INFLATION - Central banks are the engines of inflation. Whether it is the Federal Reserve in the US or the Bank of England in the UK, the sole purpose of these institutions is to inflate. At the same time, they understate the ongoing inflation problem and manage the public's fears. Therefore, in order to protect your wealth in this era of constant inflation, it is absolutely essential that you properly define and understand inflation. In other words, you need to distinguish between "cause" and "effect".

Today, most people have been conditioned to believe that inflation is an increase in prices as captured by the official "Consumer Price Index". However, the truth is that inflation is an increase in the quantity of money and credit. As the supply of money and credit are inflated (the cause), prices of goods, services and assets rise within an economy (the effect). Allow me to explain:

An over-supply of an item causes its value to diminish due to abundance. For example, a bumper crop of wheat will cause its market value to decline. On the other hand, a shortage of an item causes its value to appreciate due to scarcity. For example, a poor harvest of wheat will cause its market value to rise. Similarly, when you have a constantly increasing quantity of money and credit available within an economy, its value will continue to diminish. In other words, the purchasing power of each unit of money will dilute requiring more and more quantities of money to purchase the same amount of goods, services and assets within an economy. This "confiscation" of purchasing power is the biggest consequence of inflation.

Monetary inflation has another other dire consequence; it does not affect everybody in a uniform manner and causes a great wealth-divide. People who get access to this newly available money first, and most importantly BEFORE the remaining population, gain the most as their incomes rise prior to any increases in the prices of things they buy. In contrast, impoverished people in the remote areas of the economy who have not yet received the new money get robbed as they find that the prices have already risen before the new money has had a positive impact on their incomes. Furthermore, inflation also causes grave distortions within an economy. As this ever-expanding supply of money spreads through the economy, it causes gigantic "asset-bubbles" and the inevitable busts resulting in much hardship and wealth destruction for the majority of people. The most recent example being the sharp 10% intra-day decline in Chinese stocks.

So, if inflation is such a menace for society, why do the central banks continue with their inflationary program? And why do they claim that they are fighting inflation?

Banks are in the business of lending money in exchange for interest. The more credit they create, the greater their income through the collection of interest. Under "normal" circumstances and as long as the public is not worried about inflation, banks continue to inflate. However, for this immoral system to work and be accepted, the public must remain oblivious; hence the constant official propaganda of fighting inflation.

Occasionally, a situation arises whereby the public panics about the loss of the purchasing power of their savings. This causes people to start exchanging their paper money for tangible assets. Under these circumstances, banks momentarily stop their inflationary program and raise interest-rates to show they are indeed "fighting" inflation; a monster which they themselves created in the first place! This scenario occurred in the late 1970's, when Americans started dumping their US Dollars in exchange for gold and the Federal Reserve had to intervene by substantially raising interest-rates.

If you still have any doubts about the constant inflation agenda, you may want to note that despite the highly advertised recent monetary "tightening", US bank credit has continued to surge and currently stands at a record US$8.4 trillion. In fact, US bank credit rose 9.4% over the past year which is close to the record-high annual growth rate of 11.2% recorded in December 2005.

Furthermore, our planet is still awash in a sea of inflated "paper money". Non-gold international reserves held by non-US central banks are also at a record-high (US$4.92 trillion). Emerging nations hold a record-high US$3.52 trillion and the industrial nations hold US$1.4 trillion. It is interesting to note that China's reserves alone have soared to over US$1 trillion, whereas Japan's reserves are now around US$880 billion with no signs of a slowdown in sight (Figure 1). Finally, Asian central banks (excluding China and Japan) own another mind-boggling US$1.17 trillion of paper money.

Figure 1: Surging non-gold reserves

Source: Dr. Ed Yardeni

This ever-expanding quantity of money and credit may eventually contract. However, in the meantime, central banks have plenty of methods they could use (if required) to flood the world with additional supplies of Dollars, Euros, Pounds or Yen. Therefore, with further inflation and loss of purchasing power almost a certainty, as investors, we must try and identify those assets which are likely to benefit from this monetary malaise.

In a world of inflated asset-prices, precious metals, energy and agricultural commodities are still inexpensive in real-terms and (especially) relative to financial assets. Furthermore, given the massive Chinese demand for natural resources and tight supplies, I believe that this sector will continue to be the biggest beneficiary of monetary inflation over the coming years.

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© 2007 Puru Saxena

ABOUT THE AUTHOR

Puru Saxena is an investment adviser based in Hong Kong, he is a regular guest on CNBC, BBC, Bloomberg, NDTV Profit and writes for several newspapers and financial journals. He is the editor and publisher of Money Matters - an economic report, which is read by professionals and investors in numerous countries all over the world.

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Posted in Monetary Commentary, Guest Commentary, Puru Saxena