So I’ve blogged more then once about inflation, the federal reserve and such. Since then I have lost that blog so I figured that I would make a new blog about it and just finally combine everything together. There is generally speaking a lot of confusion about inflation, what inflation is, how it works and what it does. People understand that it exists along with it being responsible for the price of things going up but people do not have an exact understanding on what has caused the type of massive inflation we have today. All of us remember how our grandparents or someone similar told us, “When I was your age a large candy bar only cost me a quarter,” and now it’s a dollar. Logically we know stuff is more expensive but it is important to understand what is causing this.

 

The simplest way to explain inflation all relates to supply and demand really so let is take a look at this from a consumer standpoint for a product. We’ll take something very simple like a pencil for instance. Now as far as I know a pencil is very cheap in almost any part of the world, simply because a pencil is a very easy to produce item and is very common. Almost everywhere you look you can find them very easily which also makes them cheap. Now, generally speaking items go up in value when they are more rare. So just think about if there were less pencils in the world. Like say 10,000, 1000 or even just 100. Then the value of a single pencil would probably skyrocket in price. So basically with supply and demand when there is more supply then people need the value generally goes down and when there is less supply then people need the value of it will go up.

 

I will be getting to the point of this part shortly here but now we need to go to something else that toes into this and what is causing the massive inflation we see today. Back in the day, America like many other countries were on what we call a gold standard. A gold standard was that my money I have was backed by something of real world value. Back in the day people used what were known as Gold certificate’s ( http://en.wikipedia.org/wiki/Gold_certificate ) which was basically a form of paper money with a certain gold value to it. These certificates looked similar to the paper money we have today. What this means is that banks were supposed to hold gold equal to certificates issued and if you took your certificate which was forth fifty dollars down to the bank you should be able to trade the paper note in for fifty dollars worth of actual gold. All banks were supposed to hold gold and people personally owned and used gold as well. In this way your money was backed by something of real world value since everyone holds value to gold.

 

Well first of all in 1913 what was known as the Federal Reserve came into being. The Federal Reserve System ( http://en.wikipedia.org/wiki/The_Federal_Reserve ) plays an important role in our central banking system. Back in the day banks were privately owned and each one was separate from the other. But eventually it was written into law for one reason or another (which I will go over later) to have one central banking authority from which the entire money supply is issued and thus the Federal Reserve came into being. On top of this in 1933 President Franklin D.Roosevelt signed into law that the gold standard was illegal ( http://www.gold-traders.co.uk/gold-information/when-did-the-gold-standard-end.asp ) which basically made gold ownership illegal for the average person. Also everyone had to trade in their gold certificates for the federal reserve notes which we use today.

 

Naturally this made it so that only the government had ownership of gold and no longer had to distribute it to regular people. The US dollar has become the worlds reserve currency due to the fact that it could be traded for a real world item which was gold and the US government could buy or trade gold with other countries still. Finally in 1971 Richard Nixon made it so gold could never be traded at a fixed rate/price anymore which brought an end to the gold standard on a global scale since central banks could no longer trade or convert gold at a fixed rate.

 

Now finally this will all go full circle because you see under the gold standard it is clear that money had to be backed by a certain amount of real world gold. So you could never give out more money then you had gold to back it. This is no longer the case anymore. Now when we go back to our rule of supply and demand it is pretty simple. When places got more gold they could expand their supply of money. When there is more of something the value of it goes down. You’ll see where we’re going with this. Certain items of importance can of course cause fluctuations in market price as well. Oil is one obvious item. Oil is used for everything these days so when oil becomes more scarce the value of it must go up. Thus it costs more to buy and people must ask for money for good and services in return to cover the increased cost of gas and oil for them. The two things referenced above though are what I call natural inflation.

 

You see natural inflation is of course when something on a broad scale drives up prices or like we discussed earlier when there is more of something, including money, the value of it goes down. So logically the more money there is in circulation a little bit lower the value goes because it is more common. So far this all makes sense, right? All right, now everything will make sense.

