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Inflation (Editor's note: "Inflation" is the second chapter of a book by Mr. Pugsley entitled "The Alpha Strategy", written fifteen years ago. We intend to post a chapter each week. -JSB)
Without question, inflation is the most deadly of economic evils. It knows no geographical boundaries. It respects neither sex, nor race, nor creed, nor state of health or wealth. It has a more destructive effect on the lives of individuals than all other forms of plunder put together. It has been with mankind for thousands of years, has surfaced in every civilized society and has been almost universally feared and denounced. To observe its constancy throughout history, one would think it is a blight of nature, like earthquakes or the common cold, that must be suffered and accepted. Everyone claims to be its enemy, yet it defies the best efforts of the most astute and educated economists and leaders to stop it. The rate of inflation will affect your job, the value of your savings, the way you spend your money and all your future plans. Each year, you make thousands of decisions that are influenced, whether you know it or not, by your estimate of whether prices are going to rise or fall. If you believe that prices might fall, you will wait to purchase that new automobile until next year. You will try to save more money now, knowing it will buy more tomorrow. You may sell your stocks and buy bonds. On the other hand, if you think prices are going to rise, you may try to spend your money now instead of saving it. You may sell your bonds and buy some real estate. Or take a trip abroad while you can still afford it. A foreknowledge of next year's inflation rate would give you an immense financial advantage over others. Most people, including even professional economists, are hopelessly inept at predicting tomorrow's price increases, since most people have no idea as to inflation's real cause. To predict it, you must first understand it. Take the following brief test. Below are listed the seven most common things believed to contribute to a general rise in the price level. Indicate whether you think each does or does not directly contribute to inflation by putting a check in the appropriate box. Think carefully. Answer Yes or No:
I assume that you probably answered yes to most of the questions. If you did, you are in agreement with most of the economists, politicians and financial experts in the world. Unfortunately, not all of the questions should have been answered with a yes. To understand why, let's take a brief trip back to that island on which you were shipwrecked and see how inflation might have taken place there (see Chapter one; The Sting). Imagine that you have been cast ashore and have been struggling to provide yourself with food, shelter and a few rudimentary comforts. One day, to your delight, you come across another castaway, a man by the name of Maynard. It turns out that Maynard is an economist. You look on this as a stroke of good fortune, for now there are two of you and with his brains and your skills, survival should be possible until help arrives. You have finished weaving your fishnet and find that if you work diligently you can catch two large fish a day with it. Maynard is a failure as a fisherman but he has cultivated a small patch of wheat and has found that, with some effort, he can make and bake two loaves of bread a day. You have tried bread-making and found that the most you could make was one loaf per day. It seems sensible to divide up the labor, letting each person do what he does best. Each day you fish and he bakes and you trade him one of your fish for one of his loaves of bread. The two of you have your own little economy with a gross national product (GNP) you measure as four "units" of goods: two loaves of bread and two fish. When you exchange a fish for a loaf of bread, you have each established a price. The price of a fish is one loaf of bread and the price of a loaf of bread is one fish. Keep this definition in mind: price is nothing more than the exchange ration between two items. When fishing is bad and you only catch one fish or when something happens to interrupt Maynard's bread-making, your GNP falls and the two of you have less than four units of goods to consume. Usually, the person who comes up with the smaller supply of his product raises the price to the other person. If you catch one fish, you trade Maynard half a fish for one loaf of bread and vice versa. On the other hand, when fishing or bread-making is particularly good, your GNP and standard of living rises. If you catch three fish instead of two, you tend to lower the price, offering one and one-half fish for a loaf. There is a reason that you adjust your price up or down as your supply decreases of increases. If fishing is good but you still try to charge Maynard a whole fish for a loaf of bread, Maynard may find it more profitable to spend a portion of his day fishing. He may then find that he can catch two fish in half a day and still bake one loaf of bread. He won't be willing to give you a loaf of bread that takes him half a day to make in exchange for one fish that he could catch in a quarter of a day. In other words, if you don't price your product approximately proportionate to the effort required to produce it, Maynard will compete with you until you are forced to bring your price into line. On the average, however, you both create two units a day, so your price tends to stay level at one loaf of bread for one fish. One evening, as you and Maynard are relaxing by the fire, you begin