The Inflation-Manipulation Saga and the Gold Price

July 25 2014

Inflation is one of the most pernicious phenomena that permeates our society. It not only erodes the purchasing power of our money and prejudices a majority of the people; it also creates micro-economic havoc by inducing distortions in our production activities. It is not just the ‘general price level’ that moves up and down, but it rather induces something we call the ‘Cantillon

The Inflation-Manipulation Saga and the Gold Price

Inflation is one of the most pernicious phenomena that permeates our society. It not only erodes the purchasing power of our money and prejudices a majority of the people; it also creates micro-economic havoc by inducing distortions in our production activities. It is not just the ‘general price level’ that moves up and down, but it rather induces something we call the ‘Cantillon effect’, which shows that inflation in fact distorts relative prices.

This in turn shows that any measurement of inflation is unscientific and arbitrary. Unfortunately, governments are eager to turn this arbitrary measure into their advantage and have done so in several ways.

What Is the Cantillon Effect

There are two components to the prices of goods: the monetary side and the goods-related side. Given this fact, we can easily grasp the importance of our money: it is one half of every transaction we make. Now, Cantillon recognized that money is not neutral: there doesn’t exist a general price level. Individual prices go up and down.

When new money or credit is created, most commonly through the creation of new bank deposits, it does not ‘lift’ some general price level. The ones that dispose over this newly created money, or credit, actually need to go into the market to bid up prices. From there, it moves from recipient to recipient, all bidding up certain prices in the process, until the last recipient is confronted with prices that were already bid up. Inflation is a game of winners and losers: some can spend the newly created money when prices haven’t adjusted upwards yet; others suffer from having to pay higher prices although their income hasn’t increased.

Nobel laureate Friedrich Hayek once described inflation by comparing it to pouring honey onto a table. First it will create a mountain. They represent are the ones first receiving the new money. Gradually, the honey spreads over the table, representing the newly created money passing hands. At a certain point, the honey stops spreading. The inflation has stopped. All prices have been bid up to reflect the newly established price structure. Some are better off than before, others worse.

Conflict of Interest

If it was not a government, but a public enterprise with future payment obligations based on a benchmark that is measured by itself without any third party verification, the payee would object fiercely. Most payees of the government — pensioners, mostly — remain rather mild.

Matter of fact is that the government has great incentives to skew inflation numbers in their advantage. First, many obligations, such as retirement benefits, are corrected for inflation by this number. Understating inflation has the effect of lowering the effective amount to be paid. Second, tax brackets are corrected for inflation. By understating inflation, loan earners fall into higher tax brackets although their real income hasn’t really increased. Third, most governments offer inflation-protected bonds, making it most convenient to understate real inflation.

How Is Inflation Understated?

Many changes have been made to the method of measuring inflation since the Boskin Commission, or the Advisory Commission to Study the Consumer Price Index, which was appointed to research an alleged overstatement of inflation.

Without getting to technical, many items in the CPI are “hedonically adjusted”. Although the BLS will disagree with my quick explanation, a “hedonic adjustment” essentially means that when people stop eating steaks because it becomes too expensive and change to eating hamburgers, the basket of goods is updated,

John Williams of ShadowStats has actually calculated that today’s CPI understates inflation by over three percent points when compared to the way in which the CPI was calculated as recently as 1990. Compared to the measurement method in 1980, the gap grows to over 7%.

Erosion of Confidence

At first, the systemic understatement of inflation numbers suppresses gold prices as fear of inflation remains low. Yet such downward manipulation may come back with a vengeance. As soon as a majority recognizes that the decline in purchasing power is far higher and more prevalent than the government indicators suppose, a loss of confidence in the currency is far more likely and more difficult to counter than it would have been if the government would have been more transparent with its inflation measurements.

These benefits are quite short-sighted, of course. When things get out of hand, they will regret suppressing inflation numbers in the first place.

Gold Prices Might Explode

What is the effect of understating the extent to which consumer prices rise on gold prices? Inflation expectations are subdued. But when the genie gets out of the bottle, when people recognize that prices are rising fast and that nothing will be done to stop consumer prices from rising further, a currency will collapse into a full-blown currency crisis and gold prices might surge as a consequence. Increases in gold prices due to inflation fears might be subdued, but it is something that could change quickly.

As economist Ludwig von Mises concluded: “Inflation can be pursued only so long as the public still does not believe it will continue. Once the people generally realize that the inflation will be continued on and on and that the value of the monetary unit will decline more and more, then the fate of the money is sealed.”

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