Money creation is the root cause of broad-based price inflation. No unbiased, thorough assessment of the situation leads to any other conclusion.
The non-synchroneity of money creation and its effect on prices creates some confusion to-be-sure. The hoarding of newly-created money creates a lag between the creation of money and its effect on prices. That lag can sometimes obscure the connection between inflation and its root cause. We described this lag and its causes in, The Bizarre Parallel World of Hibernation.
If money creation is the root cause of a broad-based price inflation, the decision of the recipients of the newly-created money to spend it rather than hoard it is the trigger. When the recipients of new money decide to spend it, a broad-based price inflation commences.
What is it, then, that causes people to spend the money they have previously hoarded?
One of the important triggers of inflation, we believe, is people’s expectation of the future value of the currency they hold. If people expect the value of their hoarded currency to decline, they will naturally reduce their holdings of that currency. The act of reducing their holdings of the currency creates an incremental supply of that currency, which reduces its value in advance of the future event.
People, in short, will anticipate future events and position themselves to benefit as those future events unfold. The act of positioning themselves to benefit accelerates the economic effect of the event before the event actually occurs.
Salmon P. Chase was the U.S. Secretary of the Treasury during the U.S. Civil War. In his attempt to finance the war, Chase more-or-less destroyed the value of the U.S. dollar. He delivered four consecutive gut punches to the value of the currency in a fourteen-month period from late 1861 through early 1863.
As the U.S. Civil War started, currency in the United States consisted of various gold and silver coins as well as “notes” issued by both the U.S. Treasury and private U.S. banks. The bank and treasury notes were redeemable for gold. The U.S. was on the gold standard.
In late December of 1861, nine months into the war, the private banks and the U.S. Treasury jointly announced that their notes were no longer redeemable in gold. “Convertibility” of the notes into gold was suspended. That was gut punch number one. Chase had taken the U.S. off the gold standard.
Chase followed that up with three issues of so-called greenbacks, one in February of 1862, another in July of 1862 and yet another in January of 1863. Those were gut punches numbers two, three, and four. Greenbacks were paper currency in the purest sense of the words. No pretense for convertibility. They were literally just paper.
Shortly after Chase and the private banks suspended conversion, gold exchanges popped up in lower Manhattan. While the notes were no longer officially convertible by the banks or the government, they were convertible at these exchanges. A market value developed for the notes and later the greenbacks in terms of gold.
A curious pattern emerged in the value of the U.S. dollar at these exchanges as Chase delivered his four blows to the currency.
With the first tranche of greenbacks, the value of the dollar barely budged. The notes in circulation had been trading at a 4% discount to gold on the exchanges since the suspension of convertibility. When the first tranche was issued, the discount increased slightly, but generally stayed below 5%.
No one knows exactly how much currency was in circulation prior to the first $150 million tranche of greenbacks, but by most accounts that initial issue likely increased the money supply in the United States by about 30%. The U.S. was mired in an expensive Civil War. No one had any idea how the war would be financed. The federal government was all but bankrupt, having exhausted its taxing and borrowing capacity. Yet, $100 of paper dollars still bought $95 of gold, despite the substantial increase in the money supply.
When Chase issued the second tranche, the value of the dollar in terms of gold depreciated almost immediately. It began a long descent from there. People in general were becoming more aware of the financial situation Chase faced in financing the war.
At the time Chase issued the third tranche of greenbacks, the value of the dollar in terms of gold on the exchanges declined in advance of the actual issue of the greenbacks. That is, the value of the dollar declined as soon as Chase asked the U.S. Congress to approve a third issue.
The lag between the creation of new money and its effect on the value of the dollar, in other words, got progressively shorter with each successive issue. The first tranche had little effect on the value of the dollar. The second tranche affected the value of the dollar immediately at the time of issue. The third tranche affected the value of the dollar before the greenbacks were even issued.
The value of the dollar depreciated with respect to not just gold, but to all other goods and services as well. The value of the dollar declined in terms of dry goods, clothing, beef, eggs, fuel, and even in terms of an hour of labor. The price of everything, in short, went up. The price increases were modest after the first tranche of greenbacks and accelerated with the later tranches.
What exactly caused the shrinking lag? What made the delay between the issue of new currency and its effect on prices get progressively shorter until, in the end, the economic effect actually preceded the event itself?
We believe the lag shrunk because people became more and more aware of the connection between money creation and its effect on the value of the currency. As they became more aware of that connection, they started taking action to protect themselves earlier and earlier in the process. Their actions accelerated the economic effect of the increasing money supply. By the time the third issue came around, the holders of greenbacks and notes were keenly aware of the connection. They were locked on and engaged. They acted not on the issue of the greenbacks, but on the news of a possible future issue.
The shrinking lag, in other words, reflects people’s behaviors as they become more and more aware of what the government is doing to the value of the currency. That pattern of increasing awareness creates two distinct phases as inflation ripples through an economy.
The first phase is the period of deception where people are generally unaware or indifferent to the real costs of money creation. That ignorance or indifference creates long lags between money creation and its effect on prices as people hoard the newly-created money. The signature observable feature of the period of deception is money supply grows faster than prices. People’s willingness to hold the newly-created money keeps prices down despite the government creating more and more new money.
The second phase is the period of awareness where people recognize the costs of money creation. The awareness not only shrinks the lag between money creation and its effect on prices, but also catches prices up from the earlier lags. The signature observable feature of the period of awareness is prices increase faster than the money supply. People’s desire to reduce cash holdings as they become aware of the effects of money creation triggers a broad-based price inflation, just as it did during and after the third tranche of greenbacks during the U.S. Civil War.
The transition between the period of deception and the period of awareness occurs when people lock on to the connection between money creation and its effect on the value of the currency. That is the trigger.
We believe the United States is currently in that transition. Sentiment is starting to change as the holders of U.S. dollars are becoming increasingly aware of what the government is doing to the value of their holdings. As the U.S. enters the period of awareness, we believe prices will begin increasing faster than the money supply as the holders of U.S. dollars attempt to reduce their holdings. The damage, in short, has been done; the economic costs are yet to be paid.
