Inflation and the Fed
92 years together and no end in sight
By Tony Allison, April 29, 2005
"It was the case that the price level in 1929 was not much different, on net, from what it had been in 1800. But, in the two decades following the abandonment of the gold standard in 1933, the consumer price index in the United States nearly doubled. And, in the four decades after that, prices quintupled. Monetary policy, unleashed from the constraint of domestic gold convertibility, has allowed a persistent over issuance of money. As recently as a decade ago, central bankers, having witnessed more than a half-century of chronic inflation, appeared to confirm that a fiat currency was inherently subject to excess." – Fed Chairman Alan Greenspan Before the Economic Club of New York, New York City December 19, 2002 "Issues for Monetary Policy"
It’s always nice to start with a stunningly ironic quote. However, Mr. Greenspan doesn’t give deserved credit to the Federal Reserve for starting the inflation wheels turning. Throughout the 19th century and into the early 20th century, the inflation rate in the United States was essentially zero. Admittedly, there were nasty bouts of inflation (particularly during the Civil War when the U.S. went off the gold standard), as well as periods of deflation. But in the aggregate, a dollar in 1912 could buy approximately the same amount of goods or services as in 1800. Money in those days was “as good as gold” since one could redeem the paper note for gold at a fixed rate at the local bank.
A Monopoly on Money Printing
In 1913 things began to change with the establishment of the Federal Reserve Bank. The Fed, with its monopoly on printing money, was created to guard against market turbulence in the private banking system, specifically in response to the Wall Street and banking depression of 1907-1908. The concentration of this kind of power was extremely controversial at the time.
President Woodrow Wilson, who signed the Federal Reserve Act in 1913 was quoted just three years later as saying, “I have unwittingly ruined my country. The growth of the nation, and therefore all of our activities, are in the hands of a few men. We have come to be one of the worst ruled, one of the most completely controlled and dominated governments in the civilized world” (Quoted in “National Economy and the Banking System," Senate Documents Co. 3, No. 23, 76th Congress, 1st session, 1939.) And Wilson was a strong believer in centralized government.
Well before 1913, Thomas Jefferson predicted a huge national debt when the Second Bank of the United States (our first monopoly central bank) was chartered in 1816. President Andrew Jackson vetoed the renewal of its charter in 1832, amidst intense lobbying from politicians and banking interests to renew. Despite the banking-led opposition to his presidential campaign, “Old Hickory” was reelected in 1832.
A Change in the Nature of Money
It did not take long for the Federal Reserve to begin profoundly changing the nature of money. In its first seven years of operation, wholesale prices in the U.S. rose more than 240%. Not surprisingly, between 1914 and 1920, the currency in circulation had increased 242.7%. And much as the Roman Empire had clipped their coins to create more money, the Fed was already undermining the gold standard.
“With the establishment of the Fed, gold certificates began to be replaced with the new Federal Reserve Notes. Unlike gold certificates, with 100% gold backing, Federal Reserve Notes only had a 40% gold reserve behind them, enabling a dramatic expansion of the currency.” Richard Ebeling, Money Central Planning and the State (1997)
Between the Fed’s printing money more rapidly than in the past to pay for expanding government spending, and the U.S.’s total desertion of the gold conversion standard in 1933 (domestically), the value of one dollar in 1913 would now be worth less than 5 cents. Inflation has destroyed over 95% of the dollar’s value in less than 100 years. The dollar’s steady decline in purchasing power has come to be accepted as normal. As the following chart illustrates, the majority of the inflation has occurred since 1950.
The Silent Tax
Throughout the history of nations, inflation has been a time-honored and subtle method for governments to plunder its citizenry. Inflation is a silent tax, which allows increased government spending without overt tax increases. The gold standard may seem archaic today, but it enforced a spending discipline on governments. Under the gold standard, the value of a dollar was measured in terms of gold and its value fluctuated accordingly, based in large part on the public estimation of its ability to convert paper money into gold. In the 19th century the U.S. and other governments went off the gold standard periodically, usually during wartime. But public outcry and the market reaction forced governments back on the standard. The gold standard is a bit like the NFL salary cap. It’s a self-disciplining mechanism. When the cap limit is reached, no more spending. The salary cap essentially saves the NFL owners from themselves. As for governments, when you print promissory notes that are not tied to anything tangible, the urge to print more notes is overwhelming.
The Fed Feeds the Government Appetite
The creation of the Federal Reserve and its monopoly printing powers has allowed government spending to become a larger and larger part of the economy. The graphs below show the total government share of the economy has grown faster than the private sector for decades. Government spending does not create wealth or prosperity, but it can certainly create debt.
Federal Debt Acceleration
Our federal debt obligation is so big that it is hard to fathom. From the beginning of our nation in the late 18th century until the mid 1970’s, roughly 200 years, our accumulated National Debt was less than one trillion dollars. This takes into account the Revolutionary War, the Civil War, two World Wars, the Great Depression, the Korean War and Vietnam. Today our federal debt is now over $7.5 trillion, over half of which has been borrowed in the last dozen years.
The proverbial bottom line is that inflation has been eroding the value of the dollar for nearly a century. But because of the unprecedented money and credit creation of the past five years, the “quiescent” CPI inflation of recent years will soon begin to accelerate. Massive credit creation can “paper over” societal ills short term, but more and more money chasing the same amount of goods and services means only one thing long term: higher inflation. Notice how the costs of fuel, utilities, food, medical care, insurance, college tuition, etc. have risen in recent years without a similar rise in national income.
Has Inflation Helped the American Family?
Looking back into the dark ages of the 1950’s and 1960’s, one-income families lived fairly well (albeit in smaller homes and without today’s gadgets), built savings and college-educated their children without massive loans. Is this feasible today for most two-income families? Not a chance. It’s a good thing inflation has been “under control” since 1982.
In recent years, inflation has not been a topic of national interest, but it will be in the years ahead as hugely excessive liquidity seeps into many areas of the economy beyond real estate. American families are currently “saving” through inflation-driven gains in home equity. Liquidity has been pouring into housing in recent years, creating inflated prices, but no real wealth. When the bubble pops, real estate values will revert back to their historic trend line, and the “savings” of millions of Americans will vaporize. Unfortunately, so will the dream homes of many overleveraged souls with variable, interest-only loans.
Growing inflation is not kind to many investment sectors, as well as many groups in society, such as retirees. In planning for your future, it is important to understand that a dollar today and a dollar in 2010 are two different animals. Unfortunately future dollars will have far less bite, except perhaps in your wallet. It would be wise to prepare now for the inflation on the horizon. Investment in tangible assets and natural resources should be part of that strategy. As legendary investor Warren Buffett once remarked, “it wasn’t raining when Noah built the ark.”
The Genie is Out of the Bottle
In retrospect, President Wilson should have heeded the wisdom of Founding Fathers like Jefferson and Jackson and not unleashed the inflation genie from the bottle (although others would likely have done so). Getting the genie back in the bottle is going to be more than difficult.
Imagine a world of gradual price deflation, which over time increases purchasing power and real wealth, while rewarding saving. That world won’t be arriving any time soon. Gentle deflation would be a nightmare scenario in today’s credit driven and debt-burdened economy. The torrent of debt would launch sky-high in future dollars. This is yet another reason the Fed will go down with all printers blazing to stop deflation gaining any foothold. For 92 years, the Federal Reserve has created the environment for inflation to thrive. The Fed’s first, middle and last line of defense is to flood the world with dollars. That is what the Fed was born to do, and it does it very well. The long history of inflation and the Fed is far from over.
© 2005 Tony Allsion