In the Progressive Century thread we got a dose of fine propaganda. Now I'm connoisseur of fine propaganda, and this is a version of the classic confusion in propaganda of confusing real with nominal. Money is nominal, it has value because we've given it a name, and set aside. It has no value aside from this, as money. This is true even if the medium of exchange has value: the use of valuable things as a medium of exchange is a way of hedging bets - it says that even if the exchange should collapse, at least you had something you want for it. The use of the valuable thing, and its ability to stay valuable even when "words lose their meaning", is insurance against the uncertainty of politics, governments, and society. This is particularly true of governments like those of the ancient world which are roughly as capable compared to modern governments as a chariot is capable of going to the moon.

So here's why some inflation is a good thing, and why this bit of gold standard propaganda should be ignored, because it tells half of the story. The other half of the story is the rise of real wages and real GDP, which is the part of the story you and I care about: the real economy, not the nominal one.

So really the graph that was linked to is classical plutocratic porn propaganda, convince people at a time of stagnant wages, falling home prices and so on that it is nominal inflation rather than real inflation that is the problem, and do a bait and switch to sell wage deflation as the cure. This is roughly as smart running into a brick wall to cure a headache.

The good news is that now that Wall Street must think the credit crisis is over, because now they can go back to anti-Fed turgitprop after the Fed finished saving them from getting a buttectomy.

It's a pretty graph right? Shocking! The purchasing power of a dollar is falling. And if you had only one of them, well that would be a problem. However, you don't have the same number of dollars as someone in 1800 had. However as Measuring Worth points out, what's important is asking the question not "what does one dollar buy?" but what the equivalent purchasing powers are. For example George Washington was paid a salary of $25,000 - which was a great deal of money at that time. George Bush isn't getting by on a salary of $25,000.

So here's a bit of counter propaganda: this is how much you are spending. And it only goes back to 1900. Look how well off everyone is. We're just rolling it dough! Well, maybe not. This takes the same trick from the other side, it is the nominal amount that each consumer spends as part of their family or as an individual. By not taking into account inflation, it makes everything look a great deal rosier than it is.

That's why we have the difference between nominal and real in economics. Nominal measures what people called something, say a five cent cigar. The question though is not how much money it cost then, but how much it costs to buy now, and how much you have now.

So having established that it isn't nominal money that really matters, let's drive another stake through the gold standard vampire's heart, because it's Friday and we should all do the work we like to do on a Friday.

Why Inflation Is Like Salt: Too much is bad, losing it is worse.

Inflation is like salt. The nominal decline in the purchasing power of a single unit of exchange is a positive feature of modern economies, or rather the control of that consistent nominal decline. This nominal decline can be called nominal inflation. Nominal inflation is important to measure, it is important to follow, and people in a Democracy should know about it. However, nominal inflation, that is the movement of the means for adjusting between nominal prices and real outputs, is not the final real inflation. Real inflation is an increase in the real price of a good relative to the means of purchasing. If it takes you 10 hours to earn something this year and 11 next year, that's real inflation. Especially since you should be earning more in real terms as you get more experience.

Those who are opposed to nominal inflation in itself are people who have lots of the nominals that are losing value. Let's put it another: the only people who want the value of a dollar to never go down are people who have lots of them, and want to rent them to you. At a high real cost.

What is inflation? Inflation is the way of discounting previous economic activity. If someone sells you a candy bar this year, they make some amount of profit. The theory of the market says that if someone makes you happy, you pay them for the trouble of making you happy rather than making themselves happy, and they take the surplus between the trouble it took them, and the amount it made you happy, and they get to spend that. That is people who do things for others get a bit more power in each exchange and over time the people who are best at making others happy get more chances to do that, and more chances to make themselves happier. That's the theory any way, but what I know is Texas, and out there you on yo own. Sorry, back to seriousness, favorite films and all that.

Now, that means, even in theory, you don't want someone's great grand kid who made your great grandfather happy to have the same purchasing power. They didn't actually go through the trouble, and anyway, the happiness is long gone. Even in theory this smooths out mispricing and bad decisions. It's one thing for a crook to get rich, it's another for their descendants to stay rich for ever and ever. So even in theory, there needs to be a discounting mechanism for past acts of economic utility, because that utility is long gone. Inflation is that mechanism. No nominal inflation, and one needs to go about the messy business of taking money from the rich by force. This is called a revolution, and while Madame La Guillotine is an amusing guest, she does tend to eat you out of house and country pretty quickly. Any country that sends LaVoisier to execution is seriously whacked.

