If you’ve heard the euphemism “quantitative easing”, think of it as inflation in a nutshell. When greater quantities of money are flushed into the economy to ease financial strain, your money loses its value. Then, you have to earn higher wages just to keep your income at the same level. You have to invest your money in ways that will keep growing to beat the rate of inflation. And you have to learn to live in a world where the value of money is uncertain. Since you spend your days trying to make money, your very life becomes uncertain when you can’t be sure what will happen to the money you spend your time earning. Retirement becomes uncertain. Preparing for medical emergencies becomes uncertain. Being able to keep a roof over your head or even a job become uncertain.
So What causes this hemorrhaging of the value of money, which drains your life away drop by drop? There’s much more to the question of inflation and how it devalues your money than you realize.
Government Prints More Money
You’ve probably heard the simple explanation that government prints money, which results in inflation. That is certainly one cause. The more bills are out there, the more money exists with which to buy the limited goods currently available. When goods start selling faster due to the increase in money supply, a shortage arises and then manufacturers raise prices to try and limit this rush while they expand their factories and businesses to be able to produce more goods.
Printed Money Goes into Specific Areas
There’s a secondary consequence of inflation that causes money to lose its value faster. When government increases the money supply through printing more notes, the money isn’t handed out evenly to every one of us. Instead, the government decides how to spend the money, for example on fixing up old schools. Suddenly a lot of money is spent in one segment of the economy. Builders start giving precedence to school projects, because that’s where the good money is at. Companies create better products for school building, because these sell best. As a result the economic weight of one industry suddenly become inflated compared to others. Building schools becomes more expensive because of the high demand for building materials and manpower. Any industry related to this trend will be affected as well. Then, people who don’t benefit from the increase in business will find themselves paying more for certain goods, for example home renovating products, while their own income didn’t rise to offset this sudden inflation in prices.
Printed Money Goes into Specific Pockets
Even worse, inflation devaluates your money in a very selective way. Not only is the additional printed money distributed into a specific area of the economy (inflating it artificially), the money is given to a limited group of people. Anyone who is close to the government, or who has influence enough to win the bids for projects or get a share of the newly printed money, will suddenly have an increase in his income. Since prices take time to rise when new money enters the economy, this limited group of people can use their new money to buy goods and services at old prices. Then, by the act of buying these things, they will put inflation into action (introduce the new money into the economy), and make everything else more expensive for the rest of us.
Inflation Across the Board
Though inflation will typically begin in a specific area of the economy where the newly printed government money will be spent, eventually the money will circulate and affect everything. That’s when you’ll feel that your money lost its value everywhere. Food and gas are more expensive, as are repairs to your car or home or the purchase of new clothes or leisure activities. This makes perfect sense given that we all use money to barter and trade. Money keeps changing hands in ever growing circles, and eventually the $1000 (USD) people had in the year 1800 becomes equivalent to over $12,000 (USD) in the year 2009.
Inflation Through Loans
When a bank sets a low interest rate on certain types of loans, it encourages people to borrow that money. Therefore, if loans are extremely low on homes, people are likely to cash in on the opportunity and either buy a home for the first time or get a bigger home. Suddenly, this new flow of money into this specific area of the economy creates a huge surge in home building, home buying and, consequently, in home prices. So where do the banks get their money? From the Federal Reserve.
The Federal Reserve is a bank that purports to be a private institution, but which is really the bank that gives government the money it needs to pursue its agendas. The Federal Reserve prints our money. It lends this money to banks at a certain cost and decides what the cost should be when the banks lend that money to us. To encourage home ownership in the United States, the Federal Reserve, following government laws and agenda, provided money to banks to lend at low rates to borrowers who would not qualify for loans in the past. Don’t worry, said the Federal Reserve in essence, we’ll back you if the loans go bad. Suddenly, banks had no interest to lend money wisely or protect the value of our money.
Inflation Through Fractional Reserve Lending
To me the most shocking aspect of inflation and the devaluation of our money relates to how much money banks can lend out. In the old days (200 years ago), a bank was only legally permitted to lend out a portion of the total money it possessed. Let’s say, the bank opened with an initial investment of $25,000 Dollars of its own money. It could lend this money at interest and so make more money. When locals started to trust the bank, they would deposit their own money there for safe keeping in case of home invasions. The bank had to be very careful who it lent money to. It also had to keep enough money on hand to be able to pay off all its depositors should they all come knocking on the door at once, asking to withdraw their money.
