The financial world we live in is just as wild, if not more, than the mountains and woods we walk through. We are told that the fundamentals of our economy are strong, but we can feel that something is wrong. My unique financial background and survival passion make Financial Survivalist and excellent place to learn and share.

Saturday, October 22, 2011

Money Supply and Inflation

If you haven't been watching the "right" news stations, you may have missed the seemingly endless advertisements for gold stating several reasons to purchase, one of which is coming inflation. But is there really going to be inflation? Will it be stagflation? Is there any way to know?


This is a chart of the monetary base for the history of the Federal reserve. This includes all cash in circulation and deposits in banks. As you can see it took the fed almost 60 years to have any significant increase in the monetary base. The largest reason for this is because until the 70's we were on the gold standard. That means the US currency was backed by or represented a portion of gold. Physical, tangible, real gold. Then, without authority of congress, President Nixon severed the dollar's relationship with gold.

By severing the dollar's relationship with gold, the dollar became a fiat currency and was now back by debt (ie the promise of the U.S. to pay it's debt). By doing this it allowed the federal reserve to print as much money as it needed/wanted, and allowed the U.S. government to take on more debt. If you compare the chart of the monetary base to the chart of U.S. debt, you will notice they are strikingly similar.

Probably the most noticeable part of the monetary base is that in late 2009 it skyrockets. It more than triples from about $800 billion to over $2.7 trillion in a few short years. What does this mean? Well, the easy answer is inflation. Inflation is the eroding of the purchasing power of your dollar. That is, the more inflation the less you can buy with a dollar. An increase of the monetary base of this magnitude has never been known by the U.S. financial system. Smaller increases have caused runaway inflation before, but nothing like this. The closest thing we can compare this too is the Weimar Republic.

The Weimar Republic was created in 1918 to replace the post WWI German government. However, as part of Germany's punishment for WWI many countries of the world decided that Germany owed them for damages. The Weimar Republic started deeply in debt. In order to free itself from this debt the government decided to print the money. This policy quickly caused hyperinflation ending the Weimar Republic's currency.

So, if the kind of printing we are seeing by the Federal Reserve today is similar to the kind of printing experienced by the Weimar Republic, why are we not experiencing hyper inflation? There are three main reasons for this. The first is that the Weimar Republic increased their monetary base by more than 1000 times. The U.S. has irresposibly printed money, but not yet to the degree of the Weirmar Republic. However, the inflation problem of the Weimar Republic started slowly as well. It happend over the period of several years. Even today the Fed is talking about a third round of printing money. We have only just begun.

Second, the great economies of the world are working together to inflate their money. The U.S., Japan, the E.U., China and many more nations have all agreed to a policy of printing money. They do this so the trade between our contries is not affected so drasticly by inflation.

Third, inflation is not caused by money supply alone. It is also caused by how fast the money moves through the economy (ie velocity of money). People are scared. They know something is wrong, and the kind of spending that happened before 2008 is just not happening. However, mark my words, as money begins being used again we will experience severe inflation. As inflation starts to take hold the speed of money will increase exponentially. Just how bad will it be? Based soley on the money supply, in less than a few years your dollar could easily be worth 1/3 it's current value. Depending on how fast money starts moving through the economy, it could easily be worth even less.

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