit for society. It is simply a means of redistributing wealth from producers to nonproducers. Inflation creates no new wealth. No new goods or capital stock are created by it. Wealth is simply transferred to those who benefit first from the creation of the new money. This is usually the bankers and the financial system through fractional reserve banking or the government through debt monetization. It takes time for inflation to work its way through the financial system and the economy. Those who receive the new money first profit the most from it. By the time the expansion of money works its way through the system in the way of higher prices, the people are the last to know. The inflation profiteers have long since made their profits. Society as a whole must now bear the cost of that inflation through higher prices.
However, in order to keep playing the game and expropriate the people's money, the inflation profiteers must keep the people fooled. That is why all government and central bank actions are shrouded with an air of mystery or secrecy. FOMC meetings are enshrined with a religious reverence. The meetings are conducted under the air of priestly secrecy. In his book Secrets of the Temple, author William Greider says it well by stating, Like the temple, the Fed did not answer to the people, it spoke for them. Its decrees were cast in a mysterious language people could not understand, but its voice, they knew, was powerful and important The Publics confusion over money and its ignorance of money politics were heightened by the scientific pretensions of economics. Average citizens simply could not understand the language, and most economists made no effort to translate for them. 
To maintain the inflation game, it is important to keep people confused. In his book Dying of Money, author Adam Fergusson explained why the Weimar inflation was possible. He wrote, The most notable thing about the puzzlement of the financial world, not the least the writers of the Frankfurter Zeitung, was complete failure to consider the continuing flood of new banknotes as one of the reasons for the marks behavior (depreciation). Its latest fall was reckoned disastrous for the finances both of the Reich and of the regional governments: all efforts to restore order in the federal budget had been rendered void. It meant the further impoverishment of the classes on fixed incomes, state officials included, and (as another newspaper feared) further recruits for the radical circles of the Right from the 'social déclassés.
Ask any person today what causes inflation and they will tell you that it is rising prices. Like many issues on money, the inflation issue is clouded and confused. That is because the inflationists want it that way. By focusing attention on rising prices, it takes the attention away from the cause, which is excess money creation. Instead, all of the attention is focused on the symptoms of the disease rather than the root of it.
There are only three ways that prices can rise. The most important influences are as follows:
1.The supply of money and credit
2.Supply of goods and services
3.Demand for goods and services
Prices can increase by:
1.Increasing the supply of money
2.A decrease in the supply of goods and services
3.An increase in demand, i.e. population increase
Conversely, prices can decrease by the same three measures when:
1.The supply of money declines
2.The supply of goods and services increases
These are the only three ways that prices can increase or decline.
There is very little understanding of where inflation comes from or where it originates. Most individuals define inflation as rising prices. They speak about symptoms rather than cause. If inflation is simply rising prices, then what causes it? Youll find that inflation is attributed to many sourcesnone of which are accurate. The common misperceptions by policymakers and the public is that inflation has three principal causes:
1.Cost-push inflation as a result of arbitrary demands of labor unions.
2.Profit-push inflation resulting from the greed of businesses raising prices.
3.Crisis-driven inflation resulting from acts of God or weather.
The general belief that inflation is the result of something other than its true cause makes it hard to understand and resolve. Most people believe that inflation is conspiratorial such as OPEC raising crude oil prices, businessmen wanting to make higher profits, or unions looking to enhance worker benefits and pay. Somehow inflation has become an evil caused by greedy individuals and businesses. To most people inflation has become a causeless phenomenon inexplicable and born of ill will.
There is irrefutable evidence that government is the source of all inflation. An undue increase in the quantity of money is what stands behind a rise in prices. The source of all money or credit is government. Thinking of inflation only in terms of rising prices is similar to looking at the symptoms of a disease rather than the disease itself. A more exact definition of inflation would be an increase in the quantity of money and credit relative to available goods resulting in a substantial and continuing rise in the general price level, an increase in the quantity of money caused by government.
You will notice that this definition doesnt say anything about cost-push, profit-push, or crisis-push inflation. It simply states that the supply of money expands leading to higher prices. It is the expansion of money and not rising prices that leads to inflation. This also points to the real cause behind inflation as government intervention in the economy and financial system by expanding the supply of money and credit in the system.
When the government increases the supply of money and credit in the economy, it increases demand for goods leading to higher prices. Higher demand or lower supply is the only conceivable cause of higher prices. It can be demonstrated by the formula below: [Price Level = Demand/Supply]
To expand and elaborate on this formula, we must add a time factor, which is how long and how fast the holders of money decide to make it available. Lord John Maynard Keynes referred to this as liquidity preference, or how much and how long the holders of money liked to keep it on hand. The reverse of this is called the velocity of money, which measures the volume of purchases relative to the supply of money. Money velocity is the hardest to understand because it is dictated by psychological factors. The volume of spending within an economic system is not only determined by the supply of money, but also by the demand for money. The greater the demand for money, the greater is the preference to hold it. (Keynes liquidity preference) The smaller demand there is for money, the less preference there is by holders of money to want to hold or store it. Simply put, the greater the demand for money, the lower the velocity and the smaller the demand to hold money, the greater the velocity.
