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The Falling US Dollar

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Nice depressing graph. So since 1913 it appears that the federal reserve/government has stolen approximately 98% of the peoples wealth through inflation. If you started making money in the mid 90's then they've taken 47% so far. With theft rates like that I'm surprised that they need to tax at all on top of it.

Inflation is heinous, but your statement really isn't correct. It would be true if you had a duffel bag of cash from 1913 or the mid-1990s. In that case, you would have had that much of the buying power of that duffel stolen from you.

However, if your wealth consists of deposits in a bank or real property or stocks or bonds, then it also gained in nominal value along with the inflation. Having said that, you still lose out from inflation, even if not to the degree those percentages imply. First, you always hold some cash and that loses value. Second, the rise in nominal values often fails to fully compensate for the effect of inflation. This is true for stocks, for example in the inflationary 1970s when nominal stock prices were flat with the result that real stock prices collapsed.

Third, inflation causes malinvestment, thereby slowing economic growth and the rise in our standard of living. In that sense, inflation destroys wealth. But, the net effect is nowhere near as drastic as those percentages indicate... except for holdings of non-interest bearing cash, a la the duffel bag.

Of course, any destruction of our wealth through inflation is wrongful theft, and the magnitude of destruction is still quite large, even if not as large as those percentages imply. One visible aspect of the harm of inflation is the recessions it engenders. By tricking businesses to invest in uneconomic projects, inflations lead to recessions, and all the harm they bring, including unemployment, falling asset values, etc.

We are now entering a recession brought on by the monetary inflation of the past decade.

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However, if your wealth consists of deposits in a bank or real property or stocks or bonds, then it also gained in nominal value along with the inflation.

Third, inflation causes malinvestment, thereby slowing economic growth and the rise in our standard of living. In that sense, inflation destroys wealth. But, the net effect is nowhere near as drastic as those percentages indicate... except for holdings of non-interest bearing cash, a la the duffel bag.

What's really interesting and heinous about this particular recession is that your third effect can destroy the hedge of the first. In this case if the malinvestment is in real property, such our subprime mortgage issue, and it depressed the property market, then the property itself doesnt act as a hedge against inflation. Most people's inflation hedge is their house. That gets you nothing in today's market.

So says the guy trying to sell his right now... :)

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What's really interesting and heinous about this particular recession is that your third effect can destroy the hedge of the first. In this case if the malinvestment is in real property, such our subprime mortgage issue, and it depressed the property market, then the property itself doesnt act as a hedge against inflation. Most people's inflation hedge is their house. That gets you nothing in today's market.

So says the guy trying to sell his right now... :)

Good luck with your house sale, Kendall.

Unfortunately, you are right. Inflation creates all kinds of "winners" and "losers" whose only reason for winning or losing is the lucky fortune or misfortune of their timing. If you happened to buy property in the early 1990s and sold in 2006, you made a windfall. That windfall is the flip-side of someone who may have bought in 2006 and now has to sell. I know people in both categories, including someone who bought a condo at the absolute peak in 2006 in what has become one of the worst-hit housing markets in the country, Miami. She and her husband are probably underwater on their property, such that they would have to cut a check to the bank just to move somewhere else. They have negative equity in their property.

Interestingly, the people I know in these examples who gained or lost did so just by buying homes to live in. Their financial gain or loss was the equivalent of random good or bad luck for them. Such whimsical financial gains and losses that are not reflective of productive effort show inflation's injustice and also how inflation destroys the ability to plan long-range.

Translate these effects to a businessman who builds factories. Such random financial gains and losses undercut his ability to plan such investments, with the result that there are fewer of them. With fewer long-term investments, there is less wealth-creation and our standard of living suffers.

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However, if your wealth consists of deposits in a bank or real property or stocks or bonds, then it also gained in nominal value along with the inflation.

I don't understand what you mean here. Are you saying that the 1-4% that someone gets from having money in the bank would somehow make a dent in the >50% loss in the chart? Part of that 1-4% represents genuine interest, i.e. compensation from the bank for your lending them your money. So really we're talking less than 1-4% "nominal value gain" from not having one's money "duffel bagged."

If you're referring to other forms of investment, such as stocks, really those are not an option for anyone who isn't a professional investor. They all involve a degree of risk, so much of the gain there is from the assumption of risk, and not from the "nominal value gain" of the inflation.

