© Jan 3, 2012 Keith Weiner
The Keynesians and Monetarists have fooled people with a clever sleight of hand. They have convinced people to look at prices (especially consumer prices) to understand what’s happening in the monetary system.
Anyone who has ever been at a magic act performance is familiar with how sleight of hand often works. With a huge flourish of the cape, often accompanied by a loud sound, the right hand attracts all eyes in the audience. The left hand of the illusionist then quickly and subtly takes a rabbit out of a hat, or a dove out of someone’s pocket.
Watching a performer is just harmless entertainment, and everyone knows that it’s just a series of clever tricks. In contrast, the monetary illusions created by central banks, and the evil acts they conceal, can cause serious pain and suffering. This is a topic that needs more exposure.
The commonly accepted definition of inflation is “an increase in consumer prices”, and deflation is “a decrease in consumer prices.” A corollary is a myth that stubbornly persists: “today, a fine suit costs the same in gold terms as it did in 1911, about one ounce.” Why should that be? Surely it takes less land today to raise enough sheep to produce the wool for a suit, due to improvements in agricultural efficiency. I assume that sheep farmers have been breeding sheep to maximize wool production too. And doesn’t it take less labor to shear a sheep, not to mention card the wool, clean it, bleach it, spin it into yarn, weave the yarn into fabric, and cut and stitch the fabric into a suit?
Consumer prices are affected by a myriad of factors. Increasing efficiency in production is a force for lower prices. Changing consumer demand is another force. In 1911, any man who had any money wore a suit. Today, fewer and fewer professions require one to be dressed in a suit, and so the suit has transitioned from being a mainstream product to more of a specialty market. This would tend to be a force for higher prices.
I don’t know if a decent suit cost $20 (i.e. one ounce of gold) in 1911. Today, one can certainly get a decent suit for far less than $1600 (i.e. one ounce), and one could pay 3 or 4 ounces too for a high-end suit.
My point is that consumer prices are a red herring. Increased production efficiency tends to push prices down, and monetary debasement tends to push prices up. If those forces balance in any given year, the monetary authorities claim that there is no inflation.
This is a lie.
Inflation is not rising consumer prices. One can’t understand much about the monetary system from inside this box. I offer a different definition.
Inflation is an expansion of counterfeit credit.
Most Austrian School economists realize that inflation is a monetary phenomenon. But simply plotting the money supply is not sufficient. In a gold standard, does gold mining create inflation? How about private lending? Bank lending? What about Real Bills of Exchange
As I will show, these processes do not create inflation under a gold standard. Thus I contend the focus should be on counterfeit credit. By definition and by nature, gold production is never counterfeit. Gold is gold, it is divisible and every piece is equivalent to any other piece of the same weight.
Gold mining is arbitrage: when the cost of mining an ounce of gold is less than one ounce of gold, miners will act to profit from this opportunity. This is how the market signals that it needs more money. Gold, of course, has non-declining marginal utility, which is what makes it money in the first place, so incremental changes in its supply cause no harm to anyone.
Similarly, if Joe works hard, saves his money, and gives a loan of 100 ounces to John, this is an expansion of credit. But it is not counterfeit or illegitimate or inflation by any useable definition of the term.
By extension, it does not matter whether there are market makers or other intermediaries in between the saver and the borrower. This is because such middlemen have no power to expand credit beyond what the source—the saver—willingly provides. And thus bank lending is not inflation.
Below, I will discuss various kinds of credit in light of my definition of inflation.
In all legitimate credit, at least two factors distinguish it from counterfeit credit. First, someone has produced more than he has consumed. Second, this producer knowingly and willingly extends credit. He understands exactly when, and on what terms, with what risks he will be paid in full. He realizes that in the meantime he does not have the use of his money.
Let’s look at the case of fractional reserve banking. I have written on this topic before (Fractional Reserve Banking). To summarize: if a bank takes in a deposit and lends for a longer duration than the deposit, that is duration mismatch. This is fraud and the source of banking system instability and crashes. If a bank lends deposits only for the same or shorter duration, then the bank is perfectly stable and perfectly honest with its depositors. Such banks can expand credit by lending, (though they cannot expand money, i.e. gold), but it is real credit. It is not counterfeit.
Legitimate lending begins with someone who has worked to save money. That person goes to a bank, and based on the bank’s offer of different interest rates for different durations, chooses how long he is willing to lock up his money. He lends to the bank under a contract of that duration. The bank then lends it out for that same duration (or less).
The saver knows he must do without his money for the duration. And the borrower has the use of the money. The borrower typically spends it on a capital purchase of some sort. The seller of that good receives the money free and clear. The seller is not aware of, nor concerned with, the duration of the original saver’s deposit. He may deposit the money on demand, or on a time deposit of whatever duration.