It was Benjamin Franklin who observed that inflation is a silent tax, and that is a good feature, because it is otherwise difficult to rebalance the economic scales with those who collect rent. Inflation then is the rent that the society collects for allowing the rich to be rich in the first place. However, like all taxes, it is what is done with it as much as what is collected with it as much as the money collected.

So inflation discounts previous economic activity. This means that those holding money, since it rests on the work of the society, must invest that money, or society will do it for them by inflating away the value of money. The rich would always like to believe that they are the source of mysterious prosperity particles that the rest of merely absorb, so glad we should be to be next to their sun. The reality, there is no particle accelerator that will produce a money pole, despite the repeated predictions of libertarian pseudo-scientists to find one, and billions of dollars spent smashing facts to little bits to prove it. Perhaps they need to get some help from the General Theory department on that.

The problem is that is the power to tax is the power to destroy. Inflation is sort of like flight - in that for thousands of years human beings wanted to make use of it, but most experiments with it had less than satisfactory outcomes. The problem is that attraction of the inflation tax is that it is unilateral, a government can levy inflation taxes as a function of their monopoly of violence. Since the value of money rests on that monopoly of violence, there is a symmetry here, but it took the world a long time to realize what this symmetry was. That is, governments protect and create the nominal value of money, and they can tax it with the same power. However, this has a number of less than desirable features. One of them is that for most of human history, not only were governments in the violence business, but they rather much were populated by people who liked their work a bit much. They had a noticeable tendency to reinvest earnings from the violence business in more violence. On the whole, the opportunity cost of violence is rather high compared with say, doing something useful with your time like weaving baskets, even if we haven't found a way to get rid of it entirely.

This means that governments had a tendency to use the inflation tax that armies got them the chance to collect, to buy more armies. Or more navies. Those are popular too. There is, in the language of economics, no tendency to equilibrium. Or to put it in layman's terms, there's nothing to stop a king from forcing you to cough up coins, which at least have the insurance value of being made of something that will be found to be of value in another place should you decide to run like hell, and giving you instead a token stamped with a crown or piece of paper, which has no other value. Since you would not, in these circumstance, have much choice about what the King did with the money, it's on the whole not a good deal. In a world where you can only vote with your feet, it's important to have money that can vote with you.

The trick then was to make it so that the government got no only the fun of using the power that the inflation tax gave it control over, but to put in a break so that the government was only collecting the inflation tax which was related to the value that the government was producing. That's the key, not to stop the inflation tax, but to link it organically with the value provided by the government's discounting mechanism.

Or in other terms, if discounting of past economic activity is a good thing, and it is, then there must be some economic value that can be placed on that good. Which means if the government is allowed to collect that good as a tax, and then is required to spend that money on keeping the good times rolling, inflation will get out of hand from time to time, and then people will revolt and reduce the inflation tax, or change how the money is being spent, and if they are smart they don't get to be a footnote in some history textbook.

Back in the Day

But to get there first I need to give the gold standard a quick steak dinner. The graph makes it look like the 19th century was some promised land without inflation. Let's point out a few gaps. One's staring at you on the graph. You see that dotted line in the middle? That dotted line is there because of a little thing that you yankees like to call The Civil War, and which in some quarters is still referred to as The War Between The States. Now you can call me silly, but any era which points to a time which starts with the Napoleonic Wars, and caps with World War II, which was to no small extent caused by the last attempts to impose the gold standard after a lapse, as some kind of golden era, is probably not taking into account all the facts.

One of these facts is slavery. You see, in a world where money is completely stable in nominal terms, one game is just to rent money out. But another game is to find something which behaves like interest, you know something that increases at a slowly compounding rate of interest. It is not an accident that interest and population work the same way, interest is a monetary model of population. So what breeds like compounding interest? Slaves of course.

Now look at the graph again, propping up that line for about half of its length is slavery. Now maybe Barron's magazine is pro-slavery again, I haven't checked, they will get there eventually, but I'm not sure the Wall Street Journal Editorial page quite has the guts to say that they are going to endorse a Democrat for President if he runs on the Democratic Platform of 1844.

What's propping up that line for the second half? Why imperialization and conquest of course. That is what nations do to not collect the inflation tax out of nominal money, they expand the area they have a monopoly of violence. If you can't charge more for the product, expand market share. So even returning to this time only really becomes practical if you can point to the couple continents full of brown people that can be conquered, exterminated, enslaved, or other wise pillaged for their value.

