Here is a simple question for you: do wet streets cause rain? Or does rain cause wet streets? Everyone knows that rain causes wet streets and not the other way around. Yet, relating that same example to inflation, do rising prices cause inflation? If the price of oil goes up this month, does that cause inflation? If the price of insurance, or health care, or college tuition goes up, does that cause inflation? Do wet streets cause rain?



Unfortunately, the established media present inflation statistics in such a way that suggests that rising prices do indeed cause inflation. Consumers are led to believe that if the price of oil goes up on international markets, it will create a domino effect across our economy causing the prices of many other things to rise, and thus causing inflation to rise. That is pure folly. Wet streets do not cause rain, nor do rising prices cause inflation. Wet streets and rising prices are both symptoms, but not the source of the cause. Let me explain.

In our economy, there is a finite amount of "money". The definition of money nowadays is more than a little confusing. Even Alan Greenspan, former chairman of the Federal Reserve, testified before Congress that it is hard to understand and define what money actually is. The Federal reserve has some definitions. M1 includes just cash, or currency. M2 includes cash, plus cash equivalents, such as deposits in checking accounts that can be readily spent. M3 includes even more, but the Federal Reserve as of March this year stopped publishing M# statistics. Regardless of what definition of money that you use, there is a fixed amount of it in use in our economy.

The basic cause of inflation, at its very root, is the dilution in the value of money. When the value of money goes down, it has the effect of making prices of everything go up. However, prices going up is not inflation itself, but rather the result of true inflation: the dilution in the value of money. If the value of money wasn't diluted in the first place, prices would not respond by going up. Our economic system is very complex, involving literally trillions of individual transactions every year. But the basic principle of inflation is quite simple. When excess money is put into our economy, it dilutes the value of the existing money, and thus we have inflation.

Think of our economy as one big auction. Lots of things for sale, and lots of buyers actually purchasing those things. To keep our example understandable, we'll use round numbers. If there are one million items for sale in our auction, and one million buyers, each with one dollar to spend, the average price per item will be one dollar, assuming everything sells. If an outside source gives each buyer another dollar (thus doubling the total amount of money in the auction) without an increase in the amount of items available to purchase, then the average price per item would be two dollars. The more money that is introduced into this auction, the more prices will go up. Assume that several buyers were allowed to photocopy currency, and could use this to purchase items in the auction. If these people could use the photocopy machine without limit, isn't it easy to see how prices in the auction would rise in the same fashion as a result of all this "money" competing for the same items? By introducing more "money" into the system, the value of existing "money" gets diluted. That is how inflation works.

Now, the population of this country grows each year by about 1.7%. Realistically, there should be 1.7% more cars, houses, offices, etc. If the money supply increases by 1.7%, it would offset the increase in tangibles, and prices would neither fall nor rise, but remain stable. However, if the supply of money increases by 11.7%, there would be an extra 10% that would dilute the value of the existing money that is already in the system. That would be the source of inflation.

History teaches us that governments and other "powers that be" cannot resist the temptation to print paper money recklessly for their own self-interests. Realistically, the temptation is just too great. If you could photocopy money without penalty of law and jail, wouldn't you? If the only penalty of doing so was that it dilutes the value of everybody else's money, how could you resist? Want a fancy sports car? Just go the photocopy machine. Want a new waterfront estate? Another trip to the photocopier...