Inflation and deflation

Puru Saxena - Wed 23 Nov, 2005

...The entire investment community seems to be obsessed with the appointment of Ben 'Helicopter' Bernanke as the new Chairman of the Federal Reserve. What will the new maestro do? Will he continue to raise interest-rates? Will he target inflation? Let me first explain the key concepts of inflation and deflation...

Inflation and deflation

The entire investment community seems to be obsessed with the appointment of Ben 'Helicopter' Bernanke as the new Chairman of the Federal Reserve. "What will the new maestro do? Will he continue to raise interest-rates? Will he target inflation? How will the markets react?"

Such questions have been popping up almost everywhere. I am going to address some of these issues here. But first, let me explain the key concepts of inflation and deflation.

The widespread belief is that the Federal Reserve is currently increasing interest-rates to "control" inflation. This misconception stems from the fact that most people don't really understand inflation. The great majority thinks that inflation is an increase in the prices of goods and services, which is totally incorrect. In actual fact, inflation is defined as an increase in the quantity of money. A general increase in prices is merely a consequence of inflation. An over-supply of money (inflation) causes its value to drop and it takes more money to buy the same quantity of goods and services, causing prices to go up.

In addition to this, the consensus is that deflation is a fall in the prices of goods and services, which is also inaccurate. It is crucial to understand that deflation is in fact a decrease or contraction in the quantity of money. A general decline in prices is merely a consequence of deflation. A reduction in the supply of money (deflation) causes its value to rise and it takes less money to buy the same quantity of goods and services, resulting in lower price levels.

Inflation and deflation: 'The public remains oblivious'

The fact that the public does not understand inflation or deflation allows the central banks to carry on with their money printing agenda - be in the US, Britain, Europe or Japan. All the while, the public remains oblivious.

When the Federal Reserve was established in December 1913, its objective was to "control" inflation. Well, I hate to break this to you, but the Federal Reserve has failed in its task of "controlling" inflation. In fact, the US dollar has lost 95% of its purchasing power through money printing (inflation) since the Federal Reserve came into power. In other words, $1 saved in 1913 is only worth 5 cents today! This is an outright confiscation of hard-earned savings.

US consumer prices only started to go up after the Federal Reserve came into power in 1913. It is interesting to note that money lost most of its purchasing power after gold was removed from the monetary system in 1971. Once the Americans made gold redundant, central banks around the world were allowed to print as much money as they wanted -since money was no longer backed by a tangible asset.

And print money they did! This reckless printing of money is the reason why things have become so unaffordable for most people.

The grim reality is that the modern day central banking IS inflation...and the quicker we get used to this idea, the better. The deflation scare is nothing more than a decoy, which the central banks use in order to continue with their money-printing (inflationary) program.

Inflation and deflation: The Japanese deflation scare

Still not convinced? Then, consider the greatest fabrication, the Japanese "deflation" scare.

For years now, we have been told repeatedly that the root cause of Japan's economic problems is deflation. We have been forced into thinking that deflation is the culprit. Allow me to share a secret - the central banks want you to believe that deflation is a total disaster so that they can freely print more money, thereby creating inflation. After all, who benefits from the monetisation of the economy?

Despite all the brainwashing, close inspection reveals that Japan never really had any deflation! The truth is that throughout the past 15 years, Japan's money supply has continued to grow (inflation). Japan has witnessed inflation, and not deflation, since 1980. Sure, Japanese asset prices have fallen since 1990, but the cause is not deflation, as advertised by the establishment. In fact, a sharp rise in interest-rates was the trigger, which caused the Japanese stock and property bubbles to burst.

Inflation and deflation: 'Controlling' inflation

These days, we are being told that the Federal Reserve is raising interest-rates to "control" inflation. If the Federal Reserve were really curbing inflation, why would the American money supply continue to surge despite recent interest-rate hikes? Despite all the noise about inflation, the Federal Reserve has added roughly $1 trillion to the system over the last year.

So, on one hand, the Federal Reserve continues to inflate, and on the other hand, it is raising rates. "But why would they do that?" you may ask. You see, the US economy is in a mess, and a true contraction in the money supply (deflation) would send the whole world into a severe recession. Under this scenario, millions of companies and individuals would go bust and the entire financial system may collapse. Therefore, you can rest assured that the Federal Reserve will continue to inflate for as long as possible. It is shocking to note that the broad-based money supply (M3) has increased from $ 6.5 trillion to $10 trillion in five years - representing a 54% increase!

Yeah, Greenspan did a fine job "managing" inflation!

As far as the current situation is concerned, I believe the Federal Reserve is raising interest-rates to prevent an outright collapse of the US dollar. A weak currency needs to offer a high yield (interest) in order to attract capital. Indonesia, Russia, Brazil and Venezuela come to mind. Today, the United States is the world's largest debtor nation, and its current account deficit stands at $730 billion or 6.3% of GDP. Students of economic history know that no other country or its currency has ever managed to get away with such economic murder. It must be obvious to both Greenspan and Bernanke that the US dollar is skating on very thin ice. In an attempt to rescue the situation, interest-rates in the United States are being pulled up to increase the demand for dollars.

In my view, interest-rates in the United States will rise much higher than most people expect at this time. If history is any guide, Mr Bernanke will continue to inflate the money supply whilst increasing interest-rates over the coming months.

Already, he has talked about dropping dollar bills from helicopters. Well, at least the guy is honest!


Regards,

Puru Saxena
for The Daily Reckoning

P.S. "At some point, America's debts will probably be incinerated by inflation," write Bill Bonner and Addison Wiggin in their new book, 'Empire of Debt'.

"When the howls from consumers and voters grow loud enough, the Feds will panic. In desperation, Ben 'Printing Press' Bernanke will point toward Argentina."

"There," he will say, "that is our only way out..."

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