How much inflation is there in an economy? - The Daily Reckoning
The Daily Reckoning by Bill Bonner
On This Day - 29 January 2014
How much inflation is there in an economy? A  A  A

Baltimore, Maryland

Yesterday, we reported on the latest money woes in Argentina. Today, we turn back to the USA. The Dow caught a bid yesterday, with a 90-point rise, bringing it to rest at 15,928. That's 15,017 points higher than the low it hit in 1981, just after Reagan was elected. Then, in 1982 US stocks began a sustained and spectacular rise. Over a 33 year period, the value of America's most important corporations was multiplied nearly 16 times.

But wait, did we say 'value?' We meant price.

Prices are notations, bearing relative information. If you have a stock that went up to $100...and your brother-in-law's stock went up to $200, your brother-in-law just got lucky. You wisely bought the more conservative stock and protected your family from the risk. Good on you.

But if the general consumer price index - starting at the same base - rose to $300, during the same period, both you and your brother-in-law are chumps.

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It is notoriously difficult to say exactly how much consumer price inflation there is in an economy. Any answer comes with caveats and health warnings. Argentina's official inflation number, for example, needs more than the usual boilerplate. Officially clocked at 10% for the last few years, the real rate, according to Johns Hopkins professor Steve Hanke, is 63%.

If that is so, wages, dividends, and asset prices all have to be adjusted downward. Based on Professor Hanke's number, almost all the Argentines are chumps, as almost no asset or income stream can keep pace with the falling peso.

In America we don't have to worry about such high inflation rates. We have the Federal Reserve, charged with the mission - among others - of making sure we have a 'stable currency.' Back when that job was confided to it, in 1913, there seemed little doubt that it would be up to the task. Consumer prices in the US had been more or less stable since the founding of the Republic. There have been periods of rising prices -- such as the War Between the States - and periods of falling prices - such as the last quarter of the 19th century. But consumer price inflation never developed a real purchase in America until the Fed was set up to prevent it. Since then it has been off to the races.

It would be easy to explain this phenomenon simply as "the Fed printed too much money." But that is not the way it works. The Fed can add to its assets by buying bonds. That's called 'state money' - and it's only 15% of what is measured as the 'money supply.' The rest is 'bank money.' The banks create money when they make a loan. If you borrow $100,000 to build a house, for example, a bank may "print" $90,000 to lend to you...retaining only $10,000 in real capital in reserve. If the bank made 10 loans like this, it would have added $900,000 to the 'money supply,' which would then be spent by consumers. Assuming prices are set by supply and demand, this $900,000 would weigh in on the demand side; prices would rise, signaling to producers that it is time to increase supply.

Multiply this phenomenon millions of time. Add Paul Volcker's tough love at the Fed followed by Alan Greenspan's party time' invitations. Mix in the rise of Chinese manufacturing to keep consumer prices and wages down. And don't forget the bailouts, implicit 'put options' and $4 trillion of QE from the Bernanke Fed. There you have the potent highball that made so many investors giddy...and brought so much more wealth to the already wealthy. Fifteen thousand Dow points were added in a single generation. More than had been accumulated during the 7 generations before.

What made Americans suddenly so smart and so successful?

Or were they?

Stay tuned...

Bill Bonner is the President & Founder of Agora Inc, an international publisher of financial and special interest books and newsletters.

The views mentioned above are of the author only. Data and charts, if used, in the article have been sourced from available information and have not been authenticated by any statutory authority. The author and Equitymaster do not claim it to be accurate nor accept any responsibility for the same. The views constitute only the opinions and do not constitute any guidelines or recommendation on any course of action to be followed by the reader. Please read the detailed Terms of Use of the web site.

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