Why our banking and money system matters

The following graph should concern every single person out there very deeply. (courtesy of The Daily Reckoning)

“Few empirical regularities in economics are so well documented as the co-movement of money [supply] and inflation,” as Mervyn King, now governor at the Bank of England in London, said in a speech of late 2001.

“Over the 30-year horizon 1968-98,” King went on back in 2001, “the correlation coefficient between the growth rates of both narrow and broad money, on the one hand, and inflation on the other was 0.99″

The supply of money changes, and we get inflation as a result. The value of the paper currency, dollars, is diminished, their purchasing power, their value, everything about them. This has a massive impact on most people's lives, yet it goes largely unnoticed and gets little discussion outside of financial experts.

Your average punter out there feels strongly about a lot of issues, and my best guess is that the level of interest corresponds to the level of mainstream media coverage.

People are generally interested in footy, cricket, celebrities, gossip as well as news, weather, politics, "the environment" (very vaguely defined thing that it is) and maybe some economic reports - inflation, taxes, unemployment, interest rates, cost of living.

And people care very much about money.

And so they should. Capitalism is a moral philosophy, you should care about money, because savings are the result of foregone present consumption, in exchange for future consumption (whatever that may be). Savings are the product of work, of thrift, of allocating your time, your labor, your skills and your property towards productive means.

People use their savings to achieve very important things - food, shelter, clothing, energy and transport for starters. Raising your family, looking after their health and education are also important. This goes for all people, poor and rich, single or married, young or old.

So far, I haven't said anything too uncontroversial. Under free markets, when you forego consumption today, and save money, you should be able to use that money in the future and it should have a similar purchasing power. Also, everybody needs to use money, because it is a vital medium of exchange. Prices and money allow us to signal information, and it simplifies millions of transactions. We get to swap dollars for goods and services, and every transaction can be appraised and evaluated by people quite easily. $5 for a coke - bad deal. $7 lunch - good deal.

But inflation erodes the value of dollars. $50,000 for a house in 1968 - not cheap. $50,000 for a similar house in 1998 - very cheap.

We all know inflation exists. Prices going up SEEMS to be a fact of life. But so few people ask "why". We know why, its very straightforward. The Reserve Bank of Australia prints more currency, issues more unbacked credit and expands the supply of money.

The graph above shows that the notes in circulation grow over time, and almost perfectly match the inflation of prices. As well as the evidence, the theory backs it up.

Why is this a bad thing ? Can't people learn to live with rising prices ?

You sure can "learn" to live with rising prices. Economies learn all too well and change their behaviour for the worse.

Its not a good thing to have rising prices, because it discourages savings, and it hurts the poor people who have less savings.

It lowers the real rate of interest faced by borrowers, and encourages them to borrow more than they would normally. Fractional reserve banking, the practice that causes the expansion in the money supply, also motivates banks to issue new credit, not backed by reserves, to risky loans. This creates speculative bubbles, and is most probably the single cause of the boom-bust cycles according to the Austrian School of Economics.

Why stash away $10,000 under a mattress, or even in a vault, for the future, when you know it won't buy half as much in 10 years time ? Those who have worked 500 hours to build up enough savings for a holiday had better spend it now, because if left in cash, those savings won't pay for a holiday in 4 years time.

The only other alternative is to try and earn a return on your money by investing. So we witness massive speculative bubbles in the stock market, in both residential and commercial property, and other forms of investment. Many people move their money into these areas driven by a certain attitude. Not so much to take a risk, buy into a business, or a piece of land that you think will go up as demand for it goes up... but instead, to avoid inflation. To avoid having a pile of dollars that lose their value. At least property and shares go up in terms of their dollar price over the long run.

If you can invest a large chunk of your wealth in these sectors, then you might do alright out of this scheme. And the wealthier you are, the bigger the share of your wealth that can be protected against inflation by investing it.

But for the poor and the middle class, many of them do not have a large chunk of their wealth invested in assets. Even their typical biggest asset, their home, is often heavily leveraged with debt. Their standard of living is directly harmed, and the value of their savings deteriorates over time, because of inflation.

So what we need, is no more new money. The economy is currently "correcting" because of the excess money creation ever since Alan Greenspan took over as chairman of the Fed in the 1980s, and central banks around the world tried to print as much new money as the US to keep exchange rates stable and "target inflation".

We need sound banking now. Couple this with less taxes and less regulation, and you'll see an economy innovate in new ways, and prices for many goods and services actually drop. We've seen it with electronics, and other free markets. We should see it in housing, health, education and energy. But only if you vote for liberty and property rights, and reject government control of every activity, from defining and issuing the supply of money and medium of exchange, to spending and regulating our key industries.

UPDATE:
Here is the key to understanding why housing prices and share prices keep doubling, or more to the point, why the value of dollars keeps halving (Courtesy of Brookes News ):

• "From March 1996 — when Howard won his first election — to November 2007 bank deposits rose by 224 per cent and M1 by 200 per cent"

And the Daily Reckoning gives us proof that central banks around the world still haven't learnt their lessons:

• The People’s Bank of China is rumored to want money-supply growth of 15% per year, down from the current 18% plus;
• India’s broad M3 money-supply is rising 22.4% per year;
• Singapore’s money-supply increased by 14% in 2007;
• Britain’s broad M4 measure of money has expanded by 12.3% since Jan. ‘07;
• Western Europe is “enjoying” monetary inflation of 11.5% per year, three times the central bank’s target;
• Last year saw 16% money-supply growth in Australia, 13% in Canada, and 22% in Saudi Arabia;
• The US money-supply - if the Fed still reported M3 - is now guess-timated to be showing 15% annual expansion.

The printing presses are working over time !!