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Friday, March 21, 2008

What is the reason for inflation?

We hear this term over and over again. According to investopedia.com, inflation is ....

The rate at which the general level of prices for goods and services is rising, and, subsequently, purchasing power is falling.

As inflation rises, every dollar will buy a smaller percentage of a good. For example, if the inflation rate is 2%, then a $1 pack of gum will cost $1.02 in a year.

Most countries' central banks will try to sustain an inflation rate of 2-3%.

Now I know that when I first came to San Diego seven years ago, gas prices were so so cheap at USD1.30 per gallon. Today, it is USD3.60 per gallon. It is forecasted that the gas price will rise to USD5+ this year and USD7+ next year. A pizza will cost USD40 next year.

So when you feel a pinch, you know it is inflationary effect.

US recession is already here. Even Warren Buffett says so. There are people out there still denying that technically the gross domestic product(GDP) has to be negative for two consecutive quarters for the economy to be said to be going through recession. That's the official stand of the Feds. By then, it would be too late to act.

I have also been hearing the term stagflation. What is stagflation? According to investopedia again,

A condition of slow economic growth and relatively high unemployment - a time of stagnation - accompanied by a rise in prices, or inflation.

Stagflation occurs when the economy isn't growing but prices are, which is not a good situation for a country to be in. This happened to a great extent during the 1970s, when world oil prices rose dramatically, fueling sharp inflation in developed countries. For these countries, including the U.S., stagnation increased the inflationary effects.

Ah, it seems that the slow growth somehow has offset some of the inflationary effects in US. Slow growth means people cannot afford to spend, which reduces the demand for the goods and services and keep the prices from escalating, as is inflation.

Recently, the term deflation has been used repeatedly to describe the current US economy. Wow, what is deflation? Investopedia says deflation is

A general decline in prices, often caused by a reduction in the supply of money or credit. Deflation can be caused also by a decrease in government, personal or investment spending. The opposite of inflation, deflation has the side effect of increased unemployment since there is a lower level of demand in the economy, which can lead to an economic depression.

Declining prices, if they persist, generally create a vicious spiral of negatives such as falling profits, closing factories, shrinking employment and incomes, and increasing defaults on loans by companies and individuals. To counter deflation, the Federal Reserve (the Fed) can use monetary policy to increase the money supply and deliberately induce rising prices, causing inflation. Rising prices provide an essential lubricant for any sustained recovery because businesses increase profits and take some of the depressive pressures off wages and debtors of every kind.

This is getting serious. Deflation indicates the arrival of depression. What is the difference between recession and depression? Depression is defined as a negative GDP of greater than 10%. In the last Great Depression in the 1920s-30s, the GDP was something like -18%. In case you are wondering what is the Great Depression, watch this:

If you search the keyword "The Great Depression" on youtube.com, you will find some videos mentioning the second Great Depression. There are people who believe the current economic situation will inevitably lead to a depression era far worse than the 1920s. During the 1920s Great Depression, there was also a massive liquidity crisis and banks went bankrupt in great numbers.

Those days, there were bank runs - the general public panics and rushes to the bank to collect back their money. These days, it seems the government protects your bank savings deposits through the FDIC program. That is, you are insured up to USD100000, anything more will be defaulted. Now, I wonder, what if the government itself goes bankrupt as well. This is no laughing matter. Indeed, the US government was declared bankrupt during the Great Depression era.

Many people were homeless during that era. Today, people are also forced out of their houses as banks confiscate them to be auctioned away, a process known as foreclosures. I have seen a video somewhere where families are staying in tents and caravans in some patch of land in Los Angeles.

I was thinking, I am learning so much more about the financial world today than I ever did during my secondary school days. The 'perdagangan' (commerce) subject wasn't very appealing to me. Whatever you didn't know, you could figure out using some common sense. Like, they teach you to memorize the pros and cons of advertisement (iklan). After a conversation with Amy - where she reiterated her similar feelings about engineering subjects - I realized it is because the textbooks never try to answer the 'why', only 'how'.

If you love maths or physics, you will understand what I mean. Those subjects encouraged you to ask why and find out the answer to your why question. Actually (by the way), the question is more important than the answer. Anyway....

I have run through some definitions here and we are seeing these happening right here and now. I think we will know very soon how severe this financial crisis is going to be. I think it is so bad it is going to affect everyone in the world. Just a guess.

Going back to the title of this post. Why is there inflation? The investopedia only tells you the mechanism of inflation. It doesn't tell you the source or root of the problem. To understand this, click on this link and click on the first video icon on the website that says Money, Banking and the Federal Reserve. Or click here. It is a very interesting video that also covers the origin of banking and the fractional reserve system - which is responsible for inflation. In other words, the Federal Reserve System is the culprit for inflation. It caused inflation by printing money. Yes, money out of thin air.

Well, I am still digesting the information - not sure if it is true or not. But it makes me wonder if Malaysia and other countries also adopts the same banking system and monetary policy. If so, I think we are doomed to always have to work for money. And our children will have to work even harder as their income and savings cannot catch up with inflation. Remember the time when our parents and grandparents have been telling us to get a degree and then have a better and more comfortable life? When I look around, most of the people I know, the married couples - both people have to work and they pay others to take care of their children.

I think I can go on and on tonight but I will save it for another day. As for this post, I am not an economics professor lah. Just expressing my thoughts and what I have learned these past few days. Which prompts me to ask you - if you know your currency is going to devalue big time, what are you going to do about it? Buy treasuries/bonds? Or buy gold? A one million dollar question but of course, I don't have that much money - after adjusting for the damn inflation.


zewt said...

hey.... this is a really good piece. i guess as we grow up... when we are more aware of the things around us... when we are affluent enough... we will be more interested in the financial market. after all... it's money!

while deflation may risk depression... i think our country's inflation rate has gone one notch too high already.

Susu Kacang said...

paiseh lah, zewt, i can't even tell credit from debit.

i dread the day i pay RM10 for a bowl of noodle by the hawker stall....but i think this is inevitable. people even steal rice nowadays.


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