Personal Finance for Inflationary Times

In the earliest of times, man traded furs and skins and eventually grains and oils, dried fish, sheep, horses, cattle, and oxen. Because of their durability, oxen became a favorite medium of exchange. In time, with division of labor and urban living came a new era in which new uses were found for metals (copper, bronze, gold and silver). Because of their added usefulness, portability, and divisibility, their value increased and they were eventually accepted as the medium of exchange. For convenience, standardized pieces of metal, known as coins, came into use. Occasionally, when coins were in short supply, substitutes were used as “promises to pay” metals on demand. As stores of metal became too cumbersome to carry, paper receipts were issued for gold and silver deposited with goldsmiths for safekeeping. As long as the goldsmith was honest and secure, such practice was preferred, and eventually led to “banks” holding deposits for their customers and transferring them by checks.

In time, people grew accustomed to using paper money as a substitute for gold and silver. The next step in the evolution of money was “legal tender” legislation, which forced people to accept paper in settlement of government debts during times of emergency (most recently in the United States during the Civil War). After many years of “emergency” use of paper money, the ability to redeem the paper for precious metals was revoked and the money became known as a fiat currency. At this point, the currency derived its value from both the ability of the issuing government to produce hard assets as back-up for its currency (through taxes, and borrowing) and the people’s willingness to recognize (accept) the currency’s value. Of course, there is no limit to the amount of paper money and credit that can be issued, which is too much for most legislators to resist. Thus, pork barreling (buying votes) has led to budget deficits, economic “stimulation” and inflation. One type of government intervention leads to another, until there is a world-wide competition among governments to stimulate their own economies relative to all others through monetary expansion.

Another consequence of legal tender laws was that each country, by requiring that its own currency be used within its borders, shut out all other currencies, thus necessitating the exchange of one currency for another by international businessmen and travelers. Thus was born the phenomenon of exchange rates and the need for determining the price of one currency relative to another.

The “price” of money is determined the same way the prices of all other commodities are determined: through supply and demand, and expectations of future supply and demand. The greater the supply and/or expected supply, given a constant demand, the lower the price. Of course, the “price” of money is relative to the goods or other currencies that it will purchase. For example, when we talk in terms of buying an ounce of silver, we may state the price in terms of U.S. dollars as $14.00 per ounce. We may also state the price of silver in terms of Euros as €10,00. From the perspective of the currency, the price is €10,00 or $14.00, but from the perspective of the silver, the price of the currency is, respectively, one-tenth or one-fourteenth of an ounce. Notice that different currencies have different prices relative to the one ounce of silver. It depends on which measuring stick or currency we use, what the stated price of one ounce of silver is. In time, either the price of the measuring stick, i.e. the currency, or the commodity price can change as a result of changing supply and demand. For example, the price of one ounce of silver could become U.S.$20.00 and €13,33. Notice that the price of one ounce of silver has increased by 42.86% in terms of the U.S. dollar, while it has increased by 33.30% in terms of the Euro. The fact that the price of one ounce of silver changed at different rates relative to the two currencies demonstrates that the “prices” of the two currencies changed relative to one another. Thus, it is apparent that the measuring stick, i.e. the currency, has changed relative to other measuring sticks (currencies), and other commodities (one ounce of silver in this case).

This phenomenon of the prices of currencies changing relative to one another can be easily seen by looking at a history of changes between the U.S. dollar and the Euro, starting on January 3, 2000. See the Federal Reserve's website for the cost of one Euro in terms of U.S. dollars. It is interesting to note that on January 3, 2000, it cost $1.0155 to purchase one Euro, while on October 25, 2000, the price of one Euro hit a low of $.8270, and on October 25, 2007, it cost $1.4299 U.S. dollars to purchase one Euro.

If we realize and hold steadfast to the idea that inflation is the expansion of the money supply, we can also realize that it is primarily the governments, who control the money supply, who are creating "inflation." Furthermore, each country does “regulate” the price of its currency by expanding or contracting its money supply, often with an eye toward other currencies. Politicians and central bankers believe that it is easier for their exporters to export goods to other countries when their own currency is “cheaper” than the currencies of the other countries, thus promoting a more “favorable” balance of trade. What’s more, debtor nations also benefit from inflating their currencies in several ways:

Government debtors, such as Zimbabwe, the United States, and Argentina, benefit from the expansion of their money supplies. By inflating the money supply, thus making each dollar/peso worth less, they pay off their debts with cheaper money. This is especially true for the U.S. because much of the world uses the dollar as a reserve currency. This gives the U.S. a much broader base of demand, thus allowing it to export much of its inflation.
As prices rise, incomes rise, and if these governments have progressive tax systems (especially if they also have an alternative minimum tax) in place, they receive more in tax revenue as a result of incomes creeping into higher tax brackets. (Meanwhile, taxpayers are paying higher taxes on inflated income/profits, while seeing their purchasing power diminish.)
Because inflation is a gradual phenomenon (at first), those who spend newly created money first benefit the most. Those who are farther down the line receive cheaper money. Governments obviously get the first crack at spending the money they print, so they get the highest possible value for their money.

In short, governments that control their own currencies have a conflict of interest when managing the quantity of money/credit created. So far, there hasn’t been a government in the history of man that has been able to resist the temptation to abuse its power to create more money when given an opportunity. It may take a while, but it’s always happened. Watch the United States for the next instance.

In the long run, if a government acts irresponsibly in its money management policies, investors begin to realize this and act accordingly. Currency speculators buy other currencies and sell short the ones that are mismanaged. Bond traders seek out the currencies that are associated with higher interest rates. At some point, after the quality of a currency becomes suspect, there is a general flight to quality/safety.

Businessmen and other individuals buy up tangible assets in anticipation of future inflation. It becomes “smarter” to spend the depreciating currency than it is to save and invest in the future. Who wants to save a currency that is becoming worthless? Capital is consumed, causing standards of living to decline. Society becomes more belligerent as ends become harder to meet. For a picture of what can happen, see Fiat Money Inflation in France.

In the short run, while inflation is still creeping, individuals and corporations with foresight often purchase land or the tools of their trade using fixed-rate debt that will become easier to pay off in the future. As inflation accelerates, people look to precious metals and/or foreign currencies as a store of value, followed by any and all tangible goods. On the other hand, inflating governments try to (get people to act in the government’s best interest rather than in their own best interests) stem the tide of fleeing capital through wage and price controls, controls on money flow, seizures for various “crimes” or the “national interest,” and penalties for early withdrawals or exits.

This on-line publication is designed to help its world-wide readers recognize the symptoms of accelerating inflation, realize the types of dangers associated with it, and protect themselves and their families from its potential ravages.