The more I write about inflation, the more I realize how little people understand just what inflation is, what causes it, and what harm it does. Now, I lack both the time and the dedication to write a full analysis, for that I would refer you to Henry Hazlitt's The Inflation Crisis and How to Solve It (yes, promoting that book again), but I do want to look at one aspect, and propose a solution.

Just to make things clear before we start, inflation is NOT the general rise in prices some think. As I wrote before, inflation is an increase in the money supply. This inevitably leads to a rise in prices (though not necessarily a proportionate one, as some early theorists proposed), but is not synonymous with those price increases. Just as a fever is not pneumonia, rising prices are not inflation.

Second, there are no other common causes of a lasting general increase in prices. The other theories proposed just do not work. For example, if demand is pent up by enforced austerity, it can cause a temporary rise in prices, but the market will adjust once savings are expended. Nor do any other mechanisms produce the permanent changes that monetary expansion does. The only other possible cause is a collapse of the economic or governmental infrastructure, which could cause a decline in production and a general rise in prices, but as that would be rather noticeable, I exclude it as a possible cause of the price increases mistakenly called "inflation". That rise in prices is always a monetary phenomenon*.

Third, despite claims to the contrary, the supposedly antiquated gold standard serves as a check on inflation. That is why the US has experienced its worst inflation only in the years since Nixon cut off all gold redemption for dollars in 1973. Gold does not prevent inflation, it just makes it more difficult and provides a check on the rate at which the money supply can be increased, as at any time a given note may be redeemed, requiring that the money supply bear some relation tot he amount of gold on hand. You cannot increase the money supply at will under a gold regime as you can today with fiat currency.

Fourth, though early inflation may appear to be beneficial, as companies post increased profits, housing booms take place, the stock market takes off, lending requirements are eased, and so on, inflation is always harmful. I plan to write soon on more of the specific details, but for now let me just say that even in the early stages, inflation cause inappropriate allocation of resources, impoverishes some and enriches others (though not to an equal degree), and causes companies to mistakenly overestimate profits, allowing them to deplete capital in dividends or reinvestment. As I said, this will be covered later in detail, so for now I will not bother with a lengthy explanation.

Fifth, the supposed boom-bust cycle is not a feature of the free market, but of the inflationary banking structures we currently have. Yes, there were crashes before the federal reserve, but, as I will explain below, the prior system was similar to the Fed, so it helps to explain the previous cycles. In a free market there can be booms and crashes, but the pressure of the free market on a free banking system work to discourage general excessive issue of credit, making a single boom and bust unlikely, much less the regular cycles with which we have become familiar. Boom and bust cycles are a government phenomenon, caused by the centralization of banking.

Having said all that, what I want to look at is how inflation happens, and, more importantly, how our banking system, since at least the Civil War, has been designed to do nothing but create easy money and a permanent market for federal debt.

The current Federal Reserve system is built on the basis of the old three tiered banking system which was put in place immediately before the civil war. The Federal Reserve takes the place of a consortium of New York banks, and individual banks no longer issue their own notes, but otherwise the current system resembles the past one in many details.

One of those common features, and the most important from my perspective, is that banks consider treasury notes as reserves. In the past they were considered reserves on par with gold, today, without gold, they are the sole reserves. In either case, this practice means that banks must rely on constant federal borrowing. If they rely on having treasury notes to back their deposits, they must replace them as they come to maturity, which means the government must continue to run a deficit. In fact, even worse, as any planned expansion of deposits requires that they acquire more federal notes, requiring an additional expansion of national debt.

In the past this was not so bad, as there was the choice between treasury notes and gold. Banks could always find additional gold reserves if they could not find notes. In fact, during the period between the Civil War and the founding of the Federal Reserve, national debt was retired without doing harm to the economy. With our current system that is just not possible. The Federal Reserve relies upon treasury notes, that is national debt,  both to expand the money supply and to provide "reserves" against their outstanding issues. So were the government to stop running a debt, the Fed would be faced with having to contract the money supply as the notes they held were retired and no replacements found. Our system is set up to demand a constant influx of new government debt.