Usually these things aren't brought up in the polite company of economists, who like to talk about price and so on, but let's be exact as to who was buying who with what. The freedom from nominal inflation for some of the rich was bought at the price of millions of lives. They were just "other persons".

The inflation tax, the inflation burden

The solution is complex because there are three degrees of freedom here. The first is the ability to collect the inflation tax unilaterally. That's what the gold standard is meant to address, if people want gold to remain money, it more or less stops the government from being able to directly collect the inflation tax. However, it doesn't really fix the problem. That's because the government still has the monopoly on violence, and if they can't collect the tax directly from citizens, they can still collect it from non-citizens. Slaves, colonial subjects, and any Jews they happen to be able to lay their hands on. The second problem is that there is still no good organic relationship between the ability to dig gold out of the ground and the ability of capital to improve on standards of living. There is some, in that better mining and refining techniques can increase the gold supply, but not to the degree that capital can make people's lives longer and better.

Give an actor three degrees of freedom, restrict one at zero, but leave the other two largely in place, and the actor will, no suprise that the actors in question will exploit the others. And the gold standard or other forms of monetary price stability don't actually do this, what they do is require governments to allow pressures to pile up until there is a large break. Instead of period major wars, the era of monetary stability saw constant petty wars punctuated by period massive wars. This is, I suppose as step in the right direction. You see the gold standard and other forms of monetary price stability apply, until everyone agrees that this war is the one that really needs fighting, at which point all caution is thrown to the winds. Only later is stability reimposed, but by that point it is to late.

The better modern solution is to realize that there are three parts of the problem: unilateral taxation, the need for an organic link between tax and benefit, and the placing of a burden to remove the incentive to over tax. Or in simple terms, a tax should be imposed by general necessity, the revenues should match the benefits that the underlying government service provides, and should be directed towards expanding the benefits. In the case of the inflation tax, money is a means of lubricating exchange, the amount can be determined by measuring the effects of that reduced economic friction, and the results should go to creating new capital. The balance point is that the government discounts the past by inflation, and it should collect an inflation tax equal to the increase in well being and capital that the risk of inflation creates by spurring investment and consumption rather than renting and hoarding, and the tax should be directed to increasing these benefits.

This is why public pensions and universal health care are two critical components of the tension that helps restrict run away inflation taxation. On one hand the government gets more purchasing power, on the other hand, the obligations from pensions and medical costs are paid by the government. If the government is not investing the taxes collected, and note I say investing from inflation, then the burdens will go up. The pension system, by creating a body of people who are both dependent on the flow of benefits, and sensitive to the government's long term plans, in theory, will create a political coalition for responsible use of the inflation tax.

Federalize the Fed

In this context we should see that the Federal Reserve is, then, an organ of government. That it's current pretend independence is a fluke, and instead the Federal Reserve should be woven back into the fabric of elected government. The best way to do that would be to have each of the bodies of elected government, the House, the Senate, and the President, appoint members of the Open Market Committee, three each, with one of the President's appointees being the Chairman, with the advice and consent of the Senate. This will reattach monetary policy, which is, in theory, merely fiscal policy by other means, to the elected flow of government. The public will have to understand what they are voting for, but abuse can be corrected by accountability.

It also means that the budget process should be overhauled, with capital and operating budgets clearly separated, and with the requirement that any surplus in payroll taxes be spent only on capital development, the return of which must justify the expenditure in approving the health of the Social Security system.

Finally, we get to the important point, if nominal inflation is not important, and nominal increase in purchasing power is not, what is? The answer is real improvements in the standard of living, which are more complicated to measure than any single index of inflation. The way to measure this is at the ballot box, and in that case you should believe your wallet, and not a graph. The reality is that real disposable income has been going down, and it is that, not nominal dollars, or even GDP per capita, that is the best measure of well being, because that is the money you can spend freely on what you want, not on what you need to have, or what you must bid against others for.

In the 1980's Mikhial Tal, former world champion, quipped that Gorbachev said that it was the USSR against Vodka, and "I'll play for team Vodka." It can be observed that vodka has comfortably outlived the USSR, and will probably outlive Putin's time in power in Russia. Likewise, while everyone preaches against inflation, everything goes a bit better when it is there in reasonable amounts. It is real, not nominal, inflation that is the problem, and in our case real inflation is in the supply, demand, and sink problems of the petroleum economy, and the lack of investment supply that is driving a spiralling financial instability.