I'm trying to see how your statement works. Perhaps you meant something that I'm not seeing here.

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I don't understand what you mean here. Are you saying that the 1-4% that someone gets from having money in the bank would somehow make a dent in the >50% loss in the chart?

Yes, that is exactly what I am saying, because...

Part of that 1-4% represents genuine interest, i.e. compensation from the bank for your lending them your money.

the other part of that 1-4% is an inflation premium that the bank pays you to compensate you for the inflation-caused erosion of your money's value.

So really we're talking less than 1-4% "nominal value gain" from not having one's money "duffel bagged."

Yes, that is often, although not always, the case. If inflation has been steady and relatively predictable, then you are likely to get nearly fully compensated from the bank in the form of higher interest for the erosion of your money's purchasing power due to inflation. However, if inflation spikes, then you would suffer a real loss. Conversely, if inflation unexpectedly declines, you would gain at the bank's expense.

The bottom line is that inflation does destroy wealth in the manner I described, but not to the extent of the total inflation that has occurred over the years. The reason inflation does not destroy all this value is because every participant in the economy does his best to adjust his behavior to account for the inflation. Banks charge more in interest to borrowers and pay more interest to depositors to account for inflation, the storekeeper marks up his products to account for the inflation in his cost of goods sold, etc. Still, economic actors cannot fully adjust for inflation in their actions. That is why inflation does destroy wealth.

If you're referring to other forms of investment, such as stocks, really those are not an option for anyone who isn't a professional investor. They all involve a degree of risk, so much of the gain there is from the assumption of risk, and not from the "nominal value gain" of the inflation.

All investments involve risk, but you are right that inflation only increases the risks and makes investing more difficult for everyone. Having said that, most people are already invested in one of the best inflation hedges, their homes.

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Banks charge more in interest to borrowers and pay more interest to depositors to account for inflation, the storekeeper marks up his products to account for the inflation in his cost of goods sold, etc.

I haven't found this to be the case, though. I don't know of any interest-bearing account - that isn't paying heavily on the assumption of additional risk - which has come even remotely close to matching the inflation rate found on that chart.

If you know of one, please do let me know so I can move my money.

Basically the point I'm making is that while it is technically true that, as you say, "...if your wealth consists of deposits in a bank or real property or stocks or bonds, then it also gained in nominal value along with the inflation," in actual fact this gain is minuscule in comparison to the inflation and the inflation pretty much is as bad as aequalsa was saying.

Edited by Inspector

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I haven't found this to be the case, though. I don't know of any interest-bearing account - that isn't paying heavily on the assumption of additional risk - which has come even remotely close to matching the inflation rate found on that chart.

If you know of one, please do let me know so I can move my money.

Move your money into a TIPS Treasury bond. TIPS stands for Treasury Inflation Protected Securities. The principal on a TIPS bond appreciates by the rate of inflation. In other words, the real value of your money stays constant (based on the consumer price index). Therefore, the interest rate you receive is a real interest rate, above the rate of inflation. Currently, the real interest rate on a 10-year TIPS is 1.34%. That means that if you held the TIPS for 10-years, you would receive a 1.34% annual real rate of return on your investment; you have been protected from inflation. The federal government began offering TIPS bonds in 1997.

As for regular bonds, I will scare up some data on their yields versus inflation... tomorrow. My hypothesis is that in most years, the nominal yield was above the inflation rate, which means bondholders earned a positive real return.

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There is one possibly beneficial effect of inflation: it puts pressure on people to either spend or invest cash. Under inflationary conditions, money does indeed burn a hole in one's pocket, out of which falls the steady trickle of change stolen by the deficit spending of the government. It would seem that anything that spurs spending and investing is a positive force on the economy.

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Move your money into a TIPS Treasury bond. TIPS stands for Treasury Inflation Protected Securities. The principal on a TIPS bond appreciates by the rate of inflation. In other words, the real value of your money stays constant (based on the consumer price index). Therefore, the interest rate you receive is a real interest rate, above the rate of inflation. Currently, the real interest rate on a 10-year TIPS is 1.34%. That means that if you held the TIPS for 10-years, you would receive a 1.34% annual real rate of return on your investment; you have been protected from inflation. The federal government began offering TIPS bonds in 1997.