There is no counterfeiting here; this process is perfectly honest and fair to all parties. This is not inflation!
Now let’s look at Real Bills of Exchange, a controversial topic among members of the Austrian School. In brief, here is how Real Bills worked under the gold standard of the 19th century. A business buys merchandise from its supplier and agrees to pay on Net 90 terms. If this merchandise is in urgent consumer demand, then the signed invoice, or Bill of Exchange, can circulate as a kind of money. It is accepted by most people, at a discount from the face value based on the time to maturity and the prevailing discount rate.
This is a kind of credit that is not debt. The Real Bill and its market act as a clearing mechanism. The end consumer will buy the final goods with his gold coin. In the meantime, every business in the entire supply chain does not necessarily have the cash gold to pay at time of delivery.
This problem of having gold to pay at time of delivery would become worse as business and technology improved to allow additional specialization and thus extend the supply chain with additional value-added businesses. And it would become worse as certain goods went into high demand seasonally (e.g. at Christmas).
The Real Bill does not come about via saving and lending. It is commercial credit that is extended based on expectations of the consumer’s purchases. It is credit that arises from consumption, and it is self-liquidating. It is another kind of legitimate credit.
For more discussion of Real Bills, see the series of pieces by Professor Antal Fekete (see here, Monetary Economics 101 Lectures 4 through 9).
Now let’s look at counterfeit credit. By the criteria I offered above, it is counterfeit because there is no one who has produced more than he has consumed, or he does not knowingly or willing forego the use of his savings to extend credit.
First, is the example where no one has produced a surplus. A good example of this is when the Federal Reserve creates currency to buy a Treasury bond. On their books, they create a liability for the currency issued and an asset for the corresponding bond purchase. Fed monetization of bonds is counterfeit credit, by its very nature. Every time the Fed expands its balance sheet, it is inflation.
It is no exaggeration to say that the very purpose of the Fed is to create inflation. When real capital becomes more scarce, and thus its owners become more reluctant to lend it (especially at low interest rates), the Fed’s official role is to be the “lender of last resort”. Their goal is to continue to expand credit against the ever-increasing market forces that demand credit contraction.
And of course, all counterfeit credit would go to default, unless the creditor has strong collateral or another lever to force the debtor to repay. Thus the Fed must act to continue to extend and pretend. Counterfeit credit must never end up where it’s “pay or else”. It must be “rolled”. Debtors must be able to borrow anew to repay the old debts—forever. The job of the Fed is to make this possible (for as long as possible).
Next, let’s look at duration mismatch in the financial system. It begins in the same way as the previous example of non-counterfeit credit—with a saver who has produced more than he has consumed. So far, so good. He deposits money in a bank, and this is where the counterfeiting occurs. Perhaps he deposits money on demand and the bank lends it out. Or perhaps he deposits money in a 1-year time account and the bank lends it for 5 years. Both cases are the same. The saver is not knowingly foregoing the use of his money, nor lending it out on such terms and length.
This, in a nutshell, is the common complaint that is erroneously levied against all fractionally reserved banks. The saver thinks he has his money, but yet there is another party who actually has it. The saver holds a paper credit instrument, which is redeemable on demand. The bank relies on the fact that on most days, they will not face too many withdrawal demands. However, it is a mathematical certainty that eventually the bank will default in the face a large crowd all trying to withdraw their money at once. And other banks will be in a similar position. And the collapsing banking system causes a plunge into a depression.
There are also instances where the saver is not willingly extending credit. The worker who foregoes 16% of his wage to Social Security definitely knows that he is not getting the use of his money. He is extending credit, by force—i.e. unwillingly. The government promises him that in exchange, they will pay him a monthly stipend after he reaches the age of retirement, plus most of his medical expenses. Anyone who does the math will see that this is a bad deal. The amount the government promises to pay is less than one would expect for lending money for so long, especially considering that the money is forfeit when you die.
But it’s worse than it first seems, because the amount of the monthly stipend, the age of retirement, and the amount they pay towards medical expenses are unknown and unknowable in advance, when the person is working. They are subject to a political process. Politics can shift suddenly with each new election.
Social Security is counterfeit credit.
With legitimate credit, there is a risk of not being repaid. However, one has a rational expectation of being repaid, and typically one is repaid. On the contrary, counterfeit credit is mathematically certain not to be repaid in the ordinary course. This is because the borrower is without the intent or means of ever repaying the loan. Then it is a matter of time before it defaults, or in some circumstances forces the borrower to repay under duress.
