Guest Post: Inflation: An Expansion of Counterfeit Credit

Submitted by Tyler Durden on 01/07/2012 16:15 -0500
Submitted by Keith Weiner
Inflation: An Expansion of Counterfeit Credit

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. 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 (starting with Lecture 4).