The Fed and Inflation Since its Inception

(an excerpt)

     

     

A frequently voiced charge against the Federal Reserve is that it has severely debased the purchasing power of the dollar over time, through its easy and excessive creation of new money. I just read Congressman Ron Paul's new book, End the Fed, in which he suggests that the Fed (alone) is responsible for gutting the value of $1.00 from the time of the Fed's inception in 1913, to be worth under $.05 after inflation at the time of his 2009 writing. That's an over 95% drop in value of the dollar over 96 years. I read Paul's provocatively-titled book expecting some kind of argument to support his implicit assumption that whenever a business raises its prices, somehow the Fed's easy money is always behind it. Actually, in the book Paul makes no effort at all to attempt to prove that rising prices are caused wholly by an increased money supply -- he simply assumes it! I had been prepared to set to work and find his analysis to be faulty, but instead found he had no analysis at all to support this most essential point! I have read many times these hollow claims that the Fed causes all rising prices, but ask yourself this -- have you ever heard of any business raising its prices based on its having observed an increase in the size of the national money supply? How would such a thing -- either consciously or not -- actually come about? Does more money coming into a business (i.e., more sales) really make the business view the money more 'cheaply' and thus raise prices? The answer, typically, is no. Competition does not allow that, and with booming sales a business's profits are flush without the need to raise prices. Common sense and the common experience of business owners reveal that increased costs often pave the way to higher prices, but increased sales generally do not. And when the Fed eases and the money supply thereby grows, it does not increase costs for any business.

But "inflation is always and everywhere a monetary phenomenon", right?        The macroeconomic idea that price inflation is "always and everywhere a monetary phenomenon," as Milton Friedman has famously claimed, surely deserves a rigorous 'common sense' testing from such microeconomic viewpoints of individuals and businesses, since they ultimately do the setting of prices. Yet this microeconomic 'sounding board' of the macroeconomic concept of monetary price inflation is sorely missing from economics literature. To say in macro terms that "more money in existence amongst the same amount of goods must cause prices to rise" or that "a glut of money will reduce its value (purchasing power)" is not adequate as explanation. How, exactly?  My book reveals that such simplistic, overarching statements -- that boil down to a supply/demand relationship for the valuing of money -- do not make sense. For one thing, most peoples' demand for money is essentially infinite. Thus, it is exceedingly difficult for money's supply to overwhelm its demand in our economy and create a 'glut of money'. The reason for this is that money is a nearly frictionless proxy for anything and everything that money can buy. People don't want the money. They want the endless variety of things for which money can be so easily traded. Money poses no storage or liquidity problem, so demand for it is as limitless as their desire for anything and everything. Unlike the demand for a specific good or service, when considering "the demand for money", one must really equate the phrase with "the demand for all things that money can buy." You can do a test at home of how the demand for money is unlike the demand for a good. Fill some boxes with items of some value --perhaps your good used clothing or books -- and offer them on a street corner for free. See how vigorous the demand for these items is at the price of zero. Then try that with an equal value in jars full of free dollar bills or coins. Surely the first passerby will take all your jars of money and ask you whether you have any more! The demand for money is pretty insatiable. Only a quite profound sea change in the population's view of and faith in the money itself can produce a runaway 'monetary' type of price inflation in conjunction with large money growth. The inflation is a psychological -- not monetary -- phenomenon. A large influx of newly created money will only cause such rampant inflation if widespread public perception of the money's value markedly changes. This can happen at times, but I do not see the conditions necessary for this rampant inflation to be present in the U.S. economy. I expect that though the U.S. money supply is likely to grow dramatically in the coming years, price inflation will remain relatively tame.

Cash is for Spending        Let's go back to the supposed 95% loss of wealth for those possessing dollars over the 96 year period; the Federal Reserve Note was never intended for long term wealth storage, nor has the Federal Reserve or the government ever claimed so. It is printed with only the claim to be "Legal Tender for all debts, public and private." It is supposed to be tendered, or spent. For long term wealth storage, only a fool would not put their dollars into some form of interest-bearing account. Currency and equivalents (demand deposits such as checking accounts) are for one's spending money and nothing more. The Fed cannot be blamed for fools being foolish, especially when they have a century to figure out their foolishness! The supposed 95% loss of wealth over 96 years represents average annual price inflation of about 3.2%. Therefore, an interest yield of 3.2% compounded over that period would have held steady the 1913 dollar's value. Actually, an average yield of 3.2% has been easily beaten in even the very safest of government-insured investments for the great majority of the last century. Longer dated U.S. Treasuries have yielded as high as over 10% (circa 1980), more than making up for lost ground during periods of low interest rates. But even during such periods, the longer-dated maturity end of the Treasury curve has typically yielded more than 3.2%. In short, anyone in 1913 wishing to safely preserve their dollar's value for a very long period could have easily done so (and additionally achieved a substantial purchasing power gain), by investing in only the safest U.S. Treasuries or FDIC insured bank CD's.

Who has lost 95 cents on the dollar?        Virtually nobody. Ron Paul misleadingly suggests that if a family had stashed some cash back in 1913, by 2009 it would have in fact lost 95% of its value. However, it can be easily shown that this is not true. That is because there was only one way to lose your cash's purchasing power in such a big way over that period. That was to put the cash in a non-interest bearing account and let it sit for all those decades. As I said above, someone foolish enough to do that with interest bearing alternatives readily available probably deserves to lose their purchasing power! Surely, extremely few families actually did this with any significant amount of cash for decades on end, as the generations came and went. But what of somebody who was distrustful of keeping their wealth in banks or other investment management firms at all? Such fear was once quite common, especially before FDIC depositors insurance began in 1934. Many people actually did lose their deposits held at banks or other financial institutions during various 'panics' throughout the 19th and early 20th centuries. These fearful folks would sometimes hide cash at home. Fortunately for them, anybody stashing cash in the mattress in 1913 did not lose any purchasing power long term. On the contrary, currency and coins from the era have exploded in value. Depending on the dates, mintmarks, and conditions, much of the contemporary small change, preserved as it was in 1913, is fabulously valuable now to collectors. One hundred dollars in small change stuffed in a shoebox in 1913 is likely to be worth tens of thousands or more now. The fact that such coins in unworn condition are so valuable is testament to their great scarcity, which means that hardly anybody in those days stashed cash for long periods. This, of course, means that Ron Paul's complaint is a hollow claim on behalf of virtually nobody!