And that is one of the biggest problems with the central banking system. Not only does it set us up for the boom-bust cycle with its politicized decision making, which makes inevitable a cheap money policy, even with the best management in the world, it would inevitably be a cheap money engine, as the government would pressure it into buying up what debt could not be sold on the market. Not only that, but the pressures have two "positive feedbacks". First, as money becomes cheaper, it becomes easier to sell debt on the market, allowing the government to run up larger debts, requiring the Fed to buy up more bonds, making money cheaper, allowing the sale of more debt on the market, and so on. Second, should the government ever think of exercising fiscal responsibility and issuing no new notes, the immediate impact on the money supply would spook most of America, create demands for government "stimulus", and thus encourage deficit spending which would increase the money supply**.

Our current system is set up to be nothing but a market for federal debt. Unfortunately, that also means it serves as a massive inflation engine. I can think of no better proof than the fact that Alan Greenspan was widely seen as "too conservative" in his issue of money, yet the CPI nearly doubled between 1988 and 2008. If that is an excessively restrained position, then imagine what a "normal" position would be. And before someone points out that doubling in 20 years seems innocent enough, recall the massive increase in wealth and productivity in those years. With a fixed money supply, prices would have fallen significantly. Taht they rose suggests a pretty significant inflation.

The solution is simple, but unlikely to be popular. The first half is what I am sure my readers expect, the return to a commodity backed currency, to act as a break on inflation. However, I differ from some in arguing that is not enough. We had gold in the 19th century, but also had an inflationary boom-bust cycle. What we really need is not just a gold standard but a free banking system, one without a central agency to enforce uniform inflation and create such cycles. In a free system, if a bank inflates too much, investors and other banks lose confidence and it goes under. It causes a small slump, but much less than when a centralized system engage sin the same fallacy. With individually manged banks, the chances of a universal inflation or deflation is close to zero.

Of course, that is not likely to happen anytime in the foreseeable future (unless the economy gets a LOT worse and we really have to satrt from scratch), but it is the ideal. If that is not going to happen, then I suppose the best likely solution is for the Fed to stop trying to manage the currency. Leave the money supply fixed, or increase by a very small set percentage. Force the government to live within their means or else sell bonds on the private market. Also, stop trying to force down interest rates, let the market decide. Revert to the old Bank of England policy of setting the discount rate ABOVE market rate as a penalty for inter-bank borrowing, not as an inducement to inflate through credit creation. And, above all else, get rid of Fannie and Freddie, those twin generators of economic deadwood which still serve to bloat up the money supply through extensions of credit.

Not that I expect even those modest solutions to be embraced. At best, I see Obama's plan falling, a short period of Carter styule "stagflation" as people panic about his trillion plus increases of the money supply, followed by a new president. At worst, his ifnlation will cause a short lived boom, leading to more inflation, resulting eventually in a German style hyperinflation and collapse.

Sadly, I don't think there are any realistic alternatives to one or the other.

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* When we had commodity money, such as gold or silver, an increase in the stock of either could cause general price increases, but that was an increase in the money supply, and so did serve, in effect as an inflationary force. (Which is why easy credit proponents in the 19th century favored silver over gold, as silver stocks were increasing faster than gold.) However, mining more gold is much harder than printing dollars, so any inflation caused by increase in stocks of metal are unlikely to have the prolonged ill effects that the continual printing of money has.

** This is how most stimulus plans give the impression of working. They stop a needed contract with renewed inflation, putting off the correction and leading to more misallocation and greater later suffering. Sometimes they also work by increasing the money supply, causing a temporary increase in demand before prices adjust, creating a large paper boom. However, as prices soon adjust, and those who sold at pre-inflation prices realize new replacement costs mean they suffered  a net loss through increased sales, the benefit is usually short lived.