A small degree of inflation, say 1% or 2%, is used by the powers that be to keep industry and commerce rolling along nicely and to give all the people a “feel good factor”. Industry produces hard goods like tools, machines, cars, food and clothing whilst Commerce produces services like banking, transport, postal services and so on. Governments in a democracy have an immense desire to keep the people content because that means they keep their vote and stay in government. But this can influence thinking and lure them into making bad policy that as the saying goes “looked good at the time”!

A sound policy will keep inflation of the country’s money under very strict control and to do this it is necessary to keep the supply of money in balance with the product. If the money supply grows too rapidly the result is inflation, or if the product grows too quickly there is disinflation or deflation.

The difference between these two words is very important because it describes the degree of severity felt by the people. Disinflation is letting the air out of an inflated balloon slowly and in a controlled way so that nothing drastic happens, whereas deflation is letting go altogether when the balloon flies off in all directions and is totally out of control. The former is using policies which correct the situation gradually and brings everything back to the required normality over an extended timeframe and makes life easier for the people by protecting the maximum number of jobs possible. Deflation is the crash, course, kill or cure, and usually means that a large part of the population loses their jobs and their livelihood, giving great stress and anguish. If bad policies are followed for too long then the only way out is deflation – not good and normally called a “slump”. The last slump started in 1929 and continued until the late 1930′s. The result of disinflation is a “recession” which is a slowdown but not a case of falling off the edge of the precipice.

So how is this controlled?

Firstly, we have to understand that all countries want to keep expanding their output of product because that provides the people with jobs to earn a decent living. Provided there is someone to buy all of this “growth” all will be well. You will see growth factors quoted in the financial news all the time and this is what they mean. If the factor is positive then that means the product is getting bigger and if it goes negative then the output is shrinking.

Secondly, we have to keep the money supply expanding at the same rate as the product growth. There are a number of ways of doing this and some are very complex and difficult to understand but the predominant method is to persuade all of the people in the country either to use more of it (that is to spend more) or to use less of it (to spend less and save more).

If they spend more, that means a greater demand for product and if they save more that means a reduction in demand for product. When the former gets out of hand the result is not enough product to supply the demand and scarcity makes the price rocket as recently happened in house prices.

There was too much money easily available at very low cost chasing after a much more slowly growing product output. (It takes a number of years to plan, acquire land, obtain planning permission, and then build a house).

This was exaggerated to an alarming extent because the policies in the countries affected encouraged people to borrow money to do so even when those people could never pay back the loan from their income.

The lenders believed that provided the borrowers could pay the interest charges there was no problem because the house prices would keep rising and eventually take care of the repayment of the loan itself.

Another case like the “Tulip Mania” and the fable of the “Emperor’s New Clothes” where people saw what they wanted to see until someone broke the rose tinted spectacles. The method most used to control this demand is the rate of interest paid on borrowed money.

The national bank sets a rate which periodically moves up or down and this normally is taken as a guide by all financial institutions for the rates they offer to borrowers and savers. A reduction in rate encourages borrowers because they do not have to pay so much for their loans but at the same time discourages savers because they receive less on their savings.

An increase in the rate does exactly the opposite. The big problem associated with this system is that the decision has to be made after seeing what the effect of the current rate has been (that is, in hindsight) and it takes about six months for the statisticians to make their report on this. A lot of damage can be done in six months of the wrong policy when the ship is already off course.

An example of this can be seen in the current financial turmoil. Most governments kept their base rates (national interest rate guidelines ) too low for too long which encouraged people to borrow money and also made it cheaper for them (as governments ) to borrow money themselves. (That will be discussed in another blog post). The end result was an unacceptable increase in the money supply relative to product which was seen as inflation for those products home grown like houses but was offset in the overall assessment by the increasing volume of product being obtained (imported) from overseas countries like China where the prices were to our eyes phenomenally cheap. So, house values going up at 10% each year, and children’s toys, televisions, washing machines, refrigerators, cookers etc going down at 10% per annum, resulted in a net increase of around 2%. Everything looks rosy and people are happy.

BUT, wait a minute, we said earlier that in any one country the amount of money in circulation in that country must be kept in balance with its own product to control its money inflation, so whose product are all those toys, televisions, washing machines etc? The answer must be China’s and so do not reflect in the value of other countries’ currency values. So the real rate of currency inflation was the 10% affected by the indigenous housing prices! In reality it was dropping in value and would buy less and less as time progressed. The 2% net figure is another thing called the “Cost of Living index” and measures what anyone has to pay in their own currency to buy a range of goods deemed to be essential for a comfortable life regardless of where these are made.

