The Price We Pay

All prices are ratios. The price of an item in US dollars is determined not just by the item's supply and demand, but also by the dollar's supply and demand. This is why, assuming all else remains equal (a dangerous assumption), an increase in dollar supply will lead to an increase in prices. Furthermore, rather than looking at prices in the usual way - as changes in the value of something in terms of the dollar (or some other national currency) - we can consider them as changes in the value of the dollar in terms of the things we buy. For example, a gold price increase from $300 to $600 would normally be considered as a doubling of gold's value, but it could equally be considered as a halving of the dollar's value. 

What point are we trying to make? Simply that the way we express a price can change our perception. When the price of an item changes, that change may have a lot more to do with money supply and demand than it does with the item's supply and demand. Sometimes, thinking in terms of a change in the worth of the dollar provides a better understanding of what is happening with prices.

We were prompted to discuss this topic by an e-mail we received in response to one of our recent articles. The author of the e-mail argued that the world was headed for a deflationary collapse that would take the gold price to $100 and the oil price to $6. 

When someone talks about gold going to $100 and oil going to $6 they are effectively saying that the US$ is going to become 3 times more valuable than it currently is. Since the US$ is managed by an institution that has the power to monetise every private and public sector debt in the country if it chooses to do so, and since this institution has clearly chosen to follow a policy of inflation, a tripling in the value of the dollar relative to hard money and essential resources seems unlikely in the extreme. 

The Fed, of course, won't monetise every debt in the land. It won't have to. However, the experience of the past 3 years has told us that it will go as far in that direction as it needs to go to avoid deflation. Every new economic and/or financial crisis over the past 3 years has been met with a deluge of new money and there is no reason to expect a policy change at this time. As we've noted in prior commentary, a policy change (from promoting inflation to fighting inflation) will only occur when it absolutely has to occur, that is, after the effects of inflation have caused so much pain that a directional change becomes necessary. We are clearly a long, long way from such a time. It is worth noting that the Japanese took a totally different path (they chose not to inflate-away their debt burden), perhaps because they had (and still have) trillions of dollars of savings to protect. American voters do not have savings, they have assets and debts.

Statistics such as the CPI are attempts to measure the effects of inflation. It is, however, impossible to accurately measure the effects of inflation because there is no way of knowing how the excess money was used. We can make assumptions, for example if the trade deficit surged during a period of high money supply growth while consumer prices remained stable we could assume that a large proportion of the excess money was used to purchase imported goods. Similarly, if stock prices moved well above levels that would normally be considered reasonable (reasonable, that is, based on the earnings of the underlying businesses) then we could assume that a significant portion of the inflation was channeled towards the stock market. However, there is no way of accurately measuring what proportion of any price rise is a result of inflation, particularly since the cause (inflation - the money supply increase) and the effect (rising prices) are usually separated in time by more than one year. This is, of course, the inherent problem with inflation - it confuses price signals and thus leads to poor investment decisions. 

Thinking of inflation as being represented by a change in the Consumer Price Index, or any price index for that matter, is not only wrong it is dangerous. Doing so leads to the conclusion that today's break-neck money supply growth rate is not a problem simply because prices have not yet responded. Such 'logic', when practiced by those responsible for framing monetary policy, will inevitably lead to an even greater inflation problem in the future.

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