I don't talk much about politics because it's a subject I choose not to think about. When I listen to television programs about politics, I end up confused and depressed. Listen to left-wingers on late-night shows, they seem to make sense. Listen to right-wingers, they make their points quite well. So mostly I choose to ignore the whole mess. On election day this coming November, Cliff and I have decided to just vote for anybody except the incumbents.
So I wasn't paying much attention when I heard something on the noon news while I was eating dinner that threw me for a loop;
Most money isn't printed, but it's created on paper...like every time social security "checks" are transferred electronically to banks.
We normally would be seeing very significant inflation, but the world economy sucks so much people still have MORE faith in the U.S. then any other industrialized nation in paying their debts, so they keep buying our Treasury notes at absurdly low rates which keeps interest rates down.
There's three states we can be in.
Prior to 1900, we had primarily steady prices. You could buy, say a house, in 1899 for about what you would've paid in 1799.
There were a few periods when prices shot up (Civil War) but then prices came down (Deflation). The period of 1873 -- 1896 was a long period of global financial doldrums, triggered by the deflation that was marked by the Panic of 1873.
It's not a coincidence that during that time the U.S. was politically volatile -- it wasn't unusual to see 1/3rd of the House change political parties every two years, and it's the period Cleveland won the Presidency, then lost, then won again. Politicians were just as corrupt, and capitalists just as bad at shooting themselves in the foot as today.
The first modern spurt of inflation was during WWI, then we had a deflationary cycle during the Great Depression and the rest of the 30s.
Post World War II we adopted a policy of looking for 2 to 3% annual inflation. This got away from us in the 1970s, but for the rest of the post war period it worked out pretty well.
See deflation is a bad thing for investors...and people. At 2% deflation, you have $100 in assets today, next year you can only sell them for $98. The year after $96.04. Why would you invest in anything? If you just kept it as cash, you'd have $100 still. Housing, farm land, build a factory, buy machine tools...all risky investments because you know they'll lose value rapidly. It also means your labor becomes less valuable.
Take a loan? Fuggadabout it.
Let's think of a 30 year fixed mortgage that's common today (although they weren't around in the 19th century).
$100,000 = $600/month @ 6%
You're making $30,000/year. Let's assume your skills and productivity don't improve to make the math easier.
2% Deflation, in 30 year's you're still paying $7,200/year on the mortgage. But the value of your labor has dropped to only $16,698. So over 30 years your housing cost has gone from 24% of your pay, to 43% of your pay. And the value of the house has dropped to only $55,000. See a problem? At least the mortgage is almost paid...
2% Inflation, the value of your labor will have gone up to $53,275. Hey this is pretty nice, I'm paying the mortgage with cheaper dollars so I'm only spending 13.5% of my pay on housing...and the house is now worth $177,000.
Banks don't care about the inflation, they just build it into the interest rate. Banks are terrified about deflation, because no sane person will take a loan in that environment. The economy grinds to a halt because the only store of value is cash...not investments in tangible assets.
Having stable prices would be OK too...but what the banks and federal government and all worry about is that gives you very little margin of error. A little slow down, and you see deflation. Inflated wages make it easier for folks to pay off big loans...no inflation those long-term loans become riskier and riskier. Which is why mortgages in the 19th Century, even many up until the end of WWII were for 5 or 10 years, who would take an insane risk like making a 30 year loan to a working man when there was a big risk of deflation, or simply knowing the longer the time the more chance of something making it harder for him to repay it?
So the powers to be like to see 3% or so annual inflation. It doesn't hurt consumers short term, tends to help us long term by letting us pay back loans the cheaper dollars, banks can easily compensate for low to mild inflation with a little bit higher but not crippling interest rates, and keeps money flowing into investments.
Sure what I put above is simplified, and there's always bad ways for things to go (like easy credit + two income middle class families creating a run up in housing prices well above natural inflation rates, which is a large part of our current economic hangover)...but a little bit of inflation is the best overall economic policy for our modern economy.
So I do understand the concept a little better.
Now if only somebody will explain to me why "the Fed" is not Federal, I could quit puzzling about politics and go back to my garden.