As for regular bonds, I will scare up some data on their yields versus inflation... tomorrow. My hypothesis is that in most years, the nominal yield was above the inflation rate, which means bondholders earned a positive real return.

That seems to be based on a possibly incorrect view of inflation. Price is determined not only by inflation but also technological advance, demand,etc. So to base the interest rate on the prices of products in the CPI is to essentially steal the effect of lower prices due to market efficiencies before they even register. Deflation of prices should be a natural occurence in a free state. A static price(long term) is mainly due to inflation. Using price to determine inflation is a reversal of cause and effect as far as I can tell.

So if we look at a more real measure of inflation(quantity of money) then that chart shows an increase in the monetary supply of what appears to be 5% a year. 1.34% doesn't touch that.

The bottom line is that inflation does destroy wealth in the manner I described, but not to the extent of the total inflation that has occurred over the years. The reason inflation does not destroy all this value is because every participant in the economy does his best to adjust his behavior to account for the inflation. Banks charge more in interest to borrowers and pay more interest to depositors to account for inflation, the storekeeper marks up his products to account for the inflation in his cost of goods sold, etc. Still, economic actors cannot fully adjust for inflation in their actions. That is why inflation does destroy wealth.

It doesn't destroy wealth, it transfers is because the first person to spend it receives undue benefit since the effect of the extra capital has not yet registered on the economy. They buy more actual wealth then the money is actually worth. They eventually adjust to it but not until after the wealth is transfered. It's effects trickle down from the center.

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There is one possibly beneficial effect of inflation: it puts pressure on people to either spend or invest cash. Under inflationary conditions, money does indeed burn a hole in one's pocket, out of which falls the steady trickle of change stolen by the deficit spending of the government. It would seem that anything that spurs spending and investing is a positive force on the economy.

I hear that said but I don't recall ever hearing about a shortage of investments in new enterprise during the industrial revolution with gold backed currency.

Also consider that the forced investment causes more irrational investments since the pressure to maintain its value requires fairly immediate action. The higher the inflation, the more short term we are required to act. Taken to the extreme of 100%/day runaway inflation, every dollar earned must be exchanged for product immediately. Planning more then a day ahead becomes futile. I do not view more investment as necessarily a good thing. Rational action and long term planning are more likely to yield positive results then "irrational exuberance."

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If you're referring to other forms of investment, such as stocks, really those are not an option for anyone who isn't a professional investor. They all involve a degree of risk, so much of the gain there is from the assumption of risk, and not from the "nominal value gain" of the inflation.

Some equities will appreciate in value along with inflation it depends on the strucutre of the particular company and what it earnings generating potential is tied to. Not every stock is an inflation hedge, but some are.

In addition, a short term effect of inflation is a profitability jump, which boosts stock values in the short term. They'll crash later as that profitability jump does not reflect actual profit increases.

As an aside, I don't agree with your first statement. Most people hold equities in the long term, usually in the form of diversified bundles of mutual funds. Diversified baskets of equities that are purchased on a buy and hold basis for the long term are perfectly decent investment vehicles for the non-professional investor.

Edited by KendallJ

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Bonds? Forget it. I need my money liquid, not tied up for years at a time. Thanks anyway, though.

Huh? All bonds have secondary markets where you buy and sell them. What makes you think they aren't liquid?

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It would seem that anything that spurs spending and investing is a positive force on the economy.

This is Keynesian nonsense. Also covered in CTUI. The myth that inflations spurs demand, which in turn spurs the economy. The added spending that inflation creates destroys value because it is usually frivolously spent. We just covered how that effect works for industry. If business makes a bigger profit than is actuallly real and goes out and spends it unwisely, their investments don't pay off, and they soon have to pay for the poor choices they made. This works exactly the same way for the consumer. You go out and buy a big screen TV now because your paycheck increased but prices haven't, then when prices go up further, you'll realize that you spent money you actually didn't have and will have tighten your belt in some way to get back to where you would have been. If everyone was wise enough to factor the future rise in prices into their purchasing decisions today, then spending would not increase one bit. But that is why inflation is so pernicious. It fools into thinking more money is real and it causes us to take descructive decisions in the present.