reminiscing about home and the comfortable standard of living you each enjoyed before your misfortune. Soon the conversation turns to inflation. Maynard's eyes light up. "Perhaps," he says, "we can use my training in economics to improve our situation. It is common knowledge among the more enlightened economists that a little inflation is healthy for an economy. I think that what we need is a little inflation to get things going." You're dubious but you concede that you would like to get higher prices for your fish, as he would for his bread. If it really is possible that inflation results when individual producers raise their prices, then it should be easy for you and Maynard to prove it, since you're both willing to do anything possible to bring it about. You both decide that inflation must be what you need and you agree to work together to cause prices to rise. Maynard proceeds to make a list, like the one in the test you took, of all the things he knows cause inflation. "The first thing that causes inflation," he says, " is when a businessman gets greedy and raises his prices. If I raise my price for bread and charge you a whole fish for only half a loaf of bread, thereby keeping a loaf and a half for myself, that should do it, right?" "I guess so," you reply. "But isn't it true that unions also cause inflation?" If I pretend that I have a fisherman's union I'm dealing with and union members demand a greater share of the fish for their wages, I'll have less myself and so I'll have to raise my price to you. I'll have to charge you a whole loaf of bread for half a fish. That should do it, too." "Certainly," agrees Maynard. "Now it's obvious that I have a monopoly on bread here on this island, so I control the price and can set my price wherever I like. So if I set it higher, that will certainly insure inflation. Come to think of it, there's not much difference between my having a monopoly or a cartel. Even if there were other breadmakers, as long as I could get them to set their prices as high as mine, we'd still have inflation." By this time, you are both getting excited about the prospect of raising your prices and the higher standard of living you'll both enjoy as a result. "One last idea," adds Maynard, "scarcity also causes inflation, so we'll have inflation automatically any time you don't catch enough fish or my wheat crop gets wiped out by a rainstorm." "Or you start exporting your bread to America," you laugh. "Definitely!" he chuckles. "Let's get started." He walks back to his hut and you go inside yours and pick up one of your two fish. You carefully cut it in half (since you are raising your price for half a fish to a whole loaf of bread) and walk back out to the fire. Maynard is standing there with, yes, half a loaf of bread in his hand! "Wait a minute," you exclaim. "I'm raising my price because of my union and that means you give me a whole loaf of bread for half a fish." "Not on your life," says Maynard. "I'm a cartel and you must give me a whole fish for half a loaf of bread." You pause and Maynard continues to argue for his right to go first. He has just about convinced you to give in to his demand for a whole fish, when suddenly a thought hits you. It doesn't matter which one of you raises his price first, either way it won't cause inflation. (Has the fallacy of the whole thing become obvious to you yet? No? Well, read on.) Though it appears on first glance that the price level rises when you raise the price of fish, it does not. The price level is the average of all prices. If you get a whole loaf of bread for half a fish, the price of fish has doubled but what has happened to the price of bread? It has fallen in half. If Maynard goes first and you pay him a whole fish for half a loaf of bread, his price has risen but yours has fallen. You and Maynard may both ask for a higher price but you both cannot get it at the same time. Whether you raise your price and he pays it or he raises his price and your pay it, you still haven't caused inflation, for if one price goes up, the other must come down by exactly the same amount. It does not matter why you raise the price - whether it's a union demand, your own greed, your ability to control the product, scarcity or whatever - these are merely your reasons for raising it and are irrelevant to what happens once it is raised. Raising a price does not cause other prices to rise, it cause them to fall, providing an exchange of goods is made. Of course, you can both ask a higher price. Maynard can ask for two fish for a loaf of bread and you can simultaneously ask for two loaves of bread for a fish. But no trade will occur until one of you gives in. The real price level is the level at which trades actually occur, not the level at which people would like them to occur. In a barter society, everyone cannot get higher prices at the same time. It does not matter how many people are involved in trading or how many products are being traded. You can start with fish and bread and then add eggs, shoes, nails, shirts and other products, ad infinitum and the same fact will always emerge. If one product goes up in price, one or a combination of others must fall by precisely the same amount. Since a producer cannot cause other prices to rise by raising his own price, the one place inflation cannot come from is from the producer of products. This is not true just in your island economy, either. In the real world, producers cannot raise the general price level by increasing their prices. To make this clear, let's transfer this situation to the real world. Say that the United States has been