Monday, November 17, 2008

Inflation: the Cause and the Fix

How inflation caused our current breakdown, and how to solve it

Inflation is an artificial stimulation for an economy. It is a gimmick using money to get producers to produce more. An inflationary environment mimics the effects of rising wealth, without a real increase in wealth.

In a sane and functional economy, expansion is based on greater productivity, greater efficiency, and a rising standard of living, all of which combine to the effect of more available money. An analogy is to be found in your own personal budget. Say you invent a new tool, or find a shortcut method, that allows you to produce more in your workday. You just contributed to a rise in wealth in your nation's economy, since more is now being produced in the same time. You are therefore wealthier on an individual level, and you will be able to purchase or invest more as a consequence. Others in your economy will be able to produce more because you are able to afford more. This is a rise in real wealth, and a greater standard of living. If there is a constant amount of money in the economy, with more being produced, the general effect will be a gradual fall in prices as everyone is able to buy more with the same income (not to be confused with deflation).

However, in an inflationary economy, expansion is not based on a real rise in wealth, but on an expansion of the money supply. The extra money sends the signal that there is a rise in wealth, but it is a false signal. The individual producer cannot know it is a false signal, though, he simply responds to the signal, ramping up production. After all, people are coming to him with full wallets, ready to purchase. No one realizes that there is really no increase in total wealth. There is just more money chasing the same amount of goods. People are then able to bid up the cost of everything, driving up prices.

Of course, this driving up of prices does not occur across the board. People looking for a good deal focus on areas where there is a greater return on investment. Then supply and demand takes over, as more money pours into that area, prices rise further. Production gets ramped up in that area in response to the false signal of greater demand. The end result is what we call a bubble. At some point, key players realize the inflated prices are no longer supported by the real demand conditions on the ground. The price bubble then bursts and prices collapse, leaving a much greater supply than demand.

Because of our highly inflated money supply recently, we have undergone a series of bubbles, most famously in housing and oil. The aftermath of a price bubble is always the same, collapse of prices, which, if it occurs in the wide enough circle, turns into an economy-wide deflation, as productive workers are laid off, business activity slows to a crawl, and excess inventory liquidated at bargain prices.

The deflation in housing prices is the black hole that is sucking in the rest of the finance system, the root of the problem, and a still collapsing effect to be dealt with.

The most obvious, effective, and economically productive solution is simply to cancel all mortgage debt. All of it, all at once, in one fell swoop, leaving everyone in full ownership of their own properties.

The deflation in housing prices would stop immediately, as foreclosures would end. People would be free to invest their mortgage money somewhere else, in consumption, saving, or investment, pumping trillions of dollars into the productive economy.

Many banks would obviously be wiped out, as what they call their assets, which is really our debts, are discharged. But in our current environment, that is exactly what is necessary. Banks do not generate wealth. Their only economic function is to facilitate transfers of wealth. A banking system that is more concerned with its own existence than its economic function is a destructive parasite on the real economy.

If the banking system and paper money were to disappear totally, we would not be any less wealthy as a society. The only reason money exists is to facilitate exchange, and when the banking system is causing all the problems, it is the banking system that needs to go down, not the real economy.

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