A resemblance of the beginning of Weimar-style inflation

June 9th, 2008

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As we can all learn from the news media, inflation seems to be infecting every nation in the world. Despite the destruction of credit (deflation) in the United States through asset write-downs, bad debts and wealth destruction through home price deflation, price inflation is still turning into a more and more serious problem not only in the United States, but also in the rest of the world. Most notably, with the prices of oil (which is an input for many stages of production, for example, see Can rising oil prices undermine the benefits of globalisation?) in an upward warpath, government ministers are murmuring of the threat to global growth, as this Bloomberg article, Soaring Oil Price `Dangerous’ for Growth, Steinbrueck Says, reported:

Soaring oil and food prices will spur inflation and could imperil economic growth, German Finance Minister Peer Steinbrueck said.

“We are facing a very dangerous situation caused by these tremendously increasing prices for commodities, food and oil,” Steinbrueck said today at the St. Petersburg International Economic Forum.

Here in Australia, our Prime Minister is putting the blame on oil producers, as this article reported,

As the bowser price of petrol climbs towards $1.80, the Prime Minister, Kevin Rudd, and the Treasurer, Wayne Swan, have blamed a lack of supply from oil-producing countries.

Can increasing production really solve the problem? Based on the simplistic supply-demand curve taught at first year economics courses, it is easy to conclude that rising prices is due to rising demand without the corresponding rise in supply. But there is far more than meets the eye in this problem.

Here we must make one point clear: There are indeed fundamental reasons why the prices of commodities, food and oil are rising (see The Problem that can throw us back into the age of horse-drawn carriages, Why are the poor suffering from food shortages? and Example of a secular trend- commodities and the upcoming rise of a potential superpower). But monetary inflation accentuates price inflation and distorts the price signals for demand and supply. As we explained in How is inflation sabotaging our ability to measure the value of things?,

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 [and other fiat money e.g. Australian dollars, Euros, etc] can be expanded [inflation] and contracted [deflation e.g. credit contraction] at will by the Federal Reserve, how useful do you think it is as a calibration for measuring the value of oil?

The presence of index speculators in the commodities futures market (see Who is to blame for surging food and oil prices?) is an example of how prices are distorted by monetary inflation. As we explained before in How to secretly rob the people with monetary inflation?, such price distortions ultimately harm societies (and by extensions, nations) in the end. Today, it is the poor nations that are bearing the brunt of commodities price inflation as the richer ones hoard them (see Price fluctuations and hoarding), which lead to even more price inflation, which further encourages even more hoarding. Ultimately, all these will result in further global mis-allocation of resources for production. As we said in The economics of inflation, that was what happened in Weimar Germany in the 1920s:

In the acutest phase of the inflation Germany offered the grotesque, and at the same time tragic, spectacle of a people which, rather than produce food, clothes, shoes, and milk for its own babies, was exhausting its energies in the manufacture of machines or the building of factories.

Our fear is that the world may be embarking on a similar path. Countries like China and Middle East are embarking on massive investment spending sprees as they spend their hoard of rapidly depreciating US dollars. This is probably the answer to the question we posed in What to do with US$ raised from dumped US Treasuries?. Soaring commodity prices may induce massive mal-investments into the commodity producing industries. For example, massive amount of capital could be further poured into the extraction and refining of lower quality oil in hostile terrains. Wars may even be fought for the sake of securing commodities (well, we wonder whether the root of Iran’s war rhetoric and US invasion of Iraq related to the fight for commodities?). Meanwhile, investments into alternative energy are languishing and dragged slowly by other seemingly more urgent agendas.

If this hyper-inflationary crack-up boom continues, all of us here know where the root of the problem begins: lack of honest monetary system (see Why should you invest in gold?).

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