By Arthur Foulkes
The Tribune-Star
January 28, 2008

Constant, creeping price inflation may seem as normal as the leaves turning in autumn. But a general and steady increase in prices is not a natural phenomenon in the same way changes in the season are.

Economywide price increases are caused by more and more money being poured into the economy; therefore, price inflation has its roots in government policies.

We are so accustomed to constantly rising prices that we can hardly believe this is not just the ways things are. The mere idea of falling prices sends central bankers, business writers and policymakers into a panic. Yet, surprisingly, the most dramatic economic growth in American history took place during a period of generally falling prices.

From the start of the Industrial Revolution until the first decades of the 1900s, money in the United States was largely backed by gold or silver. This meant the supply of money was fairly stable.

At the same time, dramatic increases in productivity caused by industrialization meant more goods and services were available. As a result, the purchasing power of existing money grew while prices fell.

Economist Murray Rothbard wrote of this period in his book, The Case Against the Fed:

“Prices generally fell every year from … the latter part of the eighteenth century until 1940, with the exception of periods of major war, when governments inflated the money supply radically and drove up prices, after which they would gradually fall once more. … Falling prices did not mean depression, since costs were falling due to increased productivity, so that profits were not shrinking.”

Even today we see falling prices for certain goods, such as calculators, computers and other consumer electronics. Yet makers of these goods continue to grow and experience profits.

There is just one explanation for why prices in general continue to rise almost non-stop: Government policies that inflate the money supply.

The U.S. Federal Reserve creates money when it buys securities from banks and other financial institutions. To buy these securities, the Fed writes checks on itself, basically creating new money out of thin air.

After receiving this new money, banks, backed by the Fed and federal deposit insurance, lend it to borrowers who deposit these funds in other banks who then loan the new money again. This process continues until, for example, a $100 million “injection” from the Fed results in almost $900 million in new money.

Government figures show that the nation’s money supply has been growing rapidly for decades. In 1960, M2 money, which includes currency, coins, checking deposits and other highly liquid assets, stood at around $300 billion. Today M2 is around $7,500 billion – a 25-fold increase.

This explains why a bottle of root beer that cost my mother-in-law and father-in-law 5 cents on their honeymoon in 1955 costs about $1.25 today.

Economist George Reisman of Pepperdine University uses the following example to show how increasing the money supply causes higher prices.

Imagine there is only one product in the whole economy – bottled water. Imagine that after one year, 100 bottles of water were sold for a total of $100. What was the average price of goods that year? The answer is $100/100 or $1.

Now imagine that the following year, 100 bottles of water were sold for a total of $200. What was the average price of a bottle of water during that year? It was $200/100, or $2. Simple enough.

In this example, the average price of consumer goods – bottles of water – doubled. As Reisman notes, it is a mathematical impossibility for this to happen without either (1) fewer bottles of water being sold and/or (2) more money being spent during the year.

We can safely rule out that prices have been rising since World War II because there are fewer consumer goods available. If we can be sure of anything over the past several decades, it is that productivity has been rising, meaning there have been more goods and services available on the market, not less.

If the money supply had been stable in the past 60 years, more consumer goods would mean lower prices and more purchasing power for existing money. But, since World War II, greater productivity has actually gone hand-in-hand with rising prices. For this to happen, the quantity of money must be rising dramatically.

Of course, it is possible that more spending of a fixed quantity of money could also cause prices to rise; however, as Reisman notes, if there is more spending, it is still linked to the creation of more and more money. When the supply of money rises, its purchasing power drops and the incentive to hold money falls. So even if more frequent spending does account for some price inflation, it is nevertheless linked to higher quantities of money.

Most people probably believe we suffer from chronic inflation because of greedy businessmen, greedy unions or both. Some people even blame greedy consumers.

Yet none of this can explain a steady and general increase in prices. With a stable supply of money, rising prices for some goods, such as housing, would simply force lower prices for other goods whose demand was not as strong.

Price inflation is not a natural phenomenon we are stuck with. It is the result of government policies that attempt to manage the economy and protect banks and other financial interests from the rigors of a truly free market. Like almost any government action, inflating the money supply benefits concentrated, well-organized interests while the mass of consumers pay the price.

http://www.tribstar.com/business/local_story_028173354.html

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