by Archie M. Richards, Jr., CFP^®
June 23, 2003

Carol asks, "Why do we have inflation?"

Here's the cause, Carol: Americans love freebies from Uncle Sam. Old people want help because they're old. Union members want help because they're not as rich as their employers. Debtors want help because they're under the gun. Corporations want help to crush competition. Beekeepers want help because where would we be without bees?

Legislators give in to these inclinations to buy votes and because they love the power of passing money around. Also, the benefits are concentrated while the costs are dispersed. Government money received by the few beekeepers, for example, mean big bucks to them. But the cost spread among 200 million people amount to a fraction of a penny each.

The trouble is, people aren't crazy about forking over taxes to pay for all the freebies. Legislators don't insist on it because they might lose office.

Okay, the government spends more than it takes in. It covers the difference by borrowing. People with extra money lend it to the government. No inflation occurs, because the supply of money does not increase.

But excessive government borrowing stresses the economy. Among other things, it raises interest rates, which is not the kind of freebie the people had in mind.

Enter the Federal Reserve Bank, which has the power to create dollars out of nothing. Not the green stuff we carry around; that's only about 10 percent of it. The bulk of our money sits in bank accounts.

The Fed buys back some of the debt previously issued by the Treasury Department. In payment, the Fed prints numbers in the bank accounts of the sellers. That's spanking new money, which the sellers can spend as they please. The Treasury securities become owned by the Federal Reserve Bank and for all practical purposes disappear. As the economy grows, the Federal Reserve creates new money regularly.

But when the government spends excessively, the Fed creates money in excess. When the supply of money grows faster than the goods and services available to buy, prices rise. If cars cost $5,000, for example, but money grows four times faster than the number of cars, the cars eventually cost $20,000. This hurts people who have low, fixed incomes.

The peak of inflation occurred in 1979. The high taxes and heavy government expenses favored by Lyndon Johnson and Richard Nixon produced tremendous economic stress. The Fed created enormous amounts of new money, which caused prices to rise rapidly.

Beginning in the early-1980s, U.S. government policies improved. Income tax rates were cut, and substantial advances were made in technology. An outpouring of goods and services resulted. People became more prosperous, and economic stress was reduced. The Fed didn't need to create excessive amounts of money. People had more goods to buy and relatively less money to buy with. The rate of inflation therefore fell and has continued falling for over 20 years.

As we emerge from the current economic downturn, inflation may pick up again in the short run. But any upward blip will be minor. Government policies are continuing to improve. Income tax rates have again been cut, and technologies even more powerful are becoming available. The result will be a greater flood of goods and services. But since people will be prosperous, the need for new money will continue to be moderate.

The result will be lower inflation, eventually turning into deflation, that is, declining prices. Cars will not only be better; they'll be cheaper.

But people will nevertheless be wealthy.

Deflation will not be a new trend. It will simply continue the high-production and moderate-money-supply trend that began two decades ago.

When deflation starts, people tend to delay purchases in hopes of lower prices later. But improved government policies and the onrush of technology will make the coming deflation positive and long lasting. People will soon resume their buying. We will enjoy falling prices and prosperity at the same time.

Imposing term limits on U.S. legislators will advance these favorable trends even faster. Legislators who are soon to be removed from office in any event are more willing to say no to excessive government spending.