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Tuesday, May 13, 2008

Money, Time, and Inflation

Have you ever stopped to wonder how money and capitalism actually work together to provide prosperity? One of the big reasons is simply time. I said in my last posting that money can be seen as a kind of insurance product. Insurance generally has a time limit or deadline on it, and money does too. Money is a lot like electricity, it does no work unless it is flowing, meaning changing hands for the provision of goods or services. Money stuffed into your mattress does no work, and it will actually decline in purchasing value or useability over time. It may as well simply not exist. This decline in purchasing value is what we call inflation, and it is primarily due to more money being created over time, thus diluting its potentcy.

Inflation is actually very good for capitalism. It means that you just can't sit on your money. Your money will rot over time, unless you can get it invested so that you can grab a piece of the dilutive new money being created. Another alternative to keep it from rotting is to buy an inflation hedge which is generally some physical asset whose value tends to keep up with inflation such as land. While mild inflation is good for capitalism, high inflation is quite bad. When inflation is high, investment returns (production) can't keep up with the dilution. People are also incented to spend their money rather than invest it as they watch prices climb. Individuals on fixed incomes end up suffering as the dilution outruns their ability to save and invest. So what we want is inflation that's high enough to incent people to invest yet low enough to allow production returns to keep up. This is what the Bank of Canada and Fed in the US try to accomplish through setting the overnight interest rate which translates into what you and I are charged to borrow money. Borrowed money gets created out of thin air and is the source of inflation/dilution which I mentioned earlier. In this author's opinion, population growth is at the root of money supply growth.

So what happens if the population stops growing? In such a non-growing modern society with a high standard of living, the amount of borrowing doesn't exceed the amount of money already in existence. No growth in money supply means no inflation. In fact, taken a bit further, that society can be facing deflation. Deflation is when the money supply starts to shrink. Loans are paid back and that money isn't reborrowed by anybody. Money just sitting there and not flowing, as I said earlier, may as well not exist. It can be seen as simply disappearing. As the money supply shrinks, and there is less in circulation, it becomes worth more in terms of buying power. Prices start to decline. Money no longer rots if it isn't used, so people just sit on their money and don't spend it as they watch prices decline. This can cause an awful downward spiral in an economy and the term deflation can cause an economist to have nightmares.

Japan is an example of a society facing this right now. They have tried lowering interest rates all the way to zero at one point to try and get people to borrow money. To get older people to borrow money they have created the concept of multi-generational loans. But this hasn't really worked all that well to up the borrowing. So the government decided to just start printing money and fed it into the economy via social spending and bad loan bailouts. Businesses that can't properly sustain themselves are being kept on government life support to preserve jobs. Japan's government debt levels are now so high as a percentage of GDP that there's serious worries about a possible Bank of Japan collapse. Artificially fueled inflation is nothing but a time bomb. Japan has to import so much stuff that it can ill afford other nations or banks to no longer want to accept its currency.

So what are we capitalists going to do down the road when the population stops growing as the laws of physics eventually dictate? I do not know. All I know is that no generation wants to be the one left holding the bag. We can already see this slowly approaching as interest rates slowly decline as the baby boomer cohort ages. Immigration certainly helps, but can it be stepped up to the point where it can compensate for the low birth rate and the eventual accelerating death of the boomers?

One way to simulate population growth is to have other people in the world willing to borrow your nation's money with, of course, a demonstrated capability to pay it back. The dilutive effect of this borrowing has to be seen by your nation, meaning the money has to flow back in to purchase things such as production equipment. Perhaps the way out of this mess is to become bankers to the second and third world. Maybe there is method to the madness of creating the "Amero" and getting it slowly adopted by Central and South America as well as North America. It wouldn't surprise me to see, in the further out future, the Euro getting adopted by small third world nations as the EU tries to manage to keep away the deflation demon. Whether this scheme will work or not, who knows?!?

As a final note, what I've written here is extremely simplified as it doesn't, for example, address the impact of foreign exchange and foreign trading. Countries don't exist in isolation.

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