When individuals decide not to hold money and instead have a preference to spend it, the velocity of money increases. Likewise, when there are desires to hold money instead of spend it, the velocity of money decreases.
Therefore, to our quantity theory of money, we must add velocity to the equation. The new formula for price levels can then be stated as follows:
The new equation shows that the general level of prices moves in direct proportion to the quantity of money and its velocity. Price levels move in inverse proportion to the aggregate supply of real values. If money velocity is held constant, then price levels will depend on the quantity of money. It is only when people begin to distrust money and feel that the security of their money is being threatened that money velocity increases. When the value of money is insecure, the demand for it falls. There is less of a desire to hold it because its value is depreciating. People dispose of their money and find a replacement for it in tangible goods that are real. The desire to own commodities or real goods increases because these goods represent a better source for meeting future cash needs.
During the latter stages of inflation, money velocity increases because people no longer have faith in their currency. As shown in the chart below, the depreciation of the Reichmark increased as the supply of money expanded as did money velocity. Money velocity is a direct reflection of the degree of confidence that people have in their currency. A sharp increase in velocity normally takes places during the final stages of an inflationary crisis.
More will be written about this subject in later installments of this Perspective series. Suffice to say that when the money supply begins to rise money velocity lags. Stated another way, quantity leads and velocity follows. During the early stage of an inflationary cycle, price increases are muted by a reduction in money velocity. This is because the holders of money are willing to hold on to their money unaware that supply is increasing. Initially, interest rates fall due to the extra supply of money, which induces forced savings. The drop in money velocity during the initial stages of inflation represents unrealized depreciation of the currency. Later on as prices work their way through the financial system and economy, both money quantity and velocity begin to increase simultaneously. It is only during the final stages of inflation as shown in the chart above that velocity rises faster than the quantity of money. Therefore, during the early stages of an inflationary cycle, it is important to focus on the quantity of money. It provides us with a clue as to what follows afterward. For this reason we return to the quantity theory of money for a greater understanding.
This theory states that the general level of consumer prices equals the aggregate demand for goods divided by the aggregate supply of consumer goods. Therefore, the resulting rise in consumer prices is a function of a numerator (demand) divided by a denominator (supply). If there is a resulting change in price, it is the result of either a rise or fall in demand or a rise or fall in supply.
When the government or actions by the Fed increase the quantity of money in the economy, the demand for consumer goods is increased through the supply of new money being spent and re-spent within the economy. Since there is greater demand than supply, the price of most goods will go up. In the U.S. the rise in prices has not been commensurate with the supply of money and credit in the system because of imported goods. The trade deficit is a function of increased demand being satisfied by increasing imports. If the U.S. economy was self sustaining, self sufficient and able to meet all consumer demand, prices would have risen more substantially. Goods inflation has been somewhat tame only because excess demand in the U.S. has been satisfied through imported goods. Without the ability to import goods, prices would have been driven dramatically higher.
However, goods inflation eventually surfaces because a country with an expanding trade deficit eventually experiences a declining currency which raises the costs of imported goods. The graphs below of the money supply, budget deficit, trade deficit, and declining dollar are interrelated.
They are all attributable to an expansion of money and credit in the economy and financial system. Inflation and higher interest rates are often associated with government deficits. If these deficits are financed by selling bonds to the public or to institutions, there is no increase in the quantity of money. The existing supply of money stock is simply diverted from private to public consumption. Government budget deficits become inflationary when they are financed through new and additional money. This occurs when the Federal Reserve purchases government debt. In effect this is known as monetization. The full inflationary impact of the U.S. growing budget deficit has been mitigated by the purchase of government securities by foreign central banks and foreign financial institutions. The Fed hasnt had to resort to debt monetization because of direct foreign intervention in the currency markets.
As shown in the chart on the right, foreign intervention in the currency markets through direct purchases of U.S. Treasuries has prevented the full inflationary impact of government deficits from materializing. This enables the U.S. government to export its inflation. Japan and Chinas central banks purchased $300 billion in U.S. Treasuries last year.
This year that figure could go much higher. Japans Ministry of Finance has set aside $575 billion for dollar purchases, while China has allocated $150 billion. The two central banks combined have the ability of buying up to $725 billion in Treasury debt. This could produce a sharp reduction in the outstanding stock of federal government debt in circulation leading to lower interest rates. Intervention of this magnitude could give us a bond rally at a time when everyone is expecting higher interest rates. Indeed this is what has happened this year.
