Inflation Doesn’t “Just Happen”

First of all, inflation is man-made. It is the wealth-destroying outcome of reckless monetary and fiscal policies.

For instance …

From 1949 to 1969, when the Bretton Woods monetary system was working properly, official foreign exchange reserves increased 55 percent globally. Then from 1969 to 2000, after the demise of this system, they virtually exploded by more than 2,000 percent.

By the end of 2000 — when the global stock market bubble burst — official foreign exchange reserves amounted to $1.9 trillion. Ten years later, at the end of 2010, they had increased another 378 percent to $9.3 trillion.

This rapid growth in foreign exchange reserves can be used as a measure of the highly inflationary policies that have been implemented more or less globally since the end of Bretton Woods. Without a prudent monetary system politicians were totally free to play havoc with government finances and paper currencies. And they made use of this freedom in an unprecedented way of recklessness.

It’s no coincidence that the growth in foreign exchange reserves strongly resembles the currency depreciation, or inflation rates, of the U.S. and many European countries over the same long-term time span.

And it’s also no wonder that inflation is again rearing its ugly head in the U.S., as shown in the chart below.

There are some astute analysts predicting high inflation rates and even hyperinflation. And in The Global Debt Trap I established the case for an inflationary endgame as the most probable outcome of the massive over indebtedness of the U.S. and many other major countries globally.

Today I’d like to go over …

The 6 Most Important Historical
Findings on Inflation

In 2003 the renowned Swiss professor Peter Bernholz published a very practical book: Monetary Regimes and Inflation.

Bernholz’s most important findings:

1. “The political system tends to favor an inflationary bias of currencies. All major inflations have been caused by princes or governments.”

Let me make this important finding even clearer: Politicians are printing money if they are allowed to do so. No wonder — the government is the main profiteer from inflationary episodes! Inflation is nothing less than tax hikes in disguise.

2. “All hyperinflations in history have occurred during the 20th century, that is in the presence of discretionary paper money regimes, with the exception of the hyperinflation during the French Revolution, when the French monetary regime, too, was based in a paper money system.”

Given the abundance of hyperinflationary episodes — Bernholz discusses 29 of them — the still widespread belief in the advantage or even necessity of paper money being guarded by central bank bureaucrats is beyond insanity.

3. “Monetary regimes binding the hands of rulers, politicians and governments are a necessary condition for keeping inflation at bay.”

Okay, that’s how it should be. Unfortunately, in the U.S., in Europe and elsewhere there isn’t a strong enough public movement to stop the current reckless monetary and fiscal policy. Inflationists like Ben Bernanke are running amuck, without any opposition in sight! Therefore I have to conclude that “binding the hands” is next to impossible.

4. “Hyperinflations are always caused by public budget deficits which are largely financed by money creation.”

That’s an interesting finding, isn’t it? It makes it absolutely clear just how important fiscal policy is in the inflationary process. With budget deficits in the U.S., Japan, and most European countries totally out of control since the latest recession, this is a very strong argument for an inflationary endgame in the making.

But this observation also brings up an important question: With budget deficits on the rise for many years, why hasn’t inflation become a major problem yet?

There are two answers …

First, we’ve already had severe inflation! During the late 1990s it came in the form of a global stock market bubble. And after that, as a real estate bubble.

The second answer is taken from Bernholz’s book:

5. “A continuous flow of new money into the economy leads to inflation only after a more or less extended time, if the old money is also used abroad.”

Since the dollar and the euro are vastly used abroad, inflationary pressures have not yet come to fruition. But the course has clearly been set.

Let me close this elaboration on inflation and government debt with one last quote:

6. “A real budget deficit cannot be maintained permanently. The government must either reduce it or the inflating bad money will be substituted in time by the good money and the base of the inflation tax will be eroded.”

A Tough Choice to Make

The U.S. and many European countries have to make a tough choice soon. They can stop spending like the proverbial drunken sailor. If they opt for this scenario, all the money pumping and deficit spending efforts of the past few years will have been in vain and a severe recession will immediately grip the world.

Or … they can keep inflating and spending like there was no tomorrow. If that’s what they do, inflation rates will accelerate and sooner or later we’ll face a funding crisis and a currency crisis.

As of now, it looks like Europe and the U.S. will continue their reckless monetary and fiscal policies. Europe’s leaders have just decided on another bailout package for Greece, the most reckless member of the Monetary Union. And in the U.S. the case for QE3 is getting stronger with each disappointing economic report and each falling point in the stock market.

However, the pressure for QE3 is not high enough yet; therefore I do not expect it to be implemented immediately. But if the stock market slides more than 20 percent, which is what I expect during the coming months, and the economy has a negative quarter in terms of GDP growth, Bernanke will again come to what he thinks is the rescue and print even more money.

And as long as that is the outlook, I will keep recommending gold. Either in the form of coins and bars or as an ETF, like GLD.

Best wishes,

Claus