importing a billion barrels of oil each year and has been paying $10 per barrel. Suddenly OPEC decides to raise the price of oil and we must now pay twice as much for the same amount. If we spent $10 billion last year and this year the oil costs $20 billion, we are left with $10 billion less to spend on other things. Having less money, we will have to rethink what the remaining money will be spent for. We cannot buy the same things as we did a year ago. Once we have given OPEC the extra $10 billion, those products that we would have bought with that money will remain on the shelves, unsold. Of course, OPEC has the $10 billion but will probably not choose to spend it on those items we would have bought. The reason that it appears that the price level has increased when the oil price rises is that the producers of those unsold goods do not lower their prices immediately. They sit there with the unsold goods, hoping that their customers will return. It is called a business recession. The only way the goods can be moved, however, is if one of two things happens: either they lower their prices until they reach the point that there is enough money in circulation to buy them or they wait until $10 billion dollars is created to replace the money paid to OPEC. The implications of this demonstration are enormous. Individuals who produce goods for trade (and this includes all manufacturers, retailers, middlemen, laborers, union members, monopolists, members of cartels and all the other people who are producers) are absolutely and totally incapable of causing inflation, even if they want to! Whether you raise your price because of greed, because you have a monopoly, because your union demands higher wages or because your supplies are limited - no matter the reason - there is no possible way you can cause other prices in society to rise as well. When you raise your price, some other price, somewhere in society, must fall by an equivalent amount or else other products will remain unsold. Of course, every producer can ask for a higher price but asking is not receiving. The only prices that matter are those at which trades take place, not those at which people would like them to take place. By now you must be wondering what you are missing. It is obvious that I'm right about the fish and bread, yet we do have inflation and it is very real. Inflation in modern society comes about by a clever and almost undetectable fraud. The answer is obvious once it is properly explained. To demonstrate it convincingly, so that no misguided economist can ever confuse you about it again, I will show you exactly how it occurs. The easiest way to do this to return once more to the imaginary island where you and Maynard were producing and trading bread and fish. If you and Maynard expand your repertoire and begin to produce other products in addition to your old staples, bread and fish, you may soon see the advantages of using one item as the medium of exchange. Assume that the two of you now produce fish, bread, eggs, potatoes, lumber and cloth. You decide to use fish as the barter medium and so from now on everything will always be priced in terms of fish, rather than any other commodity. A loaf of bread costs one fish, a dozen eggs the same, potatoes are two fish per pound and lumber is a fish per board foot. Fish has become money. Money is simply some commodity that becomes the accepted medium of exchange. What happens when the supply of fish (money) increases? For example, what if you start catching ten fish per day instead of two? The value of fish (money) will fall (because the more there are, the less the value) and all other things will tend to rise in price relative to fish (money). Now if you discuss the price level, you might make the mistake of saying that all prices are rising at the same time (inflation). They are not, of course - fish (money) is falling in price. Only goods other than fish (money) are rising. Include fish (money) and the price level has not changed, because it has fallen in price as much as the other products have risen. At last, slowly and I hope convincingly, we are closing in on the cause of inflation. The price level can change only if measured against a money commodity and only when that commodity is excluded from the average. When the quantity of money increases, the average price of all other commodities will rise and when the quantity of money decreases, the average price of all other commodities will fall. Saying all prices are rising is the same as saying the value of money is falling. It is as simple as that. There is and can be only one single cause for inflation: the quantity of money must be increased relative to the quantity of goods. We have found the source of inflation: an increase in money. You and I cannot create money. Nor does producing real goods or services create money. In fact, production increases the quantity of goods and if the quantity of money remains constant, prices should be falling as production rises. So again we've proven that producers are not at fault. To find the cause of inflation, we need to find out where money comes from. If you and I don't make it, who does?
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We will start with the most significant, the most pernicious and the most misunderstood of all the methods of economic fraud that are being directed against you: inflation. To most of us, inflation means a rise in the average level of all prices for goods and services. It is not an increase in one price or in some prices but an increase in the average of all prices.
John Pugsley is chairman of