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FIGURE 5.2 1970s™ U.S. Inflation Was Created by “Loose” Money
Source: U.S. Federal Reserve
Inflation 103

In 1979, Paul Volcker became the chair of the U.S. Federal Reserve.
With inflation running at about 13% a year, Chairman Volcker decided to
stop the insanity. He slowed the growth of the money supply, and by 1983
inflation was down to 4%. Time magazine™s cover from October 22,
1979, pictured Volcker under the heading “The Squeeze of 1979.” This
squeeze cranked up interest rates so that some rates exceeded 20%.
Imagine getting a car loan or a mortgage in such an environment, and
it is easy to see how tight money slowed the economy and reduced

It™s Good to Be the King

In The History of the World, Part I, Mel Brooks remarks, “It™s good to be
the king!” The king has unique powers to achieve his goals (either nefar-
ious as in the movie, or noble). Similarly, the Federal Reserve has unique
rights that allow it to control the money supply, and through the money
supply, to control inflation.
The injection of money into an economy can have a powerful effect. A
simple personal example came when I was living in western Uganda in
the summer of 1997. I was spending some time at a chimpanzee research
station run by Harvard professor Richard Wrangham. Things were going
fine, but I decided that I couldn™t rely upon the station™s truck for trans-
port, and that I needed to buy my own vehicle.
Accordingly, I had my parents wire funds to a local bank so that I
could purchase a motorcycle. With the help (and protection) of several of
the research station™s employees, I negotiated the purchase of a used
motorcycle at the exorbitant price of $2,400.
As I rode the motorcycle along the local roads, people would greet me
and then laugh to each other. They found the situation funny for many
reasons. First, I was ridiculously large for the small motorcycle. Second,
I had paid at least $1,000 more than a local would have paid (in Swahili,
they said that I paid the “Mzungu,” or European, price). Third, there were
104 The Old Art of Macroeconomics

stickers on either side of the bike that showed a hunter with a spear. I was
unaware that the spear was metaphorical, and that these stickers were
public service messages to exhort the people to use condoms. So I
became a mobile source of humor.
The actual purchase took place as follows. After reaching a deal on
price, I went to the bank, took out the $2,400 in local currency. I was
acutely aware that this represented close to a decade™s wages for the
locals. I had guards on either side as I took my backpack full of bills and
picked up my condom-advertisement machine. The previous owner
asked me to hurry so that he could return the funds to the bank before
closing time. In fact, he then returned the bills to the exact same bank
manager who had given them to me earlier in the afternoon.
As I lay under my mosquito netting that night, I marveled at the power
of electronic entries in the banking system. My parents sent an electronic
message to a bank in western Uganda. Less than 24 hours later, I had a
motorcycle and the electronic bookkeeping showed that the motorcycle™s
previous owner had credit for $2,400. So by just moving a few electrons,
I now controlled a motorcycle.
My motorcycle purchase created a whole cascade of effects. The pre-
vious owner was now rich with the proceeds of his sale. He used the
money to buy a variety of products. The sellers of those products in turn
purchased more goods. By injecting some money into the economy of
western Uganda, I created a mini wave of prosperity. In my case,
Uganda™s prosperity came at the expense of some in the United States.
While I was $2,400 richer, my parents were $2,400 poorer. This was a
zero-sum game where gains were offset by losses.
Being the king of the monetary world, however, the Federal Reserve
plays by its own rules. For me to get money, my parents had to lose
money. When the U.S. Federal Reserve buys something, no one™s
account is reduced. The Fed controls the electronic system of bank cred-
its. Thus, the Fed can increase an account by $2,400 or $240 billion with
no offsetting reductions. While the Federal Reserve uses its power to buy
U.S. Treasury bonds, and not motorcycles, the effect is the same as my
mini wave of prosperity.
Inflation 105

Except, the Federal Reserve can create money from nothing. It simply
pays for its purchases by crediting the seller™s account. While private
transfers are zero-sum activities, the purchases of the Federal Reserve
are not.
Through these monetary operations, the Federal Reserve determines
the growth rate of the money supply, though the decisions of other peo-
ple impact the effect of monetary operations. For example, the speed at
which people spend their new riches has implications for the economy.
Even after taking account of the “velocity” of money, the Federal
Reserve controls the money supply and thus determines the rate of

