Silver Lining - Inflation and Waste

Life is full of paradoxes: happenings or conditions that intuition tells us are bad but which turn out to be quite good. Inflation and waste are two of these dark clouds with silver linings, if you understand the philosophy. First, let us consider the root causes of inflation. Contrary to popular belief the Federal Reserve does not create inflation by printing fiat dollars; inflation is created by consumers, the Fed only feeds it.

The old axiom, Time is Money, is as true today as ever. The difference between paying cash for a purchase or using credit is simple: when you spend cash your resources are reduced immediately, when you use credit your resources are scheduled to be reduced at some time in the future - with more cash than a straightforward transaction requires: interest. Credit purchases create money out of thin air and provide that the cash must be available to satisfy the obligation when it comes due.

Banks issue credit, that's how they stay in business. But they would not be able to issue credit if people weren't buying things on time (as money). In a ideal capitalist system banks would lend money to be used as capital to finance business ventures that would generate revenues enough to produce profits and pay off the loans. In such circumstances money would fulfill its role as a medium of exchange and the economic system would be relatively stable.

Banks are debtors as well as creditors. When you deposit money in a bank you are lending it to them. For this they pay interest a few points lower than they charge for the loans they make. The difference, called the spread is how they generate revenues of their own. And banks are finicky; they like to have both principal and interest paid to them. This is where capitalism took a sharp left turn; why pay back all that money when you can get away with paying only the interest? There's a place where that can happen: Wall Street.

Stocks are loans to businesses that do not have to be repaid as long as investors hold onto them. Stocks earn interest in the form of dividends but it's still interest. Corporations then have an incentive to produce profits that will enhance the value of their stocks and keep their investors on board. Stock were once good investment vehicles: it was when P/E (Price/Earnings Ratios) were lower than they are at present. If a stock sells for $10.00 and pays a dividend of one dollar a year, the investment will be recouped in ten years. The P/E is ten; the reciprocal (E/P) is interest. Simple? But today P/E's of 40 or more are common, meaning that it takes much longer to break even . Stock prices are theoretical values, what investors believe the prospects of a business concern are expressed as a cash value. They base their estimates on data provided by the corporations themselves - an almost irresistible temptation to "cook" the books - think Enron, Global Crossing, Worldcom, and other, lesser players.

In 1905 J. P. Morgan formed US Steel and introduced the world to the possibilities of investing in business enterprises. After World War I the US economy really got rolling, most of today's major corporations were formed, investment banks and stock brokerages sprang up, and banks were left in the lurch. So what did they do? They started investment departments and invented mutual funds which they called Trusts. Banks started buying stocks and sold shares in the net value of their holdings. On October 24th, 1929, the Great Crash changed everything. Then, as now, the culprit was credit in the form of margin buying. Banks got into stocks and brokerages got into banking: lending money to investors to purchase stocks that they held as collateral under the illusion that the stocks represented real money. So what's the bottom line?

Simple. Today we have so much stuff that people want to buy and so many dollars to buy it with. Now we are in a recession which, in a word, is a business downturn. These businesses are not selling all the stuff they have on hand, and because they have been run so inefficiently and dishonestly for decades their chickens have come home to roost, and therein lies the paradox: What's bad for the macro-economy (Wall Street, banks, corporations) is great for the micro-economy (you and me). And people are waking up to the opportunities, not spending so lavishly and - get this - saving money! And we are slowly coming to realize the true value of money - what we say it is! That is, what we are willing to spend our dollars to buy. It's that simple. And Americans are spending less on frivolities and more on staples. If prices are too high we just don't buy as much or at all, and search for ways to compensate. The corporations, when they lay off hundreds or thousands of their employees profess that they are getting leaner and more efficient, but so are we!

There are movements afoot to return to hard currency, money based on gold and silver. This is very unlikely. Currency is the blood of commerce and there must be a sufficient supply of it to go around. Our population has doubled and then some since the dollar was backed by specie metal: there wouldn't be enough to back a currency in the amounts required to carry on business unless we adjusted price levels to what they were in 1945. In 1945 you could buy a two bedroom home for $8,000.00, a new car for $2,000.00; bus rides were a nickel (jitney), gasoline was twenty cents a gallon; everything was cheaper by present standards - a lot cheaper. So what do we do?

As long as we exchange goods and services our Monopoly money, i.e.Federal Reserve Notes, has value. The difference is that the value is not fixed, rather the value is indeterminate, constantly shifting upward or downward depending upon the market pressures that bear on the currency through the normal exchange of goods and services. In simple terms this means that when a buyer wants to buy more than the seller wants to sell, prices rise; when seller wants (or needs) to sell more thanthe buyer wants to buy, prices fall.

So what is the value of the dollar? Whatever WE say it is!

Period!

Next time: How to counteract inflation.