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Saturday, March 23, 2013

Why is there not more inflation?

The title is very similar to a  question asked in the comments on the March 21 post.  I think that there are 3 reasons:

In 1983 I traveled by train from Greece to Austria which meant I went through Yugoslavia, a communist dictatorship.  It was a night trip and I was not allowed to get off of the train.  It was scary. I met a man who immediately recognized me as an American (I had gotten used to that by then.).  He waited until no one else  was near and opened his billfold and showed me in the hidden pocket several $20 bills.  He was clearly very proud to have that "real money" in a currency that had not been destroyed by politicians.

The first reason that the value of the dollar is still holding up is nervousness.  Since 2008 people have been nervous and when people get nervous there is a "flight to safety".  Even if it is pressed hard by deficit spending and "digitizing money" (what used to be called printing money) the dollar has a long history of stability and modest inflation which leads to confidence in it.

The second reason is that the dollar is the world's reserve currency.  That means that the world needs a lot more dollars than it does euros.  It uses dollars like gold.  That means we could digitize money for a lot longer than say Britain could.  But that also means that if the worm turns and people do lose confidence, then there are an awful lot dollars out there that people might lose confidence in.  That suggests the consequences (the crash) would be much more dramatic for an inflated reserve currency than a  inflated regular currency.

The third reason is that the government is lending itself money.  The Fed is not just digitizing money, they are also buying treasury bonds from the Treasury.  That is the Fed (one arm of the government) is lending money to(buying bonds from) the Treasury (a second arm of the government).  Why?  That keeps demand for treasuries high and therefore interest rates low.  Therefore, inflation low. ( If a bond is desirable you will take it at a lower rate and pay a higher price for the bond.  If it is not desirable then you will want it less and require a higher rate of interest and pay less for the bond.  If US bonds are scarce, then the price goes up and the interest rate goes down.  If the Fed is buying them, then that will make them more scarce.)  This is a bit more sophisticated than just digitizing money because by buying bonds the Fed is digitizing money and keeping track of how much it has digitized.

Those are the things that I think are keeping "inflation" low for the time being.

How will we know when the shell game is up?  When the interest rates on treasuries start to go up.

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