Wise investment, and production are what drive the economy. Spurring spending is reversing cause and effect to the detriment of investment and production. It is an attempt to have the "tail wag the dog".

Edited by KendallJ

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Wise investment, and production are what drive the economy. Spurring spending is reversing cause and effect to the detriment of investment and production. It is an attempt to have the "tail wag the dog".

But doesn't it also mean in the shorter term that if you do make wise investments, you can make more of them and profit from the inflationary period (at the expense of others who make bad decisions, basically)? Because for the wise investor, there IS more money available, so to speak, and it is easier to get capital for whatever it is you want to do. So it seems then that for anyone who performs above average, it could be an advantage (even though it is bad for the economy on average).

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But doesn't it also mean in the shorter term that if you do make wise investments, you can make more of them and profit from the inflationary period (at the expense of others who make bad decisions, basically)? Because for the wise investor, there IS more money available, so to speak, and it is easier to get capital for whatever it is you want to do. So it seems then that for anyone who performs above average, it could be an advantage (even though it is bad for the economy on average).

That is true but that is not the primary effect of inflation. Because most people arent' looking for it, the number of people who are suckered by inflation far outweighs the number of people who profit from it. In fact, if there are reeeally huge profits to be made it is because few people see the opportunity.

Also consider that a "wise" investor is not uniformly wise, and what makes a wise investor in a lasseiz faire economy is not the same as one in an regulated inflationary economy. Inflation and other non-market effects divert attention. Instead of thinking about what makes a good company and investing in it, I have be out spotting and investing based upon artificial monetary policies. I want the makret building investors who exceed at the fundamentals of creating value. I don't want to bulk up on "inflation spotters". It's a bit like thinking about the difference between a real business man and a "carpet bagger" of the Reconstruction South. The second is a far lower caliber of businessman.

The third thing to consider is that wise investment is not a phenomena that can be instantaneously increased due to short term glut of cash. Good investment vehicles take time to develop and sort through, and because it requires intelligent men to execute, at any given time there is a short term capacity limit on the amount of money you can throw into investment. Flushing the market with cash, even if it is to good investors doesn't in anyway mean they can use it immeidately.

Edited by KendallJ

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That seems to be based on a possibly incorrect view of inflation. Price is determined not only by inflation but also technological advance, demand,etc. So to base the interest rate on the prices of products in the CPI is to essentially steal the effect of lower prices due to market efficiencies before they even register. Deflation of prices should be a natural occurence in a free state. A static price(long term) is mainly due to inflation. Using price to determine inflation is a reversal of cause and effect as far as I can tell.

Yes, I agree. I did not say that CPI properly or completely accounted for the harm of inflation. However, a bond that uses it to adjust the interest paid out will at least partially compensate the holder for the harm of inflation.

As for prices, you are right that prices decline when there is stable (non-fiat) money. That occurred throughout the 1800s, interrupted only by episodes of inflation surrounding the War of 1812 and the Civil War. The secular decline in prices ended with the establishment of the Federal Reserve Bank in 1913 and the advent of fiat money. Interestingly, the 1920s had stable prices which many contemporary economists lauded. However, those stable prices were actually a sign of the monetary inflation that was occurring, since prices should have been declining.

So if we look at a more real measure of inflation(quantity of money) then that chart shows an increase in the monetary supply of what appears to be 5% a year. 1.34% doesn't touch that.

1.34% is a real interest rate. The nominal rate consists of CPI plus 1.34%. So, if CPI grew by 3%, for example, the nominal interest rate on a TIPS bond is 4.34%.

It doesn’t destroy wealth, it transfers is because the first person to spend it receives undue benefit since the effect of the extra capital has not yet registered on the economy. They buy more actual wealth then the money is actually worth. They eventually adjust to it but not until after the wealth is transfered. It's effects trickle down from the center.

Inflation does directly destroy the value of cash (i.e., non-interest bearing) instruments. In other areas, it transfers wealth, but those transfers cause uneconomic behavior that results in wealth destruction. For example, during an inflationary boom, there is too much (i.e., uneconomic) investment in certain industries which then must be liquidated during the subsequent recession. Wealth is destroyed.

Wealth is also destroyed because the uncertainty caused by inflation reduces planning horizons. Businesses and individuals find it more difficult to plan long-range. Because more valuable long-range projects are avoided, less wealth is created.

