How does the Fed create inflation?

on Thursday, October 27, 2011

A bank brokers a deal between a wine-maker and a consumer, Bob. It buys ten bottles of wine for $10 with new dollars, and sells them to Bob on credit, charging 10% interest per year. Bob agrees to repay the debt in one year, and will pay $11 as a balloon payment in twelve months. Currently, dollars are worth about $1 per bottle of wine. Assuming the bank brokers no more deals, the value of Bob's dollars will rise as the months go by, because he will eventually owe $1 that does not exist -- the bank only created $10 and he owes $11, so Bob's desire for more dollars goes up as the due date draws closer.

To solve this problem, the bank (or the Fed) buys something from anyone in Bob's neighborhood for $1, or directly from Bob. If it buys something near the payment date, it will be able to garner more material goods from Bob (or anyone who knows Bob is desperate) than it would if it purchased something at the beginning of the year, when Bob isn't so desperate to acquire another dollar.

So deflation occurs even absent a rise in the wine's value. Let's imagine that dollars, wine, coconuts, and cheese are the only assets available in the marketplace, and that there are only three men alive, the banker, Bob, and the wine-maker. All three men trade wine, coconuts, and cheese at a one-to-one exchange, and after dollars are issued, all three value wine, coconuts, and cheese at $1.00 as well.

If half the wine suddenly spoils, its value will rise; there are only 5 bottles left. Its supply has dropped relative to cheese, coconuts, and dollars, but this does not affect the value of the dollar relative to all other assets -- coconuts, cheese, and dollars continue to trade as equals. The change in the value of wine is more accurately described as "wine deflation." We can say that dollars have lost value compared to a total sampling of all assets available in the marketplace, but this confounds the true nature of the changes. Dollars didn't really drop in value relative to all other assets -- the value of wine went up; all assets dropped in tandem compared to the value of wine. So a change in the value of assets purchased by banks would appear to have no real ability to affect the value of the dollar, per se. If we look at a sampling of everything it creates the illusion of inflation, but at a distance, viewed properly, the value of dollars were only affected as much as all other goods in the marketplace, and only lost value against the original asset -- the asset we already defined as having lost value vs the dollar in the first place. A fall in the value of bank purchases would have a similar and opposite effect, but would not directly affect the value of dollars when compared to the total market.

If Bob defaults on the loan, the remaining dollars would fall to zero value rather quickly, absent anyone who wanted them to pay off a loan, so defaults do create inflation.

If the banker brokers a second deal between two other men, but is tricked into brokering a purchase at $2.00 per bottle, when the market at that moment in time values them at $1.00, the result would still seem to avoid inflation, because the man who owes $20 after the trade clears will eventually provide double the demand for dollars when compared the man who agreed to pay $10. Because the value of dollars depends on the desire of each man to pay off his debts, the specific act of paying too much for a market asset cannot affect the long-term value of dollars, if those assets are at the same time sold for too much. Dollars brokered into existence can never be inflationary, as long as defaults do not occur. If the man who bought wine for ten dollars has the same credit rating as the man who paid twenty, there can be no inflation created as a direct result of the brokering activity.

So it appears, by the above simplified logic, that the only way to create inflation is to broker deals for poor credit-risk borrowers. Sub-prime lending, in all its forms, creates inflation, but apparently it is the only thing banks control capable of lowering the value of dollars relative to other goods available in the market.