Monday, January 25, 2010

What really caused Inflation ?

Some believes inflation is a function of too much economic growth. In an increasingly interconnected global economy, shortages of labor and manufacturing capacity in any one country cannot be inflationary. They can't because, as we've regularly seen with U.S. companies, they have always accessed the world's supply of labor and capacity when producing the goods we buy. Even if we assume--as the Fed seemingly does--that the U.S. economy is closed the Fed's definition still wouldn't pass the most basic of scrutiny.

Indeed, labor shortages in any one country are always solved by new labor force entrants seeking to achieve the higher pay created by shortages, by the certain migration of workers from weak to strong labor markets and--most notably--by technological innovations that reduce the need for human labor inputs. High capacity utilization is nothing more than a market signal suggesting more is needed. And because of robotics and other production innovations, capacity is hardly a static concept.

Then there are those who simply use consumer prices as the truest, most market-driven measure of inflation. It's hard at first to argue with this approach since changes in the value of money often show up in prices, but the largely quiescent consumer-price figures during a weak-dollar decade also come up charitably short.

For one, manufacturer can raise prices without actually increasing the nominal prices of the goods they sell. One easy example here would be peanut butter. The marketers for the product decided to indent the condiment's container in order to reduce its content by 9%. Starbucks has held the line on the cost of the pastries it sells by reducing the size of each pastry.

For two, high prices usually mean that they'll soon fall. Flat-screen televisions used to cost more than $10,000 few years back, but today these prices have gone down considerably to less than $2,000. High prices invite more competitors into the market the sale of all sorts of goods, which invariably leads to price reductions regardless of whether the dollar is strengthening.

Finally, rising prices due to a strong demand for one consumer item are not a sign of inflation. If consumer demand for one good is driving its price up, demand for other products must be falling in ways that will drive the prices of other goods down. In short, if there's such a thing as a true price level, it cannot be altered by expensive goods anymore than cheap imports can drive it down.

So what is true inflation? It seems the answer relates to the precious metal call “gold”. Used as a money measure for thousands of years, gold achieved its purely monetary role precisely because its role in the productive economy is so minuscule. As a result, nearly every ounce of gold ever mined is still with us, which means gold's real price is hard to alter thanks to a great deal of gold stock in existence relative to new discoveries.

When the price of gold moves, gold's price isn't moving; rather it is the value of the currencies in which it's priced that is changing. Gold is the objective indicator of inflation: When its price in any currency rises substantially, that means the unit of account is weakening and that we're inflating.

What does this mean for the economy? Broadly it means that when the dollar weakens such that the price of gold spikes, what is limited capital seeks safe-haven in hard, unproductive assets like gold, oil, art and property. Physical assets least vulnerable to monetary debasement win out over less tangible investments of the innovative or knowledge variety. In that sense it's no surprise that technology investments thrived in the '80s and '90s when the dollar was strong.

Getting back to inflation, rather than a measure of prices that change for various reasons that have nothing to do with currency policy, inflation is at its core the painful process by which capital flows to the hard assets of the earth and away from innovative, wage-creating industries. As individuals we don't so much hate inflation for the rising prices as much as we balk at it because our chances to capture good jobs and good wages are compromised for capital essentially hiding.

As the rising price of gold has revealed throughout the decade we've been inflating, no matter what the more quiescent government measures of consumer prices have been telling us. A weak dollar explains our economic unhappiness because a weak dollar is what has made capital disappear.

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