How is inflation created and what can be done about it ?

The debate on the real cause of inflation, and whether its positive effects outweigh the negative ones  is growing steam, with the talks of more Quantitative Easing under way. Is QE3 going to generate more inflation or not? Is the view that QE and further market operations (POMOs) will fuel the increase in prices ?

To answer these questions, one has to start from the root of the problem. What is inflation and how should it be measured ?

Today's economists regard inflation as an increase in the general level of prices of goods and services in an economy. Because the prices increase, the purchasing power of consumers and companies decreases. Therefore, today's economists measure the effects of the decrease in purchasing power rather than the cause of the decrease in purchasing power. This is upside-down-economics.

The real source of the word "inflation" is "expansion of the money supply". Back in the 1920's economists acknowledged that the expantion of the money supply (and hence the term inflation) generates a decrease in the overall puchasing power, because there are more money chasing the same number of goods and services. Therefore, goods and services will become more and more expensive, as people compete for them.

The monetarists (not in vogue anymore, for reasons that will become obvious later in the article), linked the money supply to the general demand of money and therefore:

M*V=SUM(P*Q) where

M= Total quantity of money and ready redeamable demand-deposits and other financial instruments

V= Velocity of money (how fast money circulates through the economy, usually higher in booms and lower in recessions)

P= General price level 

Q=Total quantity of goods produced or services in the economy for a given time

This theory links the money supply adjusted by velocity to the overall price level. The real missunderstanding is in the meaning of the indicator: general price level. The US government measures changes in the price level by retorting to the CPI (Consumer Price Index), which calculates the change in prices of a fixed basket of goods, and the Core CPI, which excludes certain prices like the ones for energy and food.

What the government neglects is that besides the consumer prices, there are also asset prices:

1. stock prices

2. real estate prices

3. private capital prices

4. currency prices

5. credit prices (interest rates)

Is there a possibility that the heavy expansion of money supply, has been spilling into asset prices ? Is there a possibility that the real cause of the boom-bust cycle is this extreme inflation of the money supply?

Yes, the author supports the view that, the inflation of the money supply (most recent examples are QE1, QE2, QE2.5, QE lite, Operation Twist, repo's and interest swaps) cause by the US Federal Reserve, is meant to artificially prop up asset prices as a stimulus effort. The reason because the expansion of the money supply shows up faster in asset prices than in consumer prices lies within banks.

When generating money out of thin air through the market operations listed above, Fed doesn't give handouts to normal people, it instead flipps bonds to primary dealers (large cap banks). It goes like this: US government creates these bonds backed only by the future tax revenues and it sells them to the Federal Reserve through these primary dealers (which earn a hefty commision). Now, Fed doesn't really pay and cash for these bonds, instead it creates an accounting entry.

The newly created money goes into the coffers of the banking industry, which, in times of crisis use the newly acquired funds to invest (or to provide margin) in assets. In crisis times, consumer credit is low, so consumers don't really have access to the new inflows of easy-money. Therefore the inflation does not spill out in higher consumer prices (at least not right away).

Meanwhile, the Consumer Price Index may stay at a low level, even as asset prices are skyrocketing for no apparent reason. The real inflation rate calculated by ShadowStatistics is more towards the 10% level.

Now how can one protect against inflation (the general decrease in purchasing power)? First thing is to stay away from the US bonds (which will decrease in value substantially after the stimulus wears off) and in general, stay away from dollar denominated investments, especially if they are illiquid. Gold and silver are popular investments, but subject to heavy fluctuations. But the dips and hold them till the economic picture gets better.