Inflation: A Word Of Caution

My concern regards paper money. Specifically, what defines the Canadian dollar? A dictionary definition describes a dollar as being a basic monetary unit equivalent to 100 cents. Further reading reveals that a cent is equal to 1/100th of a dollar. This tautology is clearly an unsatisfactory answer.

Units of measure that are used within Canada are clearly defined within the Weights and Measures Act. This document legally defines the terms expressed within.

For instance, a metre is not defined as simply being a measure of length equal to 100 centimetres, but as, please bear with me . . . "equal to the distance travelled by light in a vacuum during 1/ 299,792,458 of a second". The second is also defined, precisely as being, "9,192,631,770 periods of the radiation corresponding to the transition between the two hyper fine levels of the ground state for the cesium 133 atom".

Now, as seemingly arbitrary as these definitions may be, they do nevertheless define the terms in a precise manner. These measurements do not change, as they are defined by a measurable and external standard.

The dollar, is also a unit of measurement, that being one of money. But, it seems unique when compared to the other units of measurement, that the dollar does not have a formal definition. In fact, it is constantly changing in value.

How can something that is constantly changing in value be used as an effective unit of measure?

On the official homepage for the Bank of Canada, there is a picture of the Ottawa headquarters with an underlying caption. It reads, "We are Canada's central bank. We work to preserve the value of money by keeping inflation low, and stable."

Inflation. Now, that is a very interesting term.

Historically, inflation referred to the expansion of the money supply, analogous to a balloon being inflated with air. Then it changed, to describe the phenomenon of rising prices. More recently, it now refers more and more to asset prices.

Deflation, the opposite of inflation has similarly changed.

So, in the 1960's we had inflation - that is to say, an increasing supply of money. In the mid-seventies, and early eighties, we also had inflation. But, at that time it referred to rising consumer prices. Nowadays, we hear a lot of fearful talk, regarding deflation. This now refers more to falling asset prices such as for houses, and the stock market.

So, what is the problem? Well, without a standardized unit of measure it becomes difficult, and potentially impossible, to gauge progress, or to forecast into the future.

While, the official prognostications today are concerned with deflation, that is to say, declining asset prices, the amount of new physical dollars in circulation has risen from 44 billion in 2005 to over 56 billion today. That is a 26 percent increase!

This will lead to higher consumer prices. We, nearly all of us, will have to work longer and harder to maintain our standard of living. Newly created dollar bills do not add wealth to a society; instead it transfers wealth from the people who already hold dollars to those people who receive the new money. It places pressure on consumer prices to increase. This hardship most affects the poorest segments of society. If wealth could be merely created by adding more money, then mankind would have eliminated poverty long ago.

New money distorts markets. As it moves preferentially into certain sectors - bidding up prices in those areas first receiving it. This creates a boom. Business owners believing the booming market represents real demand, create more infrastructure. They risk more time, effort and capital than they might otherwise have done if they had not been misled by the new money. This is called "malinvestment". Recessions are caused when the misallocation of these resources is realized. In effect, a recession is the market outlook returning to a more accurate appraisal of reality. It is a painful, yet curative process.

However, during a recession governments take populist actions to avoid the economic hardship incurred from the liquidation of malinvestment. They seek to prop up the misallocated capital which sought the mirage of profits caused by the newly created money. This simply postpones the inevitable correction and by doing so, compounds its destructive effects.

Those attempts, are funded with additional new money. That, in turn sparks yet another inflation induced boom. This in essence is the Boom-Bust cycle. However, this is not how the process is taught in universities across the country. It is described instead as an intrinsic feature of free markets. In reality, it is an inevitable result of increasing the supply of money. In other words, it is a result of deliberate policy and not, to use a phrase from an influential economist, "Animal Spirits".

Anyone, who understands the exponential nature of this cycle, will be able to predict, that like a heroin junkie attempting to escape a painful withdrawal, the dosage must increase. An overdose for the junkie results in death. An over-issuance of currency destroys all market confidence of the currency, through a process, known as "hyperinflation".

Much of the new money goes towards government. Government, who borrows this money, uses tax revenue to cover the interest. Since the amount of money to be paid back is always greater than that borrowed due to the added interest, governments must continuously borrow, in ever-increasing amounts. Again, this is an exponential function. It is ultimately unsustainable.

So, in summary, an undefined monetary unit permits an unlimited expansion of the money supply. An increasing money supply causes the following major phenomena:

- Currency devaluation

- Provides upward pressure to consumer prices

- Increases required effort to maintain a standard of living

- Causes the boom bust cycle through the process of malinvestment, and finally

- It promotes unsustainable government borrowing.

It does not have to be this way. Governments have authorized a monopoly to specific monetary authorities. If this monopoly was no longer enforced, citizens could use whatever medium they wished to use for exchange. This would at least provide an option.

The availability of this option would instil better governance because, should the general population ever perceive a devaluation of the existing paper money, they could proactively exchange their holdings into an alternate form of money. Governments would necessarily have to be more fiscally responsible. At the moment they can always rely on borrowing more new money.

To some degree, an alternate form of money already does exist. As record nominal prices for gold indicate, a certain portion of society is already transforming their wealth into something they believe will better hold its value.