Pentonomics – The Cause and Evidence of Inflation

February 4, 2011 at 11:23 AM

On the Kudlow program dated Tuesday February 1st, Donald Luskin gave his version of the textbook definition of inflation as “an overall rise in the overall price level.” But my 1988 edition of the Webster’s Dictionary puts it differently. Their definition of inflation is, “An increase in the volume of money and credit relative to available goods resulting in a substantial and continuing rise in the general price level.”

But let’s put aside technical definitions of inflation for a moment and let me help Donald understand what inflation is in reality. Of course inflation is an increase in money supply and credit; but he should ask himself why that causes prices to rise. The reason is because the U.S. dollar isn’t backed by anything anymore; as Luskin is well aware. Therefore, its value depends upon our collective belief in its current and future purchasing power and the hope that its supply will be restricted. When its supply is increased, users of the currency lose faith in its buying power and prices rise.

In addition, if current holders of the dollar feel that in the very near future the U.S. has no choice but to monetize trillions of dollars of Treasury debt, the currency will falter as well. I like to use the Enron example to make this point. The share value of a corporation represents the strength of the company. Likewise, the strength of a currency represents the strength of a country. What may happen to the U.S. dollar is notdissimilar to what happened to Enron shares. Once the accounting scandal broke, the purchasing power of Enron shares plummeted. But it was not because of an increase in the number of shares outstanding, but because of an epiphany on the part of investors that the company was totally bankrupt. Logically, shares representing a stake in an insolvent company lost all of their value. Likewise, aggregate prices will soar if global investors lose confidence in the dollar due to the realization that the US is incapable of servicing its debt. If there is the mere perception that a massive dilution to the currency is inevitable, it will cause the dollar to tank and aggregate prices to rise. Inflation is also about the confidence in the purchasing power of the currency.

My contention is that the Fed and government have set out on a deliberate strategy of creating inflation in order to monetize most of the $14.1 trillion national debt—that is growing by well over a trillion dollars per annum. So let’s look at some charts that prove the dollar is being diluted and that prices are rising. First is a chart of the monetary base, which consists of physical currency and Fed bank credit…