Inflation/Fiat Currency Question

[yltlatl]

So inflation is too much money chasing too few goods, right? And raising interest rates as a means of fighting inflation is an attempt to reduce the amount of money, right? So how does that relate to the "creation" of money by means of having a fiat currency? And where--in theory--does the value of cash come from in a fiat currency system? Any help in understanding this would be appreciated.

[Name removed]

1. Deleted message

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[dcfirefighter]

2. Don't believe the gold hype

Using gold as money is just a fancy barter system. It gives control of the money supply to the rich entities that have hoarded gold. It's generally deflationary, which hurts those in debt, usually the poor - and causes serious economic recessions.

Fiat money is fine - the devil is in the details.
#1 we allow private banks to profit from the creation of money.
#2 we allow private banks (the federal reserve) to determine the value of money.

Our fiat money is backed by government issued paper debt. Federal reserve notes, and cheque money in circulation, are all *fractionally* backed by US Gov't debt notes on deposit in the federal reserve system. We owe interest on the the debt notes.

Historically, the economy has grown slightly faster than population, at about 2.5-3%. The money supply must grow with the demand for money, or we have deflation. Generally, it's considered economically healthy to have a *very* slight amount of inflation.

Money is a marker, a measure, a means of expiditing transactions. In order for it to work, it must have a relatively stable positive value. In order for it to have value, people must accept it as payment. In order for people to accept it as payment, they must believe that someone /else/ will accept it. In order for it to have a relatively stable value, the amount in circulation cannot change very much over time.

In order to guarantee a positive value for the US Dollar, the US government merely needs to pledge to accept it as payment for debts, i.e. taxes.

Currently, the money supply is about $9,300B. The money base is about $760B. That's about $8,500B of bank-created money, created by loaning into existence, for which they charge interest. If we remove the ability of banks to lend money they don't have, by outlawing fractional reserve banking, we destroy that bank-created money. This rapid decrease in money supply would be disastrous. To keep the supply of money stable, the US Treasury (a public body) should issue $8,500B worth of new currency.

Currently the national debt is about $8,000B. This debt should be paid off with the $8,500 worth of new currency. This neatly eliminates our national debt. This process could be phased in over time, with incremental increases in the reserve requirement, and associated issues of new currency.

Each year after 100% reserves are required, the treasury would have to issue more new money, in order to keep the value of the dollar stable or slightly inflationary, rather than deflationary. The amount of issue should be around 3% of the supply, per year, or about $280B. To protect against elected politicians raiding the value of the dollar by overprinting money, strict Constitutional limits should be in place.

Doing all of this would eliminate $350B each year in interest payments while creating $280B of new money each year. This is a $630B swing, just about balancing the budget.

The costs of doing this would include an end to interest-paying demand deposits, but not an end to interest paying investments. With $680B of competition for credit eliminated, interest rates would fall.

[Selatius]

4. What you propose is good in theory

But you're basically asking the government to step in and take control of the money supply away from the banks, and they're not going to allow that to happen without a fight, especially since they've profited off that control for a long time. It would be difficult to get a constitutional amendment passed given the problem of greed and corruption in government seen today. I'm not trying to rain on your parade, but it appears to be the reality of the situation.

[Name removed]

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[bemildred]

5. That's all bullshit.

Money is little magnetic dots on computer media these days,
no connection whatsoever with anything out in the "real"
world. Money is "faith based", it works as long a people
think it will work. The "high-interest-to-fight-inflation"
idea went by the board some time ago. Hydrocarbon energy has
more than doubled since Shrub took office, and housing likewise,
not to mention food, yet we have "low" inflation and they
are able to keep interest rates at historic lows. High interest
rates have primarily been used to raise jobless rates and
beat the working class into line, now we have outsourcing to
do that job, and the Chinese don't want us to stop buying
their manufactured goods (lest their economy crash), and so
we just keep adding zeroes as needed to the "money supply",
tra la la, tra la la, ...

[German-Lefty]

6. Answers

So inflation is too much money chasing too few goods, right?
Correct, though one could replace the "goods" with produced goods/services. The economist Fischer defined velocity as how fast the average dollar moves in buying new production.
velocity = Money supply/GDP
This ratio seems stays relatively constant in the long term.

And raising interest rates as a means of fighting inflation is an attempt to reduce the amount of money, right?
Raising interest rates gets more investors to take money out of circulation, by buying bonds from the FED. Think of it as the FED+gov borrowing dollars and destroying them. Theoretically we could pay off our debts with taxes and the cash would never reenter the system.

