Two years ago, we first covered the root cause of inflation in Cause of inflation: Shanghai bubble case study:

The mainstream economists? definition of inflation is rise in the general level of prices. However, according to the Austrian School of economic thought, the definition of inflation is the increase in the supply of money, in which the effect is the rise in the general level of prices.

As we have shown in yesterday’s chart in Australian money supply growth in September 2008, the supply of money in Australia had gathered momentum in the month to September 2008. In 12 months, the M3 money supply increased by 19.5%. The narrower definition of money, M1, increased by 8.3%. Does this mean that Australia is going to face runaway price inflation soon?

As a general principle, in the long run, there is a relationship between sustained monetary inflation and price inflation. In the same way, there is a relationship between a long-term lifestyle of eating excessive junk food and ill-health. In the interim, this relationship is more complicated. Using the junk food analogy, say that junk food eater dies of heart disease. What is the cause of death? Is it the heart disease? Or is it his sustained junk-food life-style?

Back to inflation, it is certainly possible to see continuing monetary inflation and slowing price inflation. In the US, the latest CPI figure even hinted of a price deflation! Therefore, in the short-term, there may not be a correlation between monetary inflation and price inflation. Part of the problem lies in the nature of how price inflation is measured and defined. As we said before in How much can we trust the price indices (e.g. CPI)?, price indices is a logically invalid idea. The implication is that it is possible to ‘define away’ price inflation and pretend that it is not a problem by torturing the statistics.

But setting aside the logical validity of price indices, what other dynamics is involved that can result in such non-correlation in the short-term? We will introduce one such dynamic- demand for money. This dynamic should not be confused with demand for credit. In lay-person’s terms, the demand for money is the desire for people to keep cash balance. As we wrote in The mechanics of deflation- increase in demand for holding cash,

Deflation happens when liquidity dries up. This can happen in a period of severe economic pessimism when the apprehension of the future drives people to increase their holdings of cash for the sake of peace of mind. When that happens, the quantity of money in circulation decreases, which means there are fewer money chasing after a given amount of goods and services. Consequently, prices have to decrease to accommodate for the decreased supply of money in circulation.

Let’s say the quantity of money increases in the system. But if people want to increase their holdings of cash due to fear and uncertainty of the future, they will withdraw these cash from circulation in the economy. Consequently, prices fall. As we wrote,

When deflation mentality gets a stranglehold on to the minds of the people, no one will dare to borrow money out of fear. Also, when prices are falling, the money that one borrows will be worth more by the time the debt is due. There is no point in spending money because if one waits a little longer, prices will fall further. Central bankers can print as much money as they can, but in such a deflationary environment, no one will want to borrow them.

Today’s credit crisis is an example of this. Banks are hoarding cash and are unwilling to lend while borrowers are repaying debts with every scraps of cash that they can get their hands on. As a result, liquidity dries up in the system even though the supply of money is desperately increased by the central bank. In such a situation, some broader measures of money supply will be shown to decrease.

The opposite can also occur. As we quoted Ludwig von Mises in What is a crack-up boom?,

But then finally the masses wake up. They become suddenly aware of the fact that inflation is a deliberate policy and will go on endlessly. A breakdown occurs. The crack-up boom appears. Everybody is anxious to swap his money against ?real? goods, no matter whether he needs them or not, no matter how much money he has to pay for them.

In such a situation, the demand for money collapses. People want to keep their cash balance as low as possible as they constantly want to get rid of their cash for ‘stuffs.’ In the extreme case (i.e. hyperinflation), prices rise by the hour as people rush out to buy things the moment they are paid their wages, for fear that if they do not do so, price inflation will render their cash worthless.

Now, let’s look at what’s happening in the world. Merely 6 months ago, when oil prices was threatening US$150 and soaring food prices was driving people in poor nations to riots, the fear was price inflation. Today, with oil prices below US$50 and hardly any news on food prices, the fear is price deflation. Such extreme volatility is unprecedented in the history of humanity. It is this volatility and madness in prices that will wreck the real economy in the longer term (see Real economy suffers while financial markets stuff around with prices).

Where is the source of such extreme volatility?

As you may have already guessed by now, governments and central banks, in their attempt to solve the global financial crisis, is creating all these volatility through their interventions against the free market. Ironically, their ‘solutions’ are sowing the seeds of economic hardships for the next generation.