Monday, March 17, 2008

Money and dilution

On my last post, I split the general phenomenon of "inflation" (rising prices) into two parts: 1) dilution (creating more money) and 2) price changes. These two effects can work in opposite directions and thus cancel each other out, or they can work in the same direction and magnify each other's effects. I think the story of the last 70 years in America has been rampant dilution of the currency through the banking system masked (to some degree) by rapid reductions in prices thanks to technology. Think about it this way -- we are *much* more efficient and producing bottles of Coca Cola today than we were in 1930, but Coke used to cost 10 cents and now it's a dollar. As per unit production costs have fallen so dramatically, how much more must currency dilution have been to result in a net increase in price by an order of magnitude.

The Fed can create money by low interest rates (which make it cheap to borrow) and by the fractional reserve system that lets banks loan out 9 times their short term deposits in long term loans. In addition, the Fed puts the imprimatur of the US government on all kinds of other paper, including mortgage backed securities through Freddie Mac and Fannie Mae, and OFHEO. If it's backed by the US government, it's dollar currency, whether it's printed on green paper or not. All of this activity has recently increased.

So, given that Bernanke is running the printing presses like there is no tomorrow, does that mean the US is going into an inflationary period? More tomorrow.

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