Reading the Body Language
of the Federal Reserve

In Rounders Matt Damon plays a reformed poker shark forced back into
gambling by circumstances. Damon™s poker prowess lies in his ability to
read other players and thus know what cards they have. Most profession-
als agree that the ability to size up opponents is a crucial skill needed to
win at competitive poker. In these games, knowledge of human nature,
not of the mathematical odds, provides the key advantage.
Predicting inflation also requires understanding the human actors con-
trolling the situation. The rate of inflation is determined by the growth of
the money supply. In the United States, the Federal Reserve controls the
money supply. To make predictions about U.S. inflation, therefore, one
must have a good idea of the future actions of the Federal Reserve.
Many people are willing to make bold predictions of future inflation
rates. On one hand, you find books about how to protect yourself in the
coming deflation. On the other hand, some foresee an inflationary world
where investors must buy gold to protect themselves.
I remain unconvinced by those who make clear predictions about a
future inflation or deflation. U.S inflation rates will be determined by the
future decisions made by the Federal Reserve. A prediction of inflation
106 The Old Art of Macroeconomics

must be based on future decisions of the monetary authorities. Further-
more, the current chairman, Alan Greenspan, was born in 1926, so he
might not even make it to the end of his current term in June 2008. Thus,
all longer-term investments will be affected by the inflation rate deter-
mined with a new chair of the Federal Reserve.
Consider the historical period between World War I and World War II.
Between the wars, Germany experienced a hyperinflationary depression,
while the United States had a deflationary depression. The German mone-
tary authorities created huge amounts of money and destroyed the value of
the German mark. The U.S. monetary authorities did not create inflation”
quite the contrary, U.S. prices declined throughout the Great Depression.
These extremely different outcomes suggest that the people in power
determine the inflation rate. Although this may appear obvious, it is pos-
sible that the German authorities had no alternative. Similarly, some
believe the current Japanese monetary authorities are powerless to pre-
vent the current deflation. To the contrary, Milton Friedman believes that
the Japanese can end deflation by simply increasing the money supply. I
side with those who believe that the individuals in charge of monetary
policy determine the inflation rate, constrained, but not controlled, by
Thus, a good prediction of inflation requires detailed understanding of
the forces that will pull and push the people who determine inflation.
Furthermore, as in high-level poker, inflationary predictions depend on
the ability to predict human behavior. While it may be possible to predict
the behavior of the next Federal Reserve chair, even before she or he is
appointed, I have not seen a convincing prediction.

Missouri on My Inflationary Mind

Missouri is the “show-me” state, where residents are reported to wait for
proof and not act on promises. When it comes to inflationary predictions,
I suggest a show-me attitude. Rather than speculate on the future actions
Inflation 107

of monetary officials who have not yet been selected, a preferable finan-
cial strategy is: (i) based in the facts, and (ii) likely to perform well in
either an inflationary or deflationary world.
First, let™s look at the monetary facts. Figure 5.3 depicts U.S. money
supply growth over the last decade. Monetary growth has accelerated, so
the facts provide some support for those who predict rising inflation.
Monetary changes create inflation only after some time, and the Federal
Reserve may have planted some seeds of inflation that will sprout in the
years to come. Both gold prices and the value of the dollar confirm that
inflation may be stirring. Gold has risen from $250 an ounce to over $400
an ounce. Over a similar period, the dollar has fallen significantly against
many currencies and to an all-time low against the euro.17 These moves
suggest that the Federal Reserve™s loose money policy is decreasing the
value of the U.S. dollar.
The inflationary case is not, however, complete. First, money supply
growth over the last decade is still slower than the rates of increase in the
1970s. Second, money supply growth has slowed. So perhaps the Federal
Growth in U.S. Money Supply (M3)

















* estimate from part of year

FIGURE 5.3 Is the Federal Reserve Creating Inflation Again?
Source: U.S. Federal Reserve
108 The Old Art of Macroeconomics

Reserve™s policy is perfect. This optimistic view is that the Federal
Reserve created lots of money to soften the effect of the bursting stock
market bubble. Now that the economy may be emerging from that dour
period, the Federal Reserve is easing up on money growth. If this opti-
mistic scenario is correct, then inflation need not reappear.
To repeat the mantra of this chapter as expressed by Milton Friedman,
inflation is always and everywhere a monetary phenomenon. Thus, as
long as we keep a clear eye on money growth, we should have early
warning of any major change in inflation. If money growth increases,
then inflation will follow and investments should be in tangible assets
including gold and land, and in currencies other than the U.S. dollar. If
deflation becomes likely because of slow monetary growth, then finan-
cial assets, particularly certain bonds, should do well. For example, the
simple U.S. Treasury bond, even with a yield of just 5% per year, could
be extremely profitable in a deflationary environment.

Buy Your Inflation Insurance at
Irrationally Low Prices

In addition to looking out for changes in the money supply, there are a
number of financial steps that make sense in any environment.
Recall from our discussion of human nature that our lizard brains tend
to put too much weight on recent experience. Since Paul Volcker stopped
inflation in 1979, the United States has experienced nearly perfect infla-
tion rates. This suggests that most investors will be too little concerned
with the possibility of either inflation or deflation. Having spent 20 years
in a Goldilocks zone of low and stable inflation rates, we are likely to
overlook the possibility of problems.


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