In a Nutshell
When new money and credit are created, they enter the system through various avenues. The money and credit can actually be spent on domestic goods and services, foreign goods and services or financial assets leading to higher asset prices. Goods inflation and asset inflation are really two different sides of the same coin.
Unlike the inflationary 70s when money and credit went into the real economy, since the early 80s and accelerating into the 90s, this new century money has been increasingly channeled into financial assets, creating asset inflation. This was visible first in the equity bubble of the late 90s. New money created by the Fed to fight off a collapsing stock market bubble, recession, and a major terrorist attack led to additional bubbles in the bond market, mortgage and housing market, and finally in excess consumption. Rising bond, stock and real estate prices are simply another form of inflation that has been created through excess credit and money added to our financial system. All of these related financial bubbles are what is keeping the U.S. economy going. The fact that P/E multiples on the major indexes are now at 48 on the NASDAQ, 20 on the S&P 500, and 18 on the Dow Industrials is another manifestation of inflation. Just as increased demand raises the price of goods, excess demand for securities raises their price. In this case, the price of bonds goes up, lowering their yield and the price of stocks goes up, leading to higher market multiples.
The U.S. economy has morphed from a manufacturing economy to a service economy and finally to a financial economy consisting of multiple asset bubbles. It has been one reason why job growth in this latest recovery has been so anemic. Money and credit are no longer going into the real economy in the form of new investment in plant and equipment which would create new jobs. Instead credit and money creation is fed into the financial markets leading to multiple asset bubbles in the stock and bond markets and real estate.
There's Only One Way Out
Given this new aspect of Americas economic life and the fact that the Fed and the government have no inclination to live within their means or curtail rampant money creation, new asset bubbles are going to be inevitable. While one asset bubble may deflate as was the case in the NASDAQ and tech stocks from 2000-2002, other asset bubbles in bonds, mortgages, and real estate took their place. The only thing that can force a government to balance its budget or prevent a central bank from issuing endless money is to limit the power to create money. That is possible only when the money unit of a country is backed by gold and silver. With gold and silver backing the monetary unit, the government is totally dependent on the taxpayer for every dime it spends. Tax rates would be far higher in order to support the governments voracious appetite for spending. Its citizens might not be as willing to accept tax rates that border on slavery.
Inflation is nothing more than an extension of taxes through other means. Inflation, then, is a hidden tax. Deficits and taxes are really the twin pillars of the welfare state. It gives the appearance that government benefits are free, making government out to be a benevolent Santa Claus.
What We Can Expect
Printing Presses in Overdrive
Asset Bubbles in Natural Resources
It is my belief that we are now embarked on a journey that will take us into a hyperinflationary depression. There may be brief deflationary spurts that punctuate this journey along the way, but an examination of history leads me to conclude hyperinflation is much more likely than deflation. Unlike the U.S. economy during the 1930s or Japan in the 1990s, the U.S. economy is no longer self sufficient in capital, manufacturing, and energy. And unlike the 1930s, our currency is no longer backed by gold. The U.S. is now the worlds largest debtor nation versus the worlds largest creditor nation as we were in the 30s. We are no longer self sufficient in energy as we were during the last depression. We import 60 percent of our energy needs, a percentage that is growing each decade. We must also compete with other nations for the worlds last remaining barrels of oil as we enter into the twilight of the oil age. During the 30s the U.S. created the Texas Railroad Commission to regulate oil and prop up prices because of the abundance of oil in this country. In contrast to the 1930s, U.S. oil and natural gas production decline each year. This forces the U.S. to import more of its energy needs, energy we pay for with dollars. When the world no longer accepts those dollars as payment, the full impact of inflation will hit home.
I would like to end with a quote from Jens O. Parssons book Dying of Money. It perhaps explains best where we are today and where we are headed.
Everyone loves an early inflation. The effects at the beginning of inflation are all good. There is steepened money expansion, rising government spending, increased government budget deficits, booming stock markets, and spectacular general prosperity, all in the midst of temporarily stable prices. Everyone benefits, and no one pays. That is the early part of the cycle. In the later inflation, on the other hand, the effects are all bad. The government may steadily increase the money inflation in order to stave off the latter effects, but the latter effects patiently wait. In the terminal inflation, there is faltering prosperity, tightness of money, falling stock markets, rising taxes, still larger government deficits, and still roaring money expansion, now accompanied by soaring prices and ineffectiveness of al traditional remedies. Everyone pays and no one benefits. That is the full cycle of every inflation.
© 2004 James J. Puplava
 Rothbard, Murray N., What
Has Government Done to Our Money?, Ludwig von Mises Institute, 1990,
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