–Monetary Sovereignty for Young People, Part 3. Inflation

Mitchell’s laws: The more budgets are cut and taxes inceased, the weaker an economy becomes. To survive long term, a monetarily non-sovereign government must have a positive balance of payments. Austerity = poverty and leads to civil disorder. Those, who do not understand the differences between Monetary Sovereignty and monetary non-sovereignty, do not understand economics.
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Some people have learned that the federal government, being Monetarily Sovereign, now has the unlimited power to create dollars. And of those people, some have learned that taxes hurt the economy by taking dollars out of the economy. And of those people, some see that federal spending grows the economy by adding dollars to the economy.

But, far too many people still believe federal deficits should be reduced. These people want increased taxes or reduced federal spending. How can they understand that dollars grow the economy, while still wanting fewer dollars in the economy? The answer: They fear inflation.

Inflation is when prices go up. Not just one price, or a few prices. Inflation is when almost all prices go up.

Is inflation a bad thing or a good thing? It can be both. It can be a bad thing, because your dollars will buy less of what you want – less food, less clothing, less everything. So, unless you get more dollars, inflation will make you poorer.

But the federal government believes a little bit of inflation every year is good. If people know prices will go up, they will buy things now, to take advantage of today’s lower prices, rather than waiting until later.

When people buy now, business’s sales increase now, which increases profits now. This leads to increased hiring. Unemployment goes down. When more people work, more people buy things, which further benefits business.

There also is a psychological benefit from inflation. Working people want salary increases. Inflation makes it possible for businesses to give raises with less valuable dollars. So, though the buying power of the higher salaries may be no more than the buying power of the previous, lower salaries, people like feeling they have more dollars to spend.

The federal government would like inflation to be about 2% – 3% every year. I say “about,” because it is impossible for the government to precisely control inflation.

While too much inflation is bad, its opposite – deflation – is thought to be a disaster. The hypothesis: During deflation, people cut back on buying. They wait for tomorrow’s lower prices. Businesses suffer. Profits go down. Hiring goes down. Unemployment goes up. The government will do anything it can to avoid deflation, so to be safe, it leans more toward 3%, than 2%, inflation.

Although 2% – 3% inflation every year is a “little bit” of inflation, over many years it can add up to a lot. Over 10 years, a 3% annual inflation adds up to 34% inflation. When someone says we have had “a lot of” inflation, they usually are talking about longer periods of time. Fifty years of 3% inflation means prices, on average, will more than triple.

How Does The Government Control Inflation?

Inflation is a balance between the value of goods and services, and the value of money. Inflation happens when the value of goods and services goes up or the value of money goes down – or both.

The value of everything is determined by supply and demand. When the supply of anything goes up, its value goes down. When the demand for anything goes up, its value goes up.

Years ago, there wasn’t as much trade between nations as there is today. Now, we get cars from Japan, grapes from Chile, clothing from China, and answering services from India. We import millions of things from dozens of countries. We are in a world market.

This makes inflation in any one country less likely. If the price of any one product goes up, we probably can buy it from many other nations, which reduces the likelihood of a general increase in prices. But, there is an exception: Oil.

The price of oil affects the prices of all other products and services, so when the worldwide price of oil goes up, we can have a general increase in prices – inflation.

The U.S. government has very little control over the value of goods and services. So to reduce inflation, the U.S. government tries to increase the value of dollars. To increase the value of dollars, the government can limit the supply of dollars, or it can increase the demand for dollars.

There are four problems with limiting the dollar supply to control inflation:

1. A growing economy needs a growing supply of money. So historically, when the government has limited the dollar supply we have had recessions and depressions.

2. To limit the dollar supply, the government either must increase taxes or reduce spending, and either option causes a huge political debate in Congress. This debate can take months or years. People called “lobbyists” try to influence Congress. Voters write and call their representatives. Polls are taken. Meetings are held. Votes are taken in the Senate and the House. And all the while, inflation could be growing. A faster inflation control is needed.

3. The effects of tax increases and limited spending are hard to predict. Every tax affects different people. If inflation were, for instance, at 5%, which specific tax should be increased and by how much? No one knows. Government spending also affects different people. Which specific spending should be reduced and by how much? Again, no one knows. Go too far, and we could cause a disastrous deflation or even a depression.

4. Finally, each tax increase or spending limit ultimately affects businesses. But to grow, businesses need to predict the future. Frequent tax increases or spending cuts make prediction impossible.

Because trying to control inflation by controlling the supply of dollars can have serious negative consequences, the U.S. tries to control the demand for dollars.

Demand is based on risk and reward. If the risk of owning money goes up, the demand for that money goes down. If the reward goes up, the demand goes up.

For any currency, “risk” is inflation. Since controlling inflation is the goal, the way to reach that goal is to increase the reward for owning money.

Bank savings accounts, bank CDs, money markets and bonds all are forms of money. What would make you more likely to demand money rather than real estate or stocks, which are not forms of money? That is, what would make you more likely to put your money into savings accounts, CDs, money markets and bonds? Answer: Increased interest rates.

