Draft (original pub /12/27/2015, v1.0 12/30/2015)
This is the third and final essay in a three part series to overthrow 200 years of economic thought. The first essay “Just Measures”, built on six years of research, lays the foundation for a new model of economics in an attempt to make sense of America’s continuing decline. It amounts to a new theory of money and thereby rings in the death knell for free trade. “Money and Machines” in stark contrast was a quick shot from the hip based on a few months of effort in an attempt to take down the core defect of capital theory (i.e. savings and investment). And finally, here I attempt to plug the remaining hole of the economic jigsaw puzzle with a few simple ideas which emerged literally one afternoon at the coffee shop while day dreaming about the mechanics of inflation. The conclusions reached here are once again based on the core assumptions described in “Just Measures”. For the reader unfamiliar with this essay, it is strongly recommended before proceeding further. “Money and Machines” on the other hand is considered optional to the discussion that follows.
As an engineer with a background in telecommunications theory, I had learned early on to appreciate the value of separating signal from noise. So it was with such a mind set I made the decision not to initially tackle the noisy aspects of economic systems: 1) interest rates, 2) inflation, and 3) capital theory (saving and investment). The reasoning was simple: Economic theory in my view had never even managed to properly analyze and extract the fundamental signal in an economy: money. In fact, it seemed to me that economists of all shapes and sizes had instead attempted to solve the economic riddle by constructing theories that treated noise and signal as one and the same.
It therefore shouldn’t surprise the reader that the approach taken to dissecting inflation is similar to the modeling of noise in electronic systems in that the final noise level can be considered the sum of various sources, a bit like layers of an onion skin coming together to make the final product. In this initial draft of this essay, I will only address the first two layers making up the onion skin, with a hint to a possible third source for later discussion.
Before proceeding, I need to first make a clarification regarding the traditional and undisputed notion of “printing money” as a source of inflation. In order to so, let’s return to the very simple model outlined in “Just Measures” where industrial credit is literally created out of thin air in order to pay factory wages and produce goods. The monetary circle is closed by sale of goods which results in the repayment of the initial loans. The money created with credit therefore returns back into thin air so to speak, because of the final sale of the produced good.
Note the emphasis on credit, not money. Creating credit out of thin air is not the same as printing money. When money is printed by a counterfeiter for example, it never leaves the system precisely because it is not associated with the creation of an associated debt. As a result, there is little disagreement that “printing money” is inflationary, and is of no interest to this discussion, because modern governments do not simply print money to pay their bills; if they did they would never be in debt. Instead, our focus is to determine if inflationary causes can be found in a credit-based economy as described in “Just Measures”.
This leads us to a surprising observation. Money as a form of circulating debt implies that all savings deposits would eventually disappear once all debt is retired. This point has been made by others and is not original, but what follows may well be. In contrast, a loan default results in unpaid debt, which effectively amounts to an unintentional but equivalent outcome amounting to the printing of money. In other words, money has entered the system never to leave it again through the mechanices of loan default. These deposits will never vanish from the system. Therefore a default I contend is fundamentally inflationary because purchasing power now exceeds goods production. Of course, if an economy is sound with a low default rate, then this may be a small contributing factor to inflation. It was primarily described here for sake of completeness and building the baseline.
The next layer of the onion skin is more interesting, more complex, and therefore more vulnerable to critique. Because an example might be the easier way to illustrate the concept, lets start with a highly simplified scenario where 30 workers build a house in one year. The industrial output is the house and in this case has 30 years of man-labor hours embedded in it. The buyer we assume takes out a consumption loan (made out of thin air again) and requires 30 years to repay it. To keep things simple, lets assume the loan is interest free and that the home buyer uses his entire annual wage to pay back the loan each year (assume he grows his own food in garden so to speak).
Let’s step back for a moment and review a few points to help us get our heads wrapped around what might be a potential inflationary problem. The construction worker’s wages came from an annual loan made out of thin air. The construction worker loan was extinguished at the end of the year by the loan made to the home buyer. The home owner will work for 30 years to pay the loan off. It is here I contend an inflationary problem arises, because the 30 year home loan –unlike an industrial loan– does not result in 30 man-years of corresponding industrial output in the same one year time frame. We have a mismatch of output in the 30 to 1 range as a result. In contrast, in the “Just Measure” discussion we had two factories, two loans, two sets of output, and two resulting sales in order to terminate the two debts. They were effectively synchronized in time. This is not the case in our 30 year consumption loan scenario discussed here. Viewed slightly differently, the wages of the construction workers have no corresponding new goods to spend their money on, because an industrial loan creates goods, while a consumer postpones the production of goods (i.e. the home buyer has 30 years to produce his output). This I suggest amounts to inflation.
The gold bug of course may respond that’s the punishment for not using “real” money, i.e. gold. In the world of commodity money, one would have to save a portion of his income in order to be able to loan it out. But in my view, that’s just two different sides of the same coin. Saving 30 man-years of labor means 30 man-years of unemployment and deflation (lack of purchases). This leaves us with a choice, inflation with employment or deflation with unemployment. I’ll take the former, because there will always be noise in the system. In my view, there is no economic utopia.
If you still have your doubts about credit out of thin air, consider the following gold scenario. Say you have an economy of 50 bakers and 50 cheese makers. They use credit out of thin air and sell their goods to each other every day. The price of bread and cheese is based on wages as modeled in “Just Measures”. Now imagine one day 25 cheese makers and 25 bread makers decide instead to pursue digging for gold instead of producing food. The pricing structure of bread and cheese built on cost of production will collapse. Instead output is reduced and a bidding war begins for limited goods in order to bring about a much higher price level in order to reflect the reduced national output. The labor content of gold as a point of reference for wages is disrupted. Gold is therefore not money in any modern sense; it is a commodity used for bartering. It came to close to being money with the rise of the industrial revolution, since inevitably credit was extended against it based on its labor content, as classical economists had argued to some degree. If you still see gold as a pancea, imagine 99 bread and cheese workers digging for gold with one bread maker left. Total chaos would ensue. Such a break down is not possible with credit, unless used for speculation on supply-limited goods such as real estate or stocks, something gold is not immune to either. An advanced industrial economy ultimately needs book keeping, not barter.
As for the third source of inflation, I cannot help but think housing with their associated and significant property taxes may be another key candidate. Here we have a situation in which an extreme durable good in limited supply (non-production cost pricing) is resold numerous times over its life with the owner attempting to recoup property tax losses each time. This creates a price push model for the average workers wages in order to provide a roof over his head. Admittedly, my thinking on this is not closed on this idea, but if I was betting man I’d place my chips on the possibility that a state income tax would be less inflationary than a property tax approach.
As always, critique is welcome.