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Also consider that the forced investment causes more irrational investments since the pressure to maintain its value requires fairly immediate action. The higher the inflation, the more short term we are required to act. Taken to the extreme of 100%/day runaway inflation, every dollar earned must be exchanged for product immediately. Planning more then a day ahead becomes futile. I do not view more investment as necessarily a good thing. Rational action and long term planning are more likely to yield positive results then "irrational exuberance."

Yes, this is entirely true.

Moreover, even if the inflation is more subtle, it still leads to uneconomic spending by businesses. Because new inflation initially lowers real interest rates, it causes businesses to over-invest. This is the "boom" period of the boom and bust cycle caused by inflation. When these investments are later revealed as uneconomic, they are liquidated during the "bust" phase of the cycle.

Some examples: the inflationary boom in real estate investment by savings & loans banks in the 1980s. This resulted in widespread bankruptcies of the S&L's and the federal government's stepping in as liquidator of billions of dollars of uneconomic shopping malls, etc., that the economy didn't need.

More recently, the boom in real estate prices until last year is the result of inflation. Now the economy is in the process of liquidating this over-investment in housing.

Part of the 1920s stock market boom was the result of inflation during that decade, which was the first full decade the economy was subject to Federal Reserve control of the money supply. That inflation was the principal (but not only) reason the stock market crashed in 1929 and the country suffered a Great Depression.

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This is the "boom" period of the boom and bust cycle caused by inflation. When these investments are later revealed as uneconomic, they are liquidated during the "bust" phase of the cycle.

What I think is just incredibly rich is that those who advocate central banking and this type of monetary policy always claim more stability and point to the little booms and busts in the late 1800's as examples of why the gold standard didn't work. All the while ignoring the laundry lists of bust since. Free market banking has hardly created any of the instability that centralized banking has!

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What I think is just incredibly rich is that those who advocate central banking and this type of monetary policy always claim more stability and point to the little booms and busts in the late 1800's as examples of why the gold standard didn't work. All the while ignoring the laundry lists of bust since. Free market banking has hardly created any of the instability that centralized banking has!

Absolutely true. As an example, no recession in the entire history of the United States probably including the colonial era was as severe as the Great Depression. Nor was there ever an episode of inflation as drawn out and destructive as the 1970s inflation. Both of these events arose because of central banking.

Prior to 1913, even the imperfectly established gold standard that did exist protected the economy from dislocations as severe as these.

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This is Keynesian nonsense. Also covered in CTUI. The myth that inflations spurs demand, which in turn spurs the economy. The added spending that inflation creates destroys value because it is usually frivolously spent. We just covered how that effect works for industry. If business makes a bigger profit than is actuallly real and goes out and spends it unwisely, their investments don't pay off, and they soon have to pay for the poor choices they made. This works exactly the same way for the consumer. You go out and buy a big screen TV now because your paycheck increased but prices haven't, then when prices go up further, you'll realize that you spent money you actually didn't have and will have tighten your belt in some way to get back to where you would have been. If everyone was wise enough to factor the future rise in prices into their purchasing decisions today, then spending would not increase one bit. But that is why inflation is so pernicious. It fools into thinking more money is real and it causes us to take descructive decisions in the present.

Wise investment, and production are what drive the economy. Spurring spending is reversing cause and effect to the detriment of investment and production. It is an attempt to have the "tail wag the dog".

I think you're wrong here, about this being "nonsense." A rational investor, faced with a declining value of his dollar, will adjust his choices appropriately to maximize long term wealth. This means inflation, which decreases the current value of future cash holdings (compared to other future holdings), will marginally shift the investor towards investing sooner, rather than later. The effect of this quicker turnaround in investment is an increase in the velocity of money. More velocity means more a faster exchange and and an upward pressure on overall economic activity. If a large number of people started packing their mattresses with cash because they were afraid of banks, what do you think would be the effect on the market as a whole?

The "frivolous spending" argument is invalid, unless you're willing to apply that same argument to any circumstance. (It's the primary argument used to defend central planning, for instance) The big screen TV example could have come right out of a Hillary commercial for nationalized health care. A better example, with a little respect for the individual consumer, would be investing his extra money in grain futures, or Apple computers. In that case, his quick conversion of cash into some other stable or growing investment, would serve him well. Spending does increase if cash is devalued, but that doesn't (and isn't meant to) justify deficit spending as a means of increasing inflation.