Above, I offered two factors distinguishing legitimate credit:
- The creditor has produced more than he has consumed
- He knowingly and willingly extends credit
Now, let’s complete this definition with the third factor:
3. The borrower has the means and the intent to repay
Every instance of counterfeit credit also fails on the third factor. If the borrower had both the means and the intent to repay, he could obtain legitimate credit in the market.
A corollary to this is that the dealers in counterfeit credit, by nature and design, must work constantly to extend it, postpone it, “roll” it, and generally maintain the confidence game. Counterfeit credit cannot be liquidated the way legitimate credit can be: by paying it back normally. Sooner, or later, it inevitably becomes a crisis that either hurts the creditor by default or the debtor by threatening or seizing his collateral.
I repeat my definition of inflation and add my definition of deflation:
Inflation is an expansion of counterfeit credit.
Deflation is a forcible contraction of counterfeit credit.
Inflation is only possible by the initiation of the use of physical force or fraud by the government, the central bank, and the privileged banks they enfranchise. Deflation is only possible from, and is indeed the inevitable outcome of, inflation. Whenever credit is extended with no means or ability to repay, that credit is certain to eventually become a crisis that threatens to harm the creditor. That the creditor may have collateral or other means to force the debtor to take the pain and hold the creditor harmless does not change the nature of deflation.
Here’s to hoping that in 2012, the discussion of a more sound monetary and banking system begins in earnest.
Keith Weiner Economics 
Excellent article! Very clear and concise. Your definition of inflation is the best I have seen and very easy to understand. I’ll be bookmarking this entry and referring people to it, I already have a few in mind.Thank you for your good work.Chris
I like your definition of inflation and really like that you recognize the utility of the "real bills doctrine" We may very well need it in the not so distant future.Regarding gold, because of it’s finite supply, I am skeptical it is the end all be all. Silver too for that matter because of supply constaints compared to population growth and productivity, but it is certainly necessary at some level for confidence reasons when trust is low, like now. (Our land – resources, and promise of productivity – innovation, counts too)It is also intervention in supposedly "free" commodity markets.Here are some articles for you to consider.https://libertyrevival.wordpress.com/2011/12/05/libertarian-monetary-policy/https://libertyrevival.wordpress.com/2011/01/09/ending-poverty-and-political-turmoil/http://www.landandliberty.net/economics/henry-george%E2%80%99s-view-on-money/This simplifies mty point.http://www.henrygeorge.org/isms.htm
Hi Imaginer,What gives gold its moneyness is that its marginal utility (the value one places on the next ounce compared to the previous) does not decline, or if it does decline it falls so slowly as to be negligible. Only gold and silver have this property. The marginal utility of everything else falls rapidly. This is observable in stocks to flows, for all other commodities inventories divided by annual production is a few months. For gold it is 80 years. And it is observable in bid-ask spreads. In real estate, spreads are very wide. In gold, it’s 10 to 30 cents per ounce (on $1700!) I do not see how anything other than gold and silver could function as money, and certainly not land.The question is: how much gold do you think is needed for a monetary system? And how did you arrive at that number? :)I am no fan of Henry George. The banner at the top of the page is the giveaway. How to best divide the fruits of labor?First, production is not only caused by labor. Capital is needed. As is the entrepreneur.Second, production has prerequisites. It does not occur as a gift of nature. The question "(now that the wealth has got here somehow) how ought we to distribute it?" begs the question: under what conditions will the wealth "get here"? I.e. who produces wealth and what are their requirements?
To answer the question of how can gold and silver work as money inspite of it’s supply constraints and the constant increase in population. Gold and silver are a commodity and because of its “supply constraints” and its scarcity it will increase in value to match the need because of the price system and supply and demand. Consequently, when the price rises the supply will increase to match also. This is given that everything exists in a laissez faire capitalist society and there are no mining restrictions and regulations (For exploration and opening of new and reopening and expanding old mines). Reclaiming trace amounts of gold from landfills etc. will become very profitable to supply a rising demand as another example.Hope that helps…Ty
Ty: gold, as measured by the appropriate yardstock–stocks to flows–is not scarce. Aside from maybe water, gold is the most abundant commodity. By far.The idea that value derives from scarcity is not an Austrian idea and it’s not a correct idea either. The idea that one can look at *money*, in particular of all things, as a linear quantity and each unit is 1/Q or whatever just doesn’t correspond to how people think and value and act in reality in the markets.
Can’t believe you say that. Why not give me a call and hand over all your gold to me. I find it very usefull indeed and very scarce compared to copper or silver or zinc or seashells.
