Inflation, Deflation, And Currency Devaluation

We live in a world where most of the world’s currencies are Fiat or paper promises.  That is, there is no gold, silver, or other precious metals for which one can exchange a unit of paper currency for a unit of precious metal at a fixed rate.  The dollar in the United Sates had a fixed exchange rate in terms of its worth in gold bullion.  An ounce of gold was fixed by law at thirty five dollars.  And since the U.S. Federal Reserve issued currency, the paper notes, whatever the denomination were silver certificates and that was printed on each piece of paper currency.  One could have gone to the nearest federal reserve bank, there are thirteen of them located around the country and could have demanded silver for one’s dollar bill.  Many other countries held precious metals to back the value of their currencies and there were exchanges in the physical holding of these metals.  The Federal Reserve Bank in New York City has a precious metals depository and at one time many countries had their own vaults in that building.  To settle currency accounts gold or silver was physically moved from one vault to another.  And many of the world’s capitals had similar repositories.

But all of that changed back in the early seventies.  Starting in 1967 the country was experiencing an increasing rate of inflation that only ended in the mid eighties.  President Nixon was in office when there was a great demand for America to “pay its bill” abroad.  The oil producing countries in the middle east formed a cartel called OPEC and decided to increase the price of oil extracted.  The price of a barrel was quoted in a unit called Petro Dollars.  This increase in oil prices caused a rapid rise in the price of a gallon of gasoline in America.  This put further inflationary pressure on the economy.  We can trace the rise of inflationary pressure to three government actions.  The space and missile programs of the military that split into the military sector and the civilian sector (that is when NASA was born), the welfare program called the War on Poverty (it created the idea of aid to dependent children or food stamps, and other welfare programs, including medicare), and the Vietnam war, which had gone into full operations in 1964.  All of these programs took money, tax dollars collected from the tax payers.  The problem was that if the federal government had tried to do the pay as you go routine, it could not have afforded all three of the expenditures and possibly not even two of them.

So what to do?  Well, we had prior experience in the forties when we waged a war against Germany and Japan.  Our federal government ran a deficit.  That is, even while personal and business taxes were high, the money collected was not enough.  So the government urged individuals to buy war bonds or savings bonds.  The bonds were IOUs backed by the full faith of our federal government.  That is, there would never be a default on those bonds.  These Treasury bonds were authorized to be issued by the Treasury when needed to pay the government’s bills.  And by law, they had to be repaid when due.  But government debt, when financed by government bond issues is very much like have a credit card.  But the worst part is that as one’s credit line increases and is used, one finds it difficult to pay not only the interest but the current loan balance.  Add in corporate bonds and financial dealings around the world and the problems come home to roost all too soon.  Since the U.S. dollar was the world’s currency we were extended far too much credit and found that many countries were very wary of our finances.  They demanded gold to settle currency accounts (also known as current accounts and the bookkeeping is done by the International Accounts Bank).  And by this time gold was selling around the world for double what we valued it.  The problem was that we didn’t have enough gold to pay our bills and no one was going to extend our credit so that we could go out and buy the gold needed.  The world was flooded with American dollars and called by different names.  There were petro dollars and euro dollars, and many other kinds.  And if your country is awash in dollars what do you do with them all, particularly if you can’t use them all and can’t trade them in?

This was the crisis that Nixon faced and thought that it might be easily solved by having the world go off the gold standard.  Instead of having official exchanged rates fixed by each central bank we decided to try floating currencies.  Why not let the market decide what the current value would be?  This worked in the short run but as we have seen, in the long run countries like to cheat their neighbors.  China has kept its official rate of exchange low in order to steal from everyone else.  But that came at a severe cost to her people.  What you gain in exports you lose in imports.  So in devaluing our own dollar we could export more to other countries but our imports cost more.  And depending on what is needed to export, your own manufacturing costs may rise quickly if you have to depend on imported materials.  One of the problems we started having was a rapid rise of inflation due to the devaluation of the dollar.  This caused prices to rise quickly and since many union contracts had cost of living clauses in them the cost of labor rose and took much of the non union labor with it.  It is an even increasing spiral particularly when the expansion of credit is out of control.  In 1988 it was not uncommon to see home mortgage rates hit twelve percent.

Inflation causes asset bubbles and bubbles cause vast amounts of harm.  In California the price of housing rose so quickly that those individuals who had bought their homes in the thirties, forties, and fifties when the prices were very low now found themselves either priced out of the market if they were retired or unable to pay the greater increases in property taxes as a result of the government assigning ever increasing values for homes they wanted to live in.  Proposition 13 tried to address that issue and failed.  And as we have seen in many parts of the country where housing prices have peaked, burst, and retreated to as much as a third of their inflated value.  This is deflation.  Unfortunately we have both deflation and inflation occurring.  A good many assets are suffering from deflation of their values.  When interest rates are lowered to almost nothing people stop saving.  They are often forced to chase after risky high yield financial products.  On the other hand we have seen food prices soar ever higher in the past ten years.

The biggest question is what happens when the credit game collapses?  All hell breaks loose.  Corporate bonds and debt are defaulted, various government bonds and debt are defaulted.  Union investment funds collapse.  And even the rich find that they are not worth as much any more.  Do you think Bill Gates and other billionaires are sitting on huge piles of cash?  Most of their wealth is in the stocks and bonds of their former companies or in other companies.  Those expensive luxury homes become a great deal less because there are fewer rich people to buy those homes and why would they pay top dollar?  But its always the little people, the average citizen, who takes the brunt of such a financial collapse.  Jobs are lost and incomes destroyed.  Most of us will muddle through but the period of time to restore so many of us to a stronger economy will be measured in decades, not months.

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