Some bankers weren’t happy. Since all the people in the community never came, all at once, to ask for all their money to be drawn out at the same time, some bankers wanted to start lending more than they had in their vaults. After all, what’s the problem? If normally 10% of the people wanted their money back in a year, a bank will have more than enough if it kept no more than 30% of all invested money on hand. When government changed the laws to allow banks to keep only a fractional reserve of money compared, a new age in banking began, and in inflation and the devaluation of our money came with it.
Run on the Banks
Suddenly, the money supply in the economy grew. Money that you or I set aside for savings was suddenly flushed right back into the economy without our knowing. With more money in the economy, prices started to rise. Inflation was trotting forward. Sometimes the community would get wind of the fact that a bank was lending more than it had, and then people would rush to the bank all at once, demanding their money. Pretty soon, the bank would finish off its fractional reserve and collapse. Bankers didn’t like this slap from reality. They wanted to protect themselves by binding together. If one local branch folds, the branch in the next city will keep it afloat. If banks were big enough, the scheme of devaluing our money through fractional reserves lending could continue without us guessing anything. But even this wasn’t always a fail proof system. “A run on the bank” became a familiar term. The biggest bank of all had to be created to protect all the banks once and for all.
Inflation Through Monetary Control
One bank for the whole country was the answer bankers came up with. It took them many, many years of political maneuvering to get the Federal Reserve approved by law. From then on, all banks were protected by this papa bank that could play around with the value of our money at will. If a nationwide “run on the bank” occurred, the papa bank could potentially print as much money as needed to make it seem that all the money was paid back to people like you and me. Of course the huge inflation in the amount of money will cause its value to plummet. But why is that? Why can’t the Federal Reserve just print more and make everyone richer? The answer lies with the nature of money.
What Is Money?
Money is a symbol used for large scale trading. Between the farmer and the scythe maker there’s no need for money. They can trade wheat for scythes and vice versa. But what if the scythe maker needs shoes? He can’t trade scythes for shoes because the shoemaker doesn’t need scythes. Instead, they use an agreed upon commodity that represents a certain value in the community. In prison camps in war times, cigarettes were used as money. Butter was once used as money in poor rural areas. But typically gold, silver or another metal was used throughout history to create money for trading.
Why Use Gold for Money?
Gold has always been the favorite metal for money for several reasons:
1. There’s a limited supply of gold, so no one can suddenly increase the supply of gold coins and decrease the value of money.
2. Gold can be melted and shaped into whatever accepted form the community agrees on.
3. Gold is indestructible. It will keep its shape and won’t go bad with time (as butter would).
4. Gold is light. You can stick it in your pocket and go.
5. Gold can be used for other purposes than money, such as jewelry, so it has a real value in addition to its monetary purpose.
What Determines the Value of Money
To total amount of gold or paper bills available at any given time could potentially buy everything that people want to barter and trade. The value of the money comes from the value of the things it can buy. If you just print more money, you’re not actually creating any value, anything that money can buy. It’s like spreading the butter on two slices of bread instead of one-you still have the same amount of butter. The only way to increase the value of money is to reduce the cost of buying things.
This can happen when an invention makes it far easier and cheaper to make something. After the Industrial Revolution the prices of many things dropped enormously. Suddenly everything became affordable to everyone. The value of money went up without a single bill needing to be printed. 1 Dollar could buy you 100 times more than before.
In short, to increase the value of money, you don’t need to print more of it, you need to produce something that money can buy. It can be something that exists and you offer it more cheaply. Or it can be something that didn’t exist before at all.
To increase the value of money, things need to be created in reality. Money is just a representative, a symbol. And to answer the last objection often raised–that gold can be mined for the purpose of increasing the money supply-keep in mind that the cost of mining is high and the more you mine the deeper you have to go to find new gold. Consequently, the price of gold will go up because the cost of getting it will go up. This will reduce people’s ability to buy it and miners willingness to mine for it. The money supply when it comes to gold will be kept in check.
If you want to learn more about inflation, the value of your money and the role the Federal Reserve Bank plays in destroying the value of your money read The Case Against the Fed, by Murray N. Rothbard. To understand what happened with the housing bubble of the early 21st Century and the devaluation of the US Dollar, read Meltdown, by Thomas E. Woods, Jr.
For more of my articles on economics, read What Is Austrian Economics, and Buying Gold Coins: Dos and Don’ts.