So how does that relate to the "creation" of money by means of having a fiat currency?
A government can create fiat money anytime it wants by just printing and spending it. The FED decides what fraction of money is printed instead of borrowed, by buying back ~10% of treasury bonds with new money.

And where--in theory--does the value of cash come from in a fiat currency system?
It comes from the fact that the nation is forced to use the fiat currency. Different actors have to keep different levels of currency to function properly. You keep a supply of money in your wallet. Stores keep enough change to make it through at least one day. Businesses keep cash on hand for short term needs. Your bank has to keep 10% of your account as cash (or fed reserves) in case you want to pick up your money. So because we all need the fiat money to do business, the money has a value.

[umass1993]

7. Fiat is a bit misleading.....

You could say the same about our entire legal system. We have a fiat legal sysytem, it only works because people believe in it.

The supply of money is limited by law. You can't print your own or make money out of thin air....to do so is fraud. This is enforced by the Secret Service, which is a part of the Dept. of Treasury.

Money is simply a tool. It just makes commerce easier.

The real problem is speculation. Such as what led to the Great Depression,( which, BTW, was before the "fiat" standard).

Fiat just means, bound by law. Since civilisation is based on law, the "Fiat" system is as good as any other.

[bemildred]

9. Yes, I agree.

Problems arise when these conventional arrangements are
hijacked for purposes other than those they were instituted
to address, or when they are not enforced unformly, so that
their legitimacy and reliablity come into question. That
sort of thing threatens the stability of the whole system.
It's a bad thing.

[yltlatl]

8. Thanks to Everyone for Helping me Out With This

You might be interested in this FAQ, where I also learned a tremendous amount.

http://www.galmarley.com/framesets/fs_fundamental_properties_faqs.htm

[German-Lefty]

10. Looks like that site is from one of the crazy gold bugs.

There are a crowd of people that want to go back to a gold standard. Some of their ideas are pretty good. The general idea is to take the power to control the money supply out of the government's hands and (I note) put it in the hands of the gold mining industry. Many of these people are genuine some I'm sure aren't, look for the commercials to "buy gold from us". Some are kind of in between: they're sitting on a bunch of gold because they believe in it and want you to buy gold too so the price will go up.

commodity based currencies
We could ask the same question about gold in a gold standard economy: "where does the value of gold come from". With a commodity based currency there is also demand for money. An amount of the commodity is set aside in different places like fait money. This amount fluctuates since the demand for money as well as the demand for the commodity fluctuate. If gold is needed to make jewelry, people melt down gold coins. If they need more change, they'll scrap jewelry and make more coins.

Now in an economy where the commodity plays a central role such a currency makes sense. For example if we're all potato farmers with a year's supply of potatoes in each home, a potato back currency makes sense.

If you're using something like gold and you're not in a gold mining area, it doesn't work as well. Here are the economic minuses:
* The gold that sits around being used as money is not being used productively and is a wasted resource.
* The rarer the commodity the more overpriced it gets. Generally the value of gold will be inversely proportional to it's quantity and grows as the economy grows. As demand for the commodity rises, more an more energy is wasted to dig the stuff out of the ground.
* What the economy pays to have the gold price increase at say 1% a year could be given to the government as sovereignage in a fiat system.

[dcfirefighter]

11. If we have to have a commodity money

form of barter, I'd rather see the money fractionally backed by a basket of commodities: refined metals, chemicals, ores, & oils, as well as agricultural products and textiles.

I've also seen theories that money should be based on the Joule - though I think this is silly, a Joule of thermal energy at 1000 degrees is much more valuable than a Joule of thermal energy at 20 degrees.

[German-Lefty]

12. commodity baskets

"If we have to have a commodity money" form of barter, I'd rather see the money fractionally backed by a basket of commodities: refined metals, chemicals, ores, & oils, as well as agricultural products and textiles.
Yes, you can do this. I think to some degree it does make things better too, since the extra demand will be spread across several commodities. Still whatever you use the economy will waste energy producing extra of it and then stockpiling it. One idea I had was picking a basket of emergency supplies like a giant strategic fuel reserve, a bunch of MREs, and other supplies.

What anti-fiat money people propose, which does at least sound reasonable, is that the government doesn't decide. The government removes the requirement that people do business in their currency. So I can rent a flat from you for X chickens a month if we want. Some company can issue money and stockpile whatever it wants and if people want to they can trade with this money. It's very free market. I'm not sure if I trust it though.


I've also seen theories that money should be based on the Joule - though I think this is silly, a Joule of thermal energy at 1000 degrees is much more valuable than a Joule of thermal energy at 20 degrees.
1 Joule = 1 Newton * 1 Meter
http://en.wikipedia.org/wiki/Joule
You don't normally think of it as thermal. Though 1 Joule=0.239 calorie. 1 calorie is the energy required to heat 1 g of water 1°C.

