How is inflation sabotaging our ability to measure the value of things?

November 21st, 2006

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In our previous article, Is oil going to be more expensive?, we mentioned that monetary inflation (?printing? of money) is one of the reasons why we believe that the price of oil will probably rise in the long run. In fact, we can extend this rise in price to commodities in general. Even further still, if the central bank prints money consistently enough, everything will rise in price, from your weekly groceries to the stock market. A fine example of such madness will be Zimbabwe?in May this year, its inflation tops 1000 percent (yes, it is one thousand, no typo error)!

Let?s come back to the example of oil. Let?s say oil price is trending up for the next few years. What will be the first conclusion that comes to our mind? Naturally, we will believe that the rise in price of oil reflects its increase in value in the market. This will then lead us to conclude that the demand for oil is outstripping its supply. Since oil is priced in US dollars, we are in effect using it to measure the value of oil. Now, hold that thought while we divert to an analogy…

If you want to measure the length of a box, you may use the ruler to do it. The reason why a ruler can do such a job is because its length is reasonably consistent for the foreseeable future. Now, imagine that ruler is as elastic as a rubber band. Do you think it is still a useful tool to measure the length of the box? An elastic ruler is useless because you can always make up the measurement of the box to whatever you please just by stretching the ruler such that the edge of the box is aligned to any intended measurement markings in the ruler.

Now, let come back to measuring the value of oil. Since oil is priced in US dollars and if the supply of US dollars can be expanded and contracted at will by the Federal Reserve, how useful do you think it is as a calibration for measuring the value of oil? The answer will depend on how responsible the Federal Reserve is in maintaining the quality of the US dollar. We will discuss this topic for another day.

With this, we would like to end this article with a quote from Chapter 12, Section 5 (The Root of the Stabilization Idea) of Ludwig Von Mises?s book, Human Action: A Treatise on Economics:

The endeavors to expand the quantity of money in circulation either in order to increase the government?s capacity to spend or in order to bring about a temporary lowering of the rate of interest disintegrate all currency matters and derange economic calculation. The first aim of monetary policy must be to prevent governments from embarking upon inflation and from creating conditions which encourage credit expansion on the part of banks.

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