Mike: You misunderstand. Relative to its annual production, gold is quite abundant. This is a fact. Gold is much much MUCH more abundant, again relative to annual production, than any other commodity.
Far from being proof that gold is NOT valuable, this is proof that gold is quite valuable. For all other commodities, if inventories build up it is called a “glut, the price collapses and stays down until inventories are worked. Only in gold is the market willing to accumulate without any particular limit.
What you say is true in regards to inflation under credit-based and commodity-based monetary system. Inflation is usury upon the money supply. Inflation is not tax. Inflation would make an ideal progressive tax if it were a tax. There are no government forms. You can easily avoid inflation if you do something productive with your average daily balance, like make it available as credit. The tax is greater as your average daily balance increases. The usury on savings is cancelled by the tax if you wish to merely save it for later.The tax is cancelled if you have debt. The tax is minimal and can be guaranteed to be made progressive with the issuance of a citizen dividend. George Washington and Lincoln both recognized this nature of money, that inflation can be used as a tax to finance the public need. Inflation in this sense is good if it funds the public need rather than fattens the usurer, as Thomas Edison made clear in a NYT article.“It is absurd to say that our country can issue $30,000,000 in bonds and not $30,000,000 in currency. Both are promises to pay; but one promise fattens the usurer, and the other helps the people. If the currency issued by the Government were no good, then the bonds issued would be no good either. It is a terrible situation when the Government, to increase the national wealth, must go into debt and submit to ruinous interest charges at the hands of men who control the fictitious values of gold.” — Thomas Edison, New York Times, December 6, 1921http://query.nytimes.com/mem/archive-free/pdf?_r=3&res=9C04E0D7103EEE3ABC4E53DFB467838A639EDELegal tender is a creature of the state. For the government to declare gold to be legal tender is a corruption of the commodity market for gold. Gold is gold. Credit is credit. Legal tender is legal tender. You get gold from a gold miner. You get credit from the bank (from savings). You should get legal tender from the government. The state should not grant privilege to gold miners nor bankers to originate the legal tender, creating fictitious values for gold or credit. Thomas Edison also made this clear. What you promote sounds a bit absurd….http://libertyrevival.wordpress.com/2012/02/11/ron-paul-freedom-is-slavery/From what I remember, demand for gold is about 400-500 tonnes/year for technology, 1900-2000 tonnes/year for jewelry (mostly india), and 3000 tonnes/year for investment, which has grown from 2000 tonnes/year. Mining operations has provided for a little over half for that demand and recycling has provided for a little under half for that demand. And you want to further increase demand by making it legal tender?How are you going to convert existing monetary units to gold? Taxation? National Debt? Sounds like a winner to me. Let’s increase taxes so that the government can buy Ron Paul’s gold and become commodity traders.You might want to consider the consequences for your own bottom line…http://libertyrevival.wordpress.com/2012/02/18/paper-beats-rock-the-gold-standard-is-theft/To try to manage the supply of gold or other commodities as legal tender is futile. You’ll have boom/bust cycles every 10 years and will need to adjust monetary policy to accommodate monetary needs. I say 10 years because that was the history of the gold standard in America.If you do want to use a commodity, you should do as the Roman Empire did. They used cheap commodities, like copper, bronze, and brass, and minted them into coins, where the coins were worth much more than the commodity because Caesar only accepted taxes and paid for public services in that coin. The Roman Empire collapsed when Caesar went onto a gold standard. You can also just do what George Washington and Lincoln did and use paper. History is pretty useful if you look at it rather than peer it at through the Austrian School of Economics.
the real sleight of hand is calling a gold standard anything other than counterfeit credit. gold is credit because it must be borrowed from whomever has the gold by whomever wants to engage in an economic transaction. it is counterfeit because a gold standard implies government declares the commodity to be legal tender — meaning gold becomes fiat by decree or dictate. gold is relatively useless so corrupting the commodity market in gold is not so bad. what is bad is making such an expensive commodity the legal tender.the only money that is not credit is a legal tender originating by government without interest attached and without the requirement to purchase/borrow a commodity as a legal means of exchange to fund government whose supply is managed. such supply would be ideally managed to have a positive inflation rate — necessary to allow for economic growth, maintain monetary velocity as a demurrage, and to fund government without requiring tax payers to pay upon usury to private holders of public debt. inflation isn’t so bad when it helps all people rather than fattens the usurer.a gold standard has many other problems. you can look at the history of the gold standard since 50BC and through 1935AD when it was effectively abandoned. the primary problem is that it too is an expensive credit currency, often manipulated and mismanaged, inducing banking panics, and requiring government to constantly adjust monetary policy to manage the supply.