And that is how the government controls inflation. It increases interest rates to increase the demand for dollars.

This has three advantages:

  1. It doesn’t require endless Congressional debate. The Federal Reserve has the legal power to change interest rates, overnight.
  2. It has broad economic effects rather than unfairly penalizing one industry or one business.
  3. It can be done in small, frequent, controllable steps, rather than in huge steps that could have bad consequences

It is true that increasing interest rates also increases business costs, which could be inflationary – exactly the opposite of what is wanted. But history shows that on balance, the small increase in business costs has less effect on inflation than does the large increase in money value.

There could be two reasons for this:

1. A 1% increase in interest rates will have only a tiny effect on the average business’s overall costs. But if today’s interest rate is 3%, an increase to 4% is actually a 33% increase, having a huge affect on the demand for money.
2. The “world market” effect. If any business raises its prices, its goods or services can be purchased elsewhere.

In Summary

–Inflation is a general increase in the value of goods and services compared to the value of money.
–A little inflation stimulates economic growth.
–Federal deficits are absolutely necessary to grow the economy and to prevent recessions.
–By themselves, deficits could be inflationary. However, today’s world trade helps prevent this, so inflation today is caused not by deficits, but by oil prices.
–The government can control inflation via interest rates.

The Inflation Fear

Water is necessary for life, but if you drink 50 gallons of water in one day, you will die. So for a healthy life, don’t drink too little water, or too much water, but do drink water, especially if you plan to work out. And for sure, don’t stop drinking water.

Money growth is necessary for economic growth. But too much money can cause inflation. So for a healthy economy, don’t create too little money or too much money, but do create money, if you want the economy to grow. And for sure, don’t stop creating money (running deficits).

The goal is to grow the economy as much as possible without too much inflation. The method is to create as many dollars as possible, up to the point where interest rates don’t control inflation. It surprises many people to learn the U.S. never has had an uncontrollable inflation caused by too many dollars.

What About the Weimar Republic and Zimbabwe?

People who want to reduce the federal deficit often point to the (German) Weimar Republic and to Zimbabwe, as examples of countries that experienced hyperinflation (extreme inflation). The deficit reducers wrongly say those hyperinflations were caused by too much government spending.

However, the Weimar inflation was caused by harsh, World War I sanctions put on Germany by the winning Allies, and these sanctions destroyed the German economy. The Zimbabwe inflation was caused by Robert Mugabe, who stole the nation’s farm land from farmers and gave it to people we did not know how to farm.

In both cases, the inflation caused the money creation as the government tried to pay its bills, rather than the money creation causing the inflation.

In Part 4, we’ll discuss Social Security, Medicare and Medicaid

Rodger Malcolm Mitchell
http://www.rodgermitchell.com


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No nation can tax itself into prosperity, nor grow without money growth. Monetary Sovereignty: Cutting federal deficits to grow the economy is like applying leeches to cure anemia. Two key equations in economics:
Federal Deficits – Net Imports = Net Private Savings
Gross Domestic Product = Federal Spending + Private Investment and Consumption + Net exports

#MONETARY SOVEREIGNTY

18 thoughts on “–Monetary Sovereignty for Young People, Part 3. Inflation

  1. You make the need for deficit spending to simple. If it was so interesting why does the Fed Govt in conjunction with the Fed struggle to control the economy. The point is that command and control economy of the government does not work very well.

    Why not have less government spending and allow the consumer keep all of its money for spending. Govt spending does not grow the economy continually. Look at the 800 billion stimilus packag passed in 08. It did very little but increase government borrowing and Fed money creation. The Fed can create all the money it wants but if no one wants to borrow it, we get nowhere. Banks are flush with deposits but there is no loan demand. Slow economic growth. Govt deficit spending year after year will fail. Do you not believe Keynes economic theory? He was for deficit spending but he was also for govt surplus. This second part is overlooked by politicians for they want people dependent upon them, so they have to either take from the producers via taxes or borrow to continue deficit spending. This will eventually end.

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  2. Mark, perhaps you should read Parts 1 and 2., which show that in a Monetarily Sovereign government:

    1. Taxes do not pay for government spending, so that spending does “allow the consumer keep all of its money for spending”
    2. Federal spending grows the economy by putting dollars into consumers’ pockets.
    3. Federal borrowing (i.e. the creation and sales of T-securities) is unnecessary and should be ended.
    4. Every depression in U.S. history began with a series of surpluses, which removed dollars from the economy.

    Rodger Malcolm Mitchell

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    1. RMM,

      In response to #3, that T-securities are unnecessary and should be ended…

      I think in one of these posts you ought to discuss how the FED uses open market operations to target interest rates, and why that process is unnecessary… and along with that it would make sense to offer how banking can/should be structured.

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      1. Good thought. I might get there, though the detailed machinations of the Fed have become awfully complex for this type of post.

        As for how banking should be structured, I offer one basic suggestion: Eliminate the profit motive by eliminating private banking.