 

Basically what the Federal Reserve act did was create the ability to print money which did not need to be backed by the value of gold. Instead, it was the force of law which said, “You must take payment in these notes or else.” So the value did not come from a real world item but force of law instead. When you do not have the constrain of having a real world item such as gold forcing you to limit your money supply then what is stopping you from making money? Well logically, nothing at all. So if my money does not need to be backed by gold this just means that I can make as much as I want. Which is basically what the Federal Reserve does. They practice what is known as Fractional Reserve Banking where whenever a bank or anyone needs money they can simply print it up and give it out.

 

Now think about it we already know that if you apply our pencil idea to money then the more money there is circulating the lower the value of it is. So basically the real cause of the inflation we deal with today is not that the price of things is going up but that the value or our money/currency is going down. By having the supply of money not just outpace demand but far outpace demand the value of the money goes down. And that is the simplest explanation as to what modern day inflation is. Our money is no longer backed by real world value, instead being backed by force of law, so whenever the Federal Reserve needs to give out more money then simply generate it or print it up. You can see the problem with having no constraint at all in creating something supposedly of value from thin air. After all just think about how much money you could have if you could create it from nothing whenever you wanted to do so.

 

Last but not least the federal reserve works in multiple ways and I will try to explain them to the best of my ability. It tends to get a bit complicated. The most important thing here to remember is that the fed is a private business which operates independently and is overseen (supposedly) by the government. First of all the biggest and most obvious thing is that the fed prints money giving it value out of thin air and then gives it away to big companies, other countries and foreign dictators. This is probably what we’re all familiar with when the fed will give out or loan money in large sums to large banks, car companies, etc. The fed will also take part in other things such as quantitative easing programs where it will buy up treasury bonds from the US and even debt from private companies with extremely low interests rates. It will especially buy up debt or loan money to banks so they have excess cash on hand. The basic idea is that the debt has very low interest with excess cash on hand people will buy government bonds, banks will loan money and so will private companies. This in theory should keep interests rates low and make life easier for everyone. All of this is of course done by the fed creating money out of thin air to give out weather in printing, generate via computer for loans or however they chose to do so. One can see how this an odd system because fed will buy up US treasury notes. So in effect the fed creates money, buys up debt from the treasury and then the us government owes the fed money even though they are supposed to be running the fed. Strange, isn’t it?

 

So here is the basics for a recap. The US was on a gold standard until 1913 when the country was taken off of it. Being on a gold standard help make the US dollar the reserve currency. On a side note some people blame the gold standard for the great depression although most experts agree that the federal reserve played a big role in causing the depression in the first place. Anyway, at 1971 the US stopped using the gold standard as a whole on a global scale which took the entire world off of it. The federal reserve does not have our money backed by real world value but instead by force of law. Whenever money is needed or they want to keep interest rates for borrowing and lending low they print up money and buy up bad debt at low interests rates. Either way every time they create money out of thin air they are creating money with no value to it and no limits. And the larger the money supply is the lower the value of it is. Interests rates have been at record lows and the federal reserve has been giving out giant amounts of cash but basically run away inflation and lack of jobs in the US along with lack of business is driving our economy down no matter what they do. So in the short, the more money you make from thin air with no limits, the less it is worth.

 

So you might ask why would they want to do this? Well, the idea is that by being able to create money at will the federal reserve can increase our buying power much faster then if we had to back our money with real world value and they also have exact control over our money supply. So naturally you can see the problem in one group having unlimited power to create money and control the money supply of the USA and to a large extent, the world.

 

A brief note there is an excellent article here on the Roman Empire and Inflation:http://mises.org/daily/3663

 

If you’ll notice the Romans basically practiced an early version of what we do today. Which was they had something of value gold and silver coins which everyone used. But when it became to much in the way of costs to pay for their administration and the ongoing wars they got the idea to expand the money supply by making it less and less silver and instead worthless metals which had no real value to people. They practiced this for years making it more and less silver until even reaching a point where soldiers and people working for the government or rich people used stuff such as gold for money instead because their own usual currency had lost so much value. Sometimes being worth a thousand times less then it originally was. This is basically just an early example of how inflation eventually destroys the stability of a country.