Enough of the physics lesson. Yes, if energy were to be used as the base commodity one would have to ask what type. Something burnable like oil or coal makes sense. Electricity makes sense, but you can't really store that or transfer it all. I might promise 1GW*hour, but not be able to burn my stock pile of fuel all in one hour.

[On the Road]

13. I Asked a Similar Question in Business School Econ

My teacher was a fiscal policy expert at the Federal Reserve named Al Teplin, who gave a very long answer something like this:

--------

It is true that there are some countries which irresponsibly print money and devalue the currency already in circulation -- too much money chasing too few goods. That's not what happens in the US.

--------

When inflation started in the late 60s, the economy had been booming for awhile. Factory output was close to capacity. Since supply was tight, factories were able to raise prices. Employment was high, also, which allowed workers to demand more in wages (especially since more were unionized). Each of these fed the other. For each increase in prices, wages would go up. And for each increase in wages, prices would go up. It became an accepted pattern.

To stop the vicious cycle, it was necessary to prevent businesses from raising prices and workers from demanding higher wages. This was only possible with an economic slowdown in which corporations had to slash prices to stay in business and workers had to forgo wage increases to stay employed.

More recently, competition from overseas has served the purpose of depressing wage and price growth. It's one reason for the expansion of the last twenty years without double-digit inflation.

-----

The role of interest rates is indirect. It's not the rate itself that
fights inflation, but the fact that it changes the economy from a seller's/worker's market to a buyer's/hirer's market.

-----

There's also the role of supply shocks, like the two oil crises of the 70s. In this case, inflation is caused by the same amount of money chasing a smaller amount of goods. This happens all the time on a small scale -- the price of asparagus or diamonds may suddenly double. But if it's a major commodity like oil, it can force businesses to raise prices and lead workers to demand higher wages because of the higher prices. This can also lead to a cycle of inflation.

=======

That helped me understand the world as much as anything in any econ course.

As far as money based on gold and commodities go, they are not the panacea promised. More important than what currency is based on is when and how the money supply changes, and who controls it. If it's based on a commodity, there IS no control. What's worse, an economic slowdown may decrease prices by decreasing demand, and actually make recessions worse. There is no way to jump-start the economy by lowering interest rates. It would mean a return to the boom-and-bust pattern of the 19th century.

I don't think governments should directly control interest rates or the money supply, either. Politicians are notoriously bad at long-term economic responsibility. Can you imagine what the Bush administration would have done if they had the Fed's powers?

I would like to see more representation on the Fed from the consumer end and other non-banking interests. Otherwise, I don't think it's a bad system.

[dcfirefighter]

14. Wage & Price push inflation

I disagree. Sort of.

When lots of folks are employed, and lots of producers are near capacity, inflation only occurs if there is no opportunity for additional competitors to step in and undercut prices.

At or near full employment, a producer would have to attract new labor with higher wages. In such situations, working capital might or might not be hard to come by. I tend to think not. However, real estate would be expensive, limiting competition in hot markets.

The key to staving off wage & price push inflation is to decrease barriers to competition, including real estate speculation.

We're seeing inflation now, nowhere near full employment, nor near full production capacity.

[On the Road]

15. Businesses are Always Trying to Raise Prices

and workers are always seeking higher salaries. Inflation will happen whenever either of those gets the upper hand in the marketplace.

Competitors always appear, but the process takes time, resources, and economic confidence. For manufactured goods, it may a period of years. If it happens over a wide enough spectrum, as happened in the 60s, that period may be long enough to initiate an inflationary spiral.

Economics is full of indirect effects. Your position depends a lot on where you start and what you emphasize. The most important thing is to look at what actually tends to happen under certain economic frameworks.

Inflation can be caused by (1) governments diluting the value of the currency in a direct way, (2) supply shocks or commodity shortages, and (3) bidding up prices and wages in a self-reinforcing cycle.

Dilution is not a concern for the US and shortages are not usually avoidable in the short term. I would argue that a price spiral is not happening now because of price competition from imports and wage competition from outsourcing. In that sense I agree with you that dropping barriers to competition has tamed inflation (although at a substantial cost to a lot of US workers).

As far as the Fed's inflation responsibilities, I believe their method is basically correct -- minimizing the spikes and crashes by fine-tuning interest rates or the money supply.