        Virtually all of the problems leading to the recession, were caused by the profit motive in banking.

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  3. Great post. I understand that arguments over interest rate effects on inflation are the main difference between MS and MMT. You say that raising rates increases the demand for money and contributes to controlling inflation. On the other hand savers will receive more interest income and may then increase their spending – thus helping fuel inflation if the economy is near potential output.

    My question is the following: is there substantial empirical evidence for or against these two equally compelling (from a logical point of view) yet divergent arguments over the consequences of interest raises on prices and output?

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    1. The evidence is not definitive. I discuss it at: https://rodgermmitchell.wordpress.com/2012/01/07/preventing-and-curing-inflation-modern-monetary-theory-vs-monetary-sovereignty/

      In my opinion, the best evidence is this: The Fed raises rates to combat inflation, and has been successful. The only major inflation we’ve had in the past 40 years was beaten back by high interest rates.

      I can say this with some assurance. The high rates did not cause inflation as MMT predicted.

      Rodger Malcolm Mitchell

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  4. The $800 billion stimulus did little? What? It kept millions of people working. If anything, it was too small, because the state of the economy was actually much worse than they realized at the time. High unemployment and idle capacity for extended periods of time are going to do more to harm the economy than government spending ever will.

    And this whole conspiracy that them dirty liberals just want a welfare state so everyone is dependent on them so they can keep getting voted in is nonsense. Certain things need to be paid for that cannot be funded solely by the private sector. If you want to live in a country that provides good, cheap (or free) healthcare, offers high quality education to every child, develops and creates things like the GPS system, funds high tech research and development, funds NASA, etc etc etc, then the government has to spend. It really is that simple.

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    1. Of course, where people start to derp out is with how to ‘fund’ such activities. So you get silliness like cutting programs or raising taxes. Now while I believe that there are certain social or economic benefits to raising taxes or cutting programs (such as diverting or directing spending to protect the environment or in extreme cases reducing income inequality or dodging the moral hazard), the idea that because you raised the top marginal rate from 35% to 75% you can now have NASA 2.0 and eliminate FICA taxes is extremely suspect.

      That would only be the case if you were right below the ceiling of inflation, but the link between the size of the money supply and inflation is extremely suspect.

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  5. If deficit reduction almost always precedes a recession, doesn’t that imply that modern economies are persistently underperforming? That is, the economy was on the brink but puttering along but then a reduction in the money supply caused the whole house of cards to collapse?

    If this is the case, how much do you think that the economy is underperforming even in ‘good’ times? Or is it just that the margin for error is very small?

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  6. One more thing WRT income inequality:

    What’s the difference between increasing top marginal tax rates and just cutting everyone a check for however much money when you notice that the wealth is too unequal? Unless your economy is already at the brink of inflation, it seems to me that just cutting every household a monthly stimulus check of 800 euros/1200 dollars/etc. for five years would accomplish just as much as raising top marginal rates.

    It seems to me to be more ‘fair’, and thus politically realizable, than things like negative income tax (which causes class resentment towards the poor) and increasing top marginal rates.

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  7. Would be great to have an intro to RMM’s MS primer on investments such as when and what to buy and when and what to seel and what the key signals are and why as a follow on to the Social Security medicare medicaid topic as this could give a practical use and illustrate a real world benefit to the MS theories and how they can benefit the individual as well as society.

    Idea comes from the Amazon book review:

    “How to predict the U.S. economy. # The key economic buy/sell signal for investors”.

    “If you’re an investor, you will be able to predict the changes in our economy”.

    Could be a very interesting topic to introduce to Young People and then build on fo us older but still open mined folks 😉

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  8. So looks like you were not the one who wrote your book review on Amazon.com???

    Book Description
    Publication Date: September 1, 2005
    Praised by economists, yet clear enough for the average reader, Rodger Malcolm Mitchell’s easy-to-understand book, FREE MONEY demonstrates the first, important new economic theory in years. It is a theory not just supported by historical fact, but which has led to impressively accurate predictions. # Readers will learn: What tax changes will save Social Security and Medicare. # How to predict the U.S. economy. # The key economic buy/sell signal for investors. # How future tax policy and federal deficits will affect America. Learn and understand the answers to these questions and many more. If you’re an economist, you’ll discover important new ideas, that can form the basis for your own research and publishing. If you’re an investor, you will be able to predict the changes in our economy. Also, learn the answer to the single most important question in all of economics: “Because a growing economy requires a growing supply of money, where will the money come from to grow our economy?”

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  9. Max,

    Nope, but I’ll try to accommodate you anyway.

    The key (long term) economic economic signal for investors is year-to-year, annual percentage reduction in Debt Outstanding Domestic Nonfinancial Sectors. When it goes down for a while, then reverses, we often are on the cusp of a recession. See: http://research.stlouisfed.org/fredgraph.png?g=5Yh

    And the answer to the question is: From federal deficit spending.

    But mum’s the word.

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