Banking panick? Anytime a person lets others warehouse their money or currency, there will be corruption. Loan sharking is a much more honest profession.
the definition of inflation and deflation are correct. unfortunately, people get confused about the impact of international trade. increased demand from large developing nations like china and india tend to increase commodity prices, which can be offset by dropping domestic prices in things like domestic service, land, and employment in a developed nation whose monetary supply is weakened due to banks not lending the credit and being sold as national debt to places like china. inflation and deflation can be caused by different things. they can cause different things too. unfortunately, this leaves opportunity for neo-classical followers of dimwits like marx, keynes, and von mises, whom the bankers love, to redefine inflation and deflation for political agendas against all the achievements of classical liberalism to free us from feudalism, usually towards the favor of usurers, bankers, land owners, feudal aristocrats, and corporations. unfortunately, classical liberalism never got money right except for a few limited instances or under controlled conditions. ultimately, you have to consider the supply and demand of the currency being considered. the basic laws of economics are correct. you just have to be able to correctly apply them, taking into account the various complexities and understand the different economic components.
separating money from credit would be a great achievement. unfortunately, most of humanity would have to understand why such would be such an important achievement for us to be able to hold onto such achievement.
"fiat" is defined as "decree" or "dictate." i meant to say gold becomes legal tender and consequently common credit (currency) by fiat (decree or dictate) of the government. but who really cares about the real meaning of words anyway when it goes against well-funded banker propaganda.
Liberty: you have misconstrued my position. I am in favor of abolishing legal tender laws, central bank charters, and other interference into the banking, financial, and monetary system. I am in favor of a free market in money and credit. In a free market, gold is money.As to "ideal" taxes, much less idea *progressive* taxes, I totally disagree. I also disagree with creating perverse incentives to repudiate money and force everyone to frantically find a bubble to jump into because they don’t care to hold money which is either falling in value or subject to some sort of tax. The aftermath of such policies are not working out very well today.
Keith G: as I said to Liberty, I am not proposing laws to force people to accept gold. People want gold, and use gold when laws forcing them to accept paper are repealed.As to developing nations, if their productivity is developing then why should prices rise? Do we presume that their productivity of consumer goods rises while their productivity of commodities does not? Today, the real cost in terms of hours of labor required to produce it, is far lower than it was 300 years ago before the West developed. This is another way of saying that we are wealthier.You will find that my work is not about promoting this or that conspiracy theory. Let’s stick to the facts and work on developing proper theories of how things work today and how things ought to work. Phrases like "banker funded propaganda" serve little purpose other than to inflame people (though I am glad you did not say "bankster").
i should say an enterpreneur often acts in both the capacity of labor and capital. an enterpreneur produces capital and often directly provides labor for exchange. if any component of production should be dropped, it should be capital, since capital is produced with labor and since it is possible to provide service without any kind of capital. a novice can sing to the public or dig with their bare heads directly for their client.
Production without capital amounts to long hours of back-breaking labor to produce a bare subsistence. Without a surplus, one is vulnerable to the first early frost, the slight drought, or a few insects. Life back in the days when man subsisted by hunting and gathering was pretty miserable and very short.
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Any gold standard I ever heard of was a frozen price per weight of coin that lasted until the authoraties chipped away the grams for tax. It always fails because ( a frozen price on metal). The interest rate charged to loan gold money out is what determines gold price. That is because of human nature. In a free market the interest rate is bid on in the market.You can’t really expect an interest rate to work with paper currency controlled by politicians.But a free market can establish a rate of interest on gold.The actual supply of gold determines what the interest rate will do over time.Same can be said with any metal used in coin. If the supply is being used up the price of the metal will eventually rise.
the reason people don’t like gold used for money is the same reason they don’t like competition in the market to earn money.Which is the vast majority. It ain’t fair and they know it.However whoever said life was fair.If too many people consume too much oil or build too many homes, or produce too many crops.Prices drop.Consumer prices on goods. In this world today that is real dangerous.And the weapons that are built each year and the technologies which are produced each year prove it.Governments do not allow depressions with todays technologies.Even though they are the only cleansing mechanism known to man. It is really down deep depressing. WWs are fought over this concept and yet people with today’s technologies. refuse to recognize their own ignorance.
Aint it just a MAD MAD WORLD.
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Excellent article, well thought out. That ounce of gold today is purchasing a lot more than the suit. It’s buying food stamps for the toothless crack ho down the street, its paying for extra help and nail polish in the bureaucracy and, it’s buying a couple artillery shells.
Matt: Thank you for your comment.
It’s become corrupt, but I don’t agree that it’s intrinsically corrupt.
Lovee this