[dcfirefighter]

16. I maintain that Real Estate has a role

particularly real estate speculation

by suppressing competition - which allows producers to raise prices AND suppress wages.

by increasing the cost of living through direct price increases

by diverting investment money from productive activities like building capital to non-productive activities like purchasing land.

I'm no fan of the FED. These people scream 'Free-Market' but they want a centrally planned money supply?

I'd minimize spikes and crashes by reducing speculation in non-produced goods. Speculation serves a purpose in produced goods - it serves a means to smooth variations in supply. E.G. "I think wheat will be expensive next fall - I will purchase 10,000 bushels for delivery then" It allows producers to sell risk.

Speculation in non-produced goods merely witholds them from production, and raises the price of those goods.

[On the Road]

17. How Would You Reduce Speculation in Non-Produced Goods?

And how would you stop a wage-and-price spiral once it starts?

I agree that most free marketeers do not want a completely free economy. The only alternative I see to the Fed is a return to the boom-and-bust pattern of pre-depression days. The Fed was counterproductive in the Great Depression, but since then seems to have gotten progressively better.

[dcfirefighter]

18. If I were the benevolent dictator....

Non-produced goods: land, air, water, raw minerals, broadcast rights, etc.

Charge a significant 'user fee' for holding / using / having the right to extract them. If I were rich, I could by 6 homes in downtown Baltimore, for cheap. I could rent them out like a slumlord and pay the taxes out of my cheap returns. Or I could knock them down and fence in the lot, reducing my taxes by 2/3'ds. I wait 5-10 years, and sell, making much more than it cost me in taxes to hold the lots.

In simplest terms, raise the property tax, while exempting buildings. Auction off mining, timber, fishing, drilling and water rights every five years or so. No point in holding these things if you're not going to use them, then. For new competitors, the acquisition cost is similar (actually less): you pay less in purchase price but more in annual taxes.

Wage & price spiral:
I'm assuming low interest rates here? I favor a free market in interest rates, which should be self-equalizing.

Hot economy? What's the complaint? Oh, yeah, inflation.

Employers can't attract employees without offering better wages? This is pretty much my goal.

Unions won't work without a raise? Meh. I'm ambivalent towards the role of Unions, and I are one. I say go for it. Ask for too much, and the shop will close. I've never put much faith in the theory that union demands could cause inflation.

Prices rise for lack of competition? Where's the barrier? There are folks who say land is the mother of all monopolies.

It depends, of course. I'm personally of the belief that if the government collected a large portion of Adam Smith's 'Rent', and maintained a stable but steadily increasing money supply, booms & busts as well as inflation would be a thing of the past. I think you could have noninflationary full employment. If you absolutely must attempt to fiddle with things, do it with fiscal policy rather than monetary policy. If things are too slow, raise taxes and spend money.

CPI - (for what it's worth) consists of:
15% Food & Beverage: pretty close to efficient markets here, esp. staples. I actually support 'expensive' (unsubsidized) food, rather than subsidized food. Fairer for other countries, easier to employ people in agriculture here. Pretty hard to start a market farm - land near cities is far too expensive: it's likely to be made into housing developments because housing pressure can't be met in the cities because too many landowners are sitting on their strip malls and brownfields.
42% Housing: absolutely NOT efficient. Roughly 1/4 to 1/3 of the cost of housing is due to the previous (current) owner of the land, for something he didn't create. It's a drain on the economy, all that payment for nonproduction. 12% of income, just for residential property. Home heating & electricity are here as well: energy use is inefficiently allocated as well, due to the 1) externalities of mining and combustion and 2) due to the 'natural wealth' unproduced nature of coal seams and oil deposits (we pay 'rent' to the 'owner')
4% Apparel: pretty efficient markets here, as well.
17% Transportation: Fuel, as mentioned above, as well as subsidized road use. Land speculation leads to sprawl and increased transportation costs.
6% Medical care. No price mechanism between patients and caregiver. Health providers pass ininsured costs onto paying patients. Pharma has huge barriers, using Patent manipulation. Two improvements: 1) universal market based patient chosen individual compulsory insurance, with partial subsidies for low income people and 2) limit 'free' patents to 5 years, auction them off every 5 years thereafter.
6% Recreation: mostly efficient. Lot's of branding, but there's not much to be done about that. The largest section is 'club fees', highly dependent on real estate prices.
3% Education: Mostly monopoly government providers here. Competition could be improved, though it's largely subsidized, so prices probably couldn't go down without larger subsidy.
3% Communication: pretty efficient, could be improved by periodically auctioning FCC licenses and pole cable rights.
3% Other: tobacco, toiletries, laundry

[Mr. Streisand]

19. Blame it on Bush

www.thanksalotw.com