What You Need To Know About Inflation

the inflation of their waistline from Christmas dinner, but this is actually a critical topic that every investor MUST understand, in the context of today’s economic shifts. I recognize that for most people, the topic of inflation is about as exciting as watching paint dry.  However, if you’re going to prosper in 2009 and beyond, it’s critical that you understand what inflation is, why it’s important, and how it affects your wealth and investments. And I promise, I’ll try to keep this discussion from sounding like an Economics 101 lecture. Many people falsely believe that the definition of inflation is higher prices.  This isn’t what inflation actually is — inflation is properly defined as “the expansion of the monetary supply”.  In fact, higher prices are a symptom of inflation, not a cause of it. Another way to look at it is that there is more money chasing the same supply of goods and services. Think of it this way – I’ll use a very simple analogy.  Let’s assume that a given economy has a million dollars circulating in its money supply, and that the only good or service available for sale in that economy is a cup of coffee.  The price of a cup of coffee is $1.00, so there are a million cups of coffee sold at $1 in that economy each year.  This means the GDP output is $1,000,000 for this economy. Then, one day, the goverment decides to increase its money supply, and it prints another million dollars of money, adding it to the economy.  So now, there are $2 million dollars in the economy, but there still remains only a million cups of coffee for sale. All things being equal, this means that in order to maintain the same level of GDP output, the price of coffee must go up to $2, because each dollar in the economy has lost 1/2 of its value (because there are twice as many dollars in the system now). Another way to look at inflation is the purchasing power of a dollar.  Inflation results in the erosion of the value of a dollar, which means that it takes more dollars to buy the same amount of goods or services in the future. Here’s where most people get confused — when you see “prices rise”, you’re not actually seeing the price of the good go up .. you’re actually witnessing the purchasing power of the dollar go down (but it looks like the price has gone up). In other words, goods and services aren’t actually changing in value .. it’s only the currency that we use to buy them that’s changing.  You just have to use more of those paper bills you have in your wallet to buy the same good or service, because each of those bills has gone down in its purchasing power. So let me go back to my point that inflation is an increase in the money supply.  So, what’s the money supply?  It’s the total available amount of money and credit available in the economy.  Now, you’d think that this would be a measurable thing, but it’s really not — all you can do is estimate what the money supply is at any given time. It used to be easier to understand what the money supply is in the U.S. for example, but several years ago, the U.S. Fed stopped reporting M3, which was the best measure of money supply.  Why did they do that? The simple answer is that because inflation is a good thing for the government, because it acts as a silent thief of wealth from the people, and allows the government to pay off debt without having to raise taxes. I know this seems kind of strange, but it’s true.  The government LOVES inflation, because it allows them to increase the debt they incur, and inflation erodes the real value of that debt (because over time, those dollars of debt erode in value). Inflation increases the tax revenues for the government, and it helps wipe out the debt incurred by the government along the way.  And, do you really believe that the government has any intention of ever paying off its debt?  The U.S. government debt now exceeds $10 Trillion dollars, and the entire GDP output of the U.S. is only $14 Trillion per year!  And even that number is suspect, because a lot of the ‘production’ is double counted in that number, and includes not just production, but consumption .. hardly productive for an economy. It has become impossible for the U.S. government to ever retire its debt, and all of the bailouts and steps they’ve taken to increase the money supply in 2008 has absolutely assured this.  Obama is talking about $1 Trillion dollars in spending deficits next year to “jolt” the economy back into prosperity.  Is he kidding? When the politicians talk about paying off the federal debt, they’re either oblivious to the way that money really works, or they know they’re lying.  It’s one of the two, because there is no chance that the debt will ever be paid off. It will continue to spiral up, in part because the government will continue to allow inflation to rise wherever it can, while at the same time trying to hide its presence from the people. For a great example of how the government tries to hide the REAL rate of inflation, go to this site and check out some of the information there.  The fact is, the Consumer Price Index that you hear about in the media as the measure of inflation is a complete hoax – and the government knows it.  It’s designed that way. It does not report the true rate of inflation and again, that’s on purpose – the government wants it reported below it’s true level because they don’t want to get the citizens upset.. and, a lot of the obligations the government has are tied to the inflation rate. You’ve heard of inflation-adjusted benefits?  The concept that you are paid benefits by the government, and your payments increase to keep up with the rate of inflation? Well, what happens if they are not using the real rate of inflation and in fact only give you increases on a portion of the real inflation rate? That’s right .. over time, you lose, because your payments DON’T keep up with inflation.  So it’s in the government’s interest to purposely under-report the true rate of inflation. Anyway, these economic topics are always a rabbt hole for me on my blog, because I could go on for days about them.  Aside from the fact that it’s fascinating how the government spins the story and statistics however it best serves them, the important point is this .. You must understand the impact of inflation on your money and your wealth.  I believe that we are going into a period of significant inflation (and likely hyper inflation in the U.S. in particular).  If you don’t understand the effects of inflation, you’re at risk of making the wrong investment decisions that will erode your wealth, and you won’t even know its happening. I said in a previous post that in an inflationary period, debt is a good thing.  The reason for this is that if you can lock in debt at today’s price, if inflation is high, you’ll be using tomorrow’s dollars to pay off today’s debt.  And because the debt will be priced in tomorrow’s dollars, which are worth LESS than today, your debt will actually be destroyed over time by inflation. This is why real estate can be a great asset in an inflationary period – because inflation drives the asset value up, which means the relative amount of debt on the asset goes down. I can’t possibly do justice to the topic of inflation, so if you’re interested in learning more and getting a better handle on how inflation works, I would highly recommend that you do some additional research.  There are some excellent websites that provide a detailed view into inflation, deflation, and all the research and data you could ask for. A couple of them are Investopedia and Wikipedia, which will give you a great basis of knowledge to work from.  They include links and detail on deflation, stagflation, etc. The final site I would highly recommend you visit again is www.shadowstats.com, because it provides you a different view than what you read in the media regarding the true inflation rates in the U.S. Holiday Bonus: Since you’ve stuck in this far, I also thought I’d include a video that you will likely find interesting, if you’ve been able to make it through this discussion of inflation. This video, called Money As Debt, gives you insight into how the money system really works, the role of gold in the money system (or at least what it used to be), and helps explain some of the breakdown that we’re currently seeing in the global economy.  This video is about 47 minutes long, but it’s well worth it if you really want to get your head around the money system.

If you’ve seen The Matrix, you understand the concept of stepping back from the reality you know, only to realize there’s an entire world operating just outside your awareness.

For a lot of people, this video will give you that same sensation, because you’ll realize that money is NOT what you thought it was.

This is just another view into the subject, and certainly isn’t the only one you should listen to. 

However, as I often say, your ability to be an intelligent and successful investor requires you to take in as many different opinions and views as possible, so that you can create your own conclusions based on information and not emotion.

Enjoy the video!