As I was reading through the Minutes of a recent Federal Open Market Committee meeting held at the offices of the Board of Governors of the Federal Reserve System in Washington D.C., I was once again reminded why I do not believe in fiat money, or have any faith in those who purport to be able to manage a fiat currency for the benefit of the people.
In the real world capital is scarce and those in possession of capital usually guard it vigorously - if they don't they will soon be parted from it. Economic growth depends not only on the availability of labor and natural resources, but also on financial capital. Because the owners of capital are vigilant and highly selective about where they invest their money, and because capital by nature is a very scarce commodity, the demand for it always exceeds its supply. Enter government.
Politicians figured out that if they took that which is scarce and made it abundant they could buy votes, control the economy and by extension, control the people. It was easy to convince the population that if they gave the government total control of money, and allowed the government to create money at will, then the government in turn would make sure that capital is always freely available to those who need it.
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The basic premise is that government can stimulate the economy by making sure that businesses and entrepreneurs have all the money they need to create new companies and products through fiat inflation of the money supply. This creates employment, which in turn creates demand for goods and services, which benefits the companies and entrepreneurs - everyone wins.
However, it is just a con game of smoke and mirrors because while government can create fiat money at will, it cannot create capital. To illustrate why, we first need to look at what capital really is.
Capital is excess capacity. If I earn $100,000 a year and my total cost of living is only $80,000 then I can save $20,000. That $20,000 excess income becomes my financial capital. But capital is not really money - money is only one form of storing capital. In this example the capital was created because I worked 25% harder (or longer) than was necessary to sustain my lifestyle. If I only worked long and hard enough to cover my expenses I would not create any capital and my only alternative would be to cut down on my expenses. The capital I created was the direct result of having more capacity to work than was needed to pay my expenses.
If I already had financial capital, which I employed by investing in a business for example, then I would take the risk of losing that capital and have an opportunity to increase the capital. For the investment to be successful the capital would have to be employed in such a way that it creates more excess capacity. For example, if I invested the capital in a business that used the money to buy more efficient machinery so that they could produce more products from the same amount of labour and raw materials, and if the excess capacity was more than the cost of the machinery plus the interest on the capital invested, then the capital would grow. Notice, however, that the creation of capital only takes place when we produce more from a given amount of labour or raw materials. Capital cannot create more capital without leveraging the output from either labour or raw materials. In the real world, unfortunately, this seldom happens and very often the return on invested capital is negative and the capital is destroyed. That is why capital is so scarce.
By creating fiat money, government creates the illusion that capital is freely available since many companies and entrepreneurs can borrow money from banks. In the short term this creates a boost of economic activity as a lot of money is borrowed and invested, boosting economic output. The fallacy lies in the fact that when the government creates money out of thin air they also reduce the value of that money by an equal percentage. So if, for example, the money supply is increased by 10% then all the money in existence becomes worth only 91% of what it used to.
The theory that governments operate on is that even though they may devalue the money by, say 10%, they can boost the economy by an even greater nominal amount, say 12%, and so the real economic growth is 2%. The problem is that the creation of fiat money occurs through the creation of debt and the lenders of that debt demand a real return as well. Never mind the real-life, low probability of successfully employing capital in the first place. That leaves very little room for the borrowers of money to benefit and usually only leads to a transfer of capital to the lenders without any net increase in excess capacity.
By systematically eliminating the smoke and getting rid of the mirrors one realizes that the same economic growth would have been possible without creating fiat money at all. Whether you created fiat money or employed non-debased financial capital, the same leverage would have been obtained from the existing labor and available raw materials.
Owners of real capital therefore still benefit in the same way from the prudent investment of their capital while the illusion of wealth permeates through society and the insidious nature of fiat money slowly erodes the welfare of those who can least afford it.
For the sake of example let us assume that real economic growth is 2% and that I can earn a real 2% return on capital that I invest. Let us also assume, as it is in real life, that wages and salaries never keep up with monetary inflation. For simplicity, let us assume that the money supply increases by 10% but wages and salaries do not increase at all. If my living expenses were $80,000 a year then the 10% inflation would cause my expenses to increase by $8,000. If I did not have any capital to invest (and my income did not increase) my net worth would decrease by $8,000. But if I had $400,000 in capital that I could invest it and earn a real 2% return, then my capital would grow by $8,000 and I would not be any poorer as a result of the monetary inflation. If I had $4,000,000 in capital then the loss of value through inflation would become less significant and if I had $40,000,000 in capital it would be insignificant.
But consider the situation for someone who earns $50,000 a year and whose living expenses (including tax) amounts to $48,000. 10% inflation would mean that next year he is under water by $3,000 and if he cannot find a way to earn more money he will get poorer every year. His only option is to reduce his living standard or go into debt, which will eventually lead to a much worse living standard as he will now have to pay interest on his debt in addition to all his previous expenses. The median household income in the United States was $46,326 a year during 2005 and rose only 1.1% from 2004. However, if you read the next column of the US Census Bureau's most recent report you'll see that the 90th percentile confidence interval is +/- 0.75. That means with 90% confidence we can say that median household income rose between 0.35% and 1.85%. Statistically, the median household income in the US did not rise at all from 2004 to 2005 and, in fact, has not increased in five years (it is still considerably lower than it was in 2000).
Nonetheless, that 1.1% increase is supposed to be a real increase, meaning net of inflation, but because of the way the US Government calculates inflation I can assure you that in real terms America's median income actually declined from 2004 to 2005. The fact is that people all over the world are getting poorer - not because of free enterprise, open markets or globalization but because government created monetary inflation robs them of their living standards. The only ones who can immunize themselves are those with sufficient capital and that is why the rich get richer and the poor get poorer.
When we understand that monetary inflation means an increase in money supply and that an increase in money in money supply causes a devaluation of all the money outstanding we can make sense of the world even as economists, journalists and politicians attempt to obscure the truth.
In the Open Market Committee minutes I was reading there were recurring references to the growing weakness in the US economy and persistent inflationary pressures. Inflation here was meant to be an increase in prices, which in reality is a result of the devaluation of money by inflation and not inflation itself. By obscuring the truth -- that inflation is an increase in money supply that can lead to an increase in prices -- and focusing on price levels instead, they can keep everyone, including themselves, confused.
Your only protection from government confiscation through fiat money creation is education (say that five times quickly).
First published on Kitco.com (www.kitco.com)
By Paul van Eeden
Paul van Eeden works primarily to find investments for his own portfolio and shares his investment ideas with subscribers to his weekly investment publication. For more information please visit his website (www.paulvaneeden.com). If you would like to read more from Paul, you can sign up to get his weekly commentary at https://www.paulvaneeden.com/commentary.php.
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