The Most Important Financial Question You Must Ask


What is inflation?

I believe this is the most important financial question a person can ask. I am constantly on a trek to better understand money and wealth. Here is some of what I’ve learned thus far:

Per its original meaning:

  • Inflation is not a rise in prices
  • Inflation is a rise in the money supply

I have a 1920 Webster’s dictionary that says inflation is a rise in the money supply. I have a 2006 Webster’s dictionary that says inflation is a rise in consumer prices. From this point forward, I will use “inflation” for its original definition (an increase in the money supply) and I will use “price inflation” to refer to a general increase in  prices.

How did this “Newspeak” happen?

Inflation is harmful because it leads to a rise in prices. When everyone’s expenses are rising faster than their incomes as a result of the actions of the government and banking system, it is like a tax on the American people.

With the harm being a rise in prices, the focus on the topic of “inflation” shifted from the cause (inflation) to the effect (rising prices). And so, over a period of decades, everyone (news media included) shifted into speaking about inflation as a rise in prices.

Why don’t inflation and price increases correlate directly anymore?

You can take simple economic examples and draw a direct correlation from increasing the money supply to a rise in prices not complemented by a rise in incomes. These are usually fictional stories of a group of people being stranded on an island and creating their own economy. They will illustrate with great clarity that increasing the money supply takes from the regular person and gives to the banker or his friends (such as the government).

Now apply those concepts to our current economy and you will be so confused, it will be easy to surrender to saying, “Gosh this stuff is for super-geeks to figure out and I’ll just go with whatever is reported to me.” Of course, we’ve learned that following the crowd and getting your information from normal reporting sources is a sure way to be led off the edge of a financial cliff.

Why do these simple concepts work in simple, theoretical economies and not our real economy? Why can’t we draw a direct correlation between inflation and price increases? We are on a trajectory away from a free market. Our country started with a 6 page Constitution. People and businesses were once operating in a free[er] market. We developed our understanding of the economy based on a free market. Today we have over 100,000 pages of laws and regulations. And each year we add to the pile. Almost every law interferes with the way things occur naturally. And almost every law takes us one step further away from a free market.

Our understanding about economics and money is based on the past, but we are in the present. In the case of inflation and price inflation, manipulations make the connection difficult to see. In a free market, inflation would create  price inflation clearly and directly. But in our economy, the government has already tinkered with prices in countless areas. There are subsidies, tariffs, minimum price mandates, maximum price mandates, etc, etc. The buyers and sellers of the market don’t come together to determine price. They come together to try to transact within the confines of the 100,000 pages of laws and regulations that the government imposes. Within that system the price of one thing may skyrocket while other things stay the same.

What does monetary inflation do today?

In the case of the housing bubble, the Fed created tons of money through interest rate manipulation. In a free market that new money would have gone everywhere and prices of everything would rise. In our actual market, Fannie Mae and Freddie Mac (government-sponsored enterprises or GSEs) then attracted mortgage borrowers in ways that non-GSE private businesses couldn’t. That directed all of the new money into real estate and took its prices to the moon and then back down to earth. Now we all have whiplash and lighter pockets.

Meanwhile, the government organization that measures price inflation (BLS) has found that reporting price inflation (through CPI, the Consumer Price Index) is quite challenging. “Man, what do we do?! The prices of certain things are moving erratically!” thought BLS. They (and other governments) decided to make many adjustments to not count things rising rapidly in price. Through many phases of altering their calculations and adjustments, CPI charts have effectively become pieces of art with the economic utility of a Jackson Pollock piece.

The other day, somebody sent me a link to this chart and asked me what can be drawn from it. I replied that data was gathered, processed and reported differently from one decade to the next. It would be like taking the price of apples in the 50s, bananas in the 60s, oil in the 70s, cotton in the 80s, and wheat in the 90s. Now put that onto a chart. What does it mean? Nothing. Just like price inflation. CPI didn’t report the same thing 20 years ago as it does today, and putting the different reports on a chart and connecting dots with lines is almost as arbitrary as children’s connect-the-dot puzzles.

The difference is the child knows it’s a meaningless game. With our arbitrary line graph puzzles, we make big decisions based on them. Ouch.

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