Like Bailing out a Leaky Boat

Monetary incentives were dramatically altered with the founding of the Fed in 1913. This new regime ushered in a primary tendency for inflation that is not very detectible on a year-to-year basis, but has been extraordinarily high as its effects compound over time. The compounded annual average growth rate of consumer prices has been just 3.3 percent from the Fed’s founding to 2007, but this means that a nickel in 1913 is worth more than a dollar today.

In the 19th century there was some value to holding wealth in the form of money: On one hand money would buy more commodities over time due to deflation; on the other, one would receive several percentage points of real (and untaxed) return on investment from lending at the low-risk rates even in short-term maturities.

The fiat money system of the 20th century would change the rules: Holding monetary wealth would be like bailing out a leaky boat. One might accrue 4 to 5 percent interest on prime short-term paper, but between inflation and taxation there would be no real earnings and perhaps even erosion of value. Is it any wonder that the savings rate is chronically low, debt has risen to record levels compared to income, and wealth has been compelled to reside in risky assets?

It may sound flippant, but the bedrock of today’s monetary policy is the rapid expansion of monetary aggregates at all points in the business cycle. The broadest measure of money supply (M3) was over $14 trillion in the United States as of December 2008, at which point its year-over-year growth rate was almost 11 percent.

The power of compounding is remarkable. No one notices that prices in the United States increased 400 percent from 1940 to 1980. Disinflation reigned from the chairmanship of Paul Volcker on, but the price level of 2008 is over two and one-half times that which held when Reagan took office, and this is calculated with a CPI-U that is increasingly biased. M3, conveniently no longer reported by the Fed but estimated by others, began expanding in double digits beginning in December 2006, not the first time in this decade.


Bill Baker,
for The Daily Reckoning

[Editor’s note: This passage is reprinted from William W. Baker’s book, Endless Money: The Moral Hazards of Socialism, with the permission of John Wiley & Sons, Inc (©2010). You can get your own copy here.]