 

So basically there is what I would call natural inflation due to natural changes in the market and an increase in the money supply over time by people acquiring more things of value to back the money. Then there is artificial inflation which we suffer from now where the supply of the money far outpaces the demand and makes the value of the money go down. Most people agree that a vast majority of the increase of prices for things we have seen today including gold are more due the money itself losing value then the items themselves becoming more scarce. In essence we’re practicing a very similar system to what the Romans did back in the day and also what help lead them to ruin.

 

A topic worth touching on is also the national debt which is funny because a friend and I had a discussion about it in depth. If you’re unsure of what the debt is there is a good piece here:http://www.federalbudget.com/

 

But simply put the national debt is how much money the government owes. Now the two terms used as debt and deficit. Simply put the government each year (I think) or however often the government calculates how much money it will bring it through taxes and such versus how much it will spend. If it is spending how then it is making it is called a deficit and the government must borrow the money either from the federal reserve or another country to cover this shortfall. The money is borrowed in low interest which will be paid back eventually. Now a debt is normal for any country to hold because a country will be forced to borrow money and pay it back later on for any number of reasons. This here helps show the basic idea of our debt over time:http://en.wikipedia.org/wiki/History_of_the_U.S._public_debt

 

If you’ll notice there is a basic connection here where we maintained a much smaller debt on average until the federal reserve was created. This is when our debt mainly started to really jump up. It should also be noted that not to long before we went off of the gold standard on a world wide scale is when we began to run a deficit every year. So that is basically what the debt is. The government cannot pay its expenses so it borrows the money in the ways of treasury bonds and other such debts it owes with the promise to pay it back in the future.

 

My friend was explaining to me how she feels the debt is used as a scare tactic which to be honest it is used as a scare tactic a lot. But basically it is used to scare people and it is not as bad as we make it out to be. In a way I do agree with her because the debt has been used as a scare tactic by people in politics to gain points but the problem is a real one. Basically ever since the creation of the federal reserve and going away from the gold standard we have become addicted to debt. Now our paying off debt to a country is not like a regular Joe using a credit card and paying back in interest. The deal relates to however the deal was set up and usual done in chunks. You know so say we borrowed 1 million from China and then another 1 million later. The total debt we owe is 2 million but generally I believe countries pay them off separately, not all together as one large lump sum. While this is all fine though the real problem comes in the fact that we keep spending and spending and spending and borrowing more then we are able to produce in terms of money. So we borrow more and we also print more and you can see the insanity in this.

 

Basically you’re borrowing with no real plan on how to pay it back and on top of that every time we print money the same money we’re going to pay people back with loses some of its value. The problem is and things like this relate to out credit rating being downgraded for instance then eventually no one will want our money due to inflation and no one will want to loan us or the government money because they do not feel it is a safe investment in which they will get paid back. Our national debt has spiraled out of control once averaging only in the millions to over 14 trillion now and climbing. The problems are a lot of problems coming together but at the heart of all of this is our printing of money.

 

The federal reserve has been cited for doing multiple things wrong including losing 9 trillion in dollarshttp://www.dailymarkets.com/economy/2009/05/14/federal-reserve-cannot-account-for-9-trillion/and loaning out 16 trillion without Congress having known about it, http://www.unelected.org/audit-of-the-federal-reserve-reveals-16-trillion-in-secret-bailouts

 

A final thought some people might think I am wrong here and say that Bill Clinton balanced the budget and paid off the national debt. This however is not true. There is a good article here:http://www.craigsteiner.us/articles/16

 

The long and short of it is basically that Clinton paid down the public debt while increasing government debt. So overall debt increased during his time in office. Just something to keep in mind.

 

S all of this together shows us the problems we face with our run away inflation and that going on a stable currency which cannot be manipulated is our best way to get back to financial freedom.