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I found this table, and I think it illustrates how much inflation we have really seen

Since 2002:

Gasoline is up 40.0%

Sugar is up 79.3%

Aluminum is up 98.3%

Gold is up 132.0%

Coffee is up 148.5%

Platinum is up 183.7%

Silver is up 198.8%

Natural Gas is up 202.5%

Rubber is up 262.5%

Heating Oil is up 276.4%

Oil is up 279.7%

Copper is up 389.4%

Nickel is up 408.4%

Cadmium is up 1,375.4%

http://www.moneyandmarkets.com/newsletter/...511&sc=G100

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Most people hold equities in the long term, usually in the form of diversified bundles of mutual funds.

I think we're referring to different things here. When I hear "stocks," I think of, well, stocks, and not diversified bundles of mutual funds.

And when I hear "bonds," I think of those things which you buy from the government where they are set for 5-20 years, not... um, whatever it is that you're talking about where you trade them.

I do apologize for my ignorance on these things - I am not a professional investor like you and Galileo. Nor am I in a position to do any investing right now - basically what I need is something that works like a bank account, where I can put money in and take it out as I need.

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There is one possibly beneficial effect of inflation: it puts pressure on people to either spend or invest cash. Under inflationary conditions, money does indeed burn a hole in one's pocket, out of which falls the steady trickle of change stolen by the deficit spending of the government. It would seem that anything that spurs spending and investing is a positive force on the economy.

I bolded the last sentence.

I disagree with that. The problem with inflation is that it spurs inappropriate spending and investing. Let's look at how that works. Extra money is magically added to the economy by the Fed. The first recipients of that money are the banks. With more money to lend, banks give money to less creditworthy borrowers. For their part, those less creditworthy borrowers are eager to borrow those funds because interest rates have declined reflecting the extra money given to the banks.

Those less creditworthy borrowers build hotels and apartments buildings, they expand factories, they invest overseas. They do lots of things that would be valuable, if you strip away the context of those investments. Those investments are made based on artificially available money and artificially low interest rates. Such money and interest rates are artificial because they are not sustainable at that level. They do not reflect real world conditions.

As a result, the owners of the new hotels, apartment buildings and factories discover that they do not have sufficient business to justify the investment made to create them. They become unprofitable. Their owners go banrkupt. The economy has a recession.

All inflation has done here is to distort the flow of investment and thereby impoverish the economy to that extent. The inflationary process is not complete until those investments are liquidated in bankruptcy and lie fallow for some time until economic activity expands enough to make productive use of them. That is why the hotel is only 50% occupied, the apartments are unsold, and the factory is under-utilized.

The diversion of capital caused by inflation results in the destruction of potential wealth that would have been created if market forces had been allowed to operate uninfluenced by inflation's distortions.

So. in response to your last sentence, it is not true that anything that spurs investment is good. Only investment based on reality is good. Pseudo-investment prompted by the deception of inflation is not good. It impoverishes us.

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So. in response to your last sentence, it is not true that anything that spurs investment is good. Only investment based on reality is good. Pseudo-investment prompted by the deception of inflation is not good. It impoverishes us.

Quite true, GB. One of the big current puzzles related to global investing and economics is whether the Chinese investment boom of recent years is driven by distortions in the US and Chinese financial systems that provide incentives for malinvestment. The big challenge is that malinvestment rarely looks like malinvestment to most people at the time it's initiated. I can find anecdotal and causal evidence to support the hypothesis that at least some of China's massive fixed asset investment is negative IRR over the long run. The hard part to determine is how much of it. Unfortunately, one really only knows until the tide of credit expansion goes out and economies begin to slow.

China has had bank loans growing at 30% or so for years, with fixed asset investment representing around 40% of economic activity. Since the start of the decade, it's annual steel consumption has more than tripled, with most of this going into construction uses, much of it directed by bureacrats who have much to gain and little to lose if a project (office or residential real estate) is completed, and with government controlled banks providing the lending, banks with a very poor track record in differentiating good from bad loans. That smells like malinvestment. It may well be that monetary policy in the US is tied to investment trends in China in this case, and perhaps vice-versa.

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