Over the course of many years the money inflation rate is the vital one but the quickest and easiest to see is the cost of living inflation which is why more attention is paid to this. Ultimately though, it is the value of a country’s money and the confidence that people have in it that controls how much people have to pay for that acceptable standard of living.

Oh dear, where is that fairy godmother when you really need her?

Quite so, but there is also a much more sinister meaning which eats away at our monetary worth by stealthily dipping its hand into our pocket. Usually we do not feel it but we do see its effect in the way prices keep rising.

If prices rise we need more money to buy the goods and if we cannot get more money then we can only buy less. What causes this to happen? This is a very complex question and because it is so complex, people outside the world of finance block it out as something they cannot understand. BUT it affects all of us every day of our lives so we should at least try. If we understand the cause then we can do something to correct it.

I have talked on this blog in the past about money and value; inflation is all about the value of money. Search out those previous articles and it will help you to follow this one.

The value of money is simple, isn’t it? A Dollar is a dollar, a Euro is a euro, a Pound is a pound, and a Yen is a yen. If each of these countries were totally isolated, with a great wall around them, so that they could not communicate with each other then everything used in each country would have to be produced within its own walls and would be paid for in its own money (currency). This money is issued and guaranteed by the government of the country and the total amount at any one time is controlled by that government and passes around from person to person and business to business to settle debts. This is called “money in circulation”.

Now this isolated country that we have invented has to produce all of its own food and drink for its people to live and also everything that the people use in their daily lives. This is the “product”, and if the number of people and the product remains constant and the money in circulation remains constant then the cost of everything used will remain constant because the cost is “the money divided by the product”. For example, if the total money in this wonderland is 100,000 and we have a total produce of 1,000 identical items then the cost of each one is 100 (100,000 divided by 1,000).

So far so good, but if the balance is disturbed, say by transferring some of the people making this product onto other jobs which do not make any product, then the amount of product will drop, let’s say to 500 and the cost of each will then be 200 (100.000 divided by 500).

In simple terms the product has become scarcer and its value has increased to reflect this based upon the “human perception” principle mentioned in one of the previous posts. Similarly if the product remains the same but the powers that be, increase the money supply, then the cost of each item will increase. (200,000 to produce 1,000 = 200 each).

An example of this occurred in Germany after the First World War. The armistice agreement imposed on the German people a liability to repay France for all the damage done. This was payable in German currency which the French would convert to their own currency to make good the damage by using their own people. Germany however was a bankrupt nation after the cost of the war, like most of the others, and could not earn enough by selling its produce to pay the debt, so the easy way out was for the Government to print additional quantities of its currency every time a payment became due. Thus they increased the supply of money without an equal increase in product and the result was that the money bought less and less. The debt to France was paid as required by the agreement (in German currency), but the value of the payment when converted to French Francs became more and more worthless so they had no real benefit.

Eventually there was so much German money around for no compensating increase in product (that is, the money became so valueless) that no-one including all of the German people wanted it, and in Germany a single loaf of bread cost a wheelbarrow full of money to pay for it. This imposed enormous hardship on the German people who found themselves unable to buy the necessities for them to live.

Prices were doubling by the day and money became completely useless so the only solution was to go back to barter. In these conditions a week’s load of food was worth more than the most valuable diamond in the world and would be exchanged for it provided the food owner was willing.

A similar situation is taking place today in Zimbabwe. The produce (output) of the country has been shrinking for many years and the money supply has been progressively increased by the national bank to pay for the government’s liabilities with the result that the currency is totally worthless. A recent report said that a new Z$10,000,000 (that’s right, ten million)note has been issued but all that it will buy is a loaf of bread. This is inflation on a massive scale and is devastating for the people who live there.

So inflation is not a good thing but governments and borrowers flirt with it because it makes it easier to pay off debt. At one or two percent per annum it does some harm but not enough to cause any serious hardship. As it gets above this level however we all begin to feel the pinch because our money will, quite visibly, not buy what it would before. The end result is to penalise the careful, thrifty people and to make life easier for those who run up big debts. That is not a result that is that is either wanted or just but is convenient for those who have borrowed and have to make repayment.

So keep an eye on those figures announced every month in your country. It is the policies exercised by the government that affect them and if the trend is upwards that is not a good sign. Trends are important because these actions take a long time to become apparent and by that I mean years not months, but if the wrong policies are followed for too long then inflation will happen just as surely as night will follow day.

Of course there are a vast number of complexities mixed into the pot to make the issue difficult to understand clearly, even for financiers, but the basic principle remains the same whatever the “confusers” tell you.

Like the balloon at the beginning, inflation causes monetary things to get bigger and bigger until eventually BANG!!!