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Pentonomics - The Cause and Evidence of Inflation

Thursday, February 3, 2011
Michael Pento

On the Kudlow program dated Tuesday February 1st, Donald Luskin gave his version of the textbook definition of inflation as “an overall rise in the overall price level.” But my 1988 edition of the Webster’s Dictionary puts it differently. Their definition of inflation is, “An increase in the volume of money and credit relative to available goods resulting in a substantial and continuing rise in the general price level.”

But let’s put aside technical definitions of inflation for a moment and let me help Donald understand what inflation is in reality. Of course inflation is an increase in money supply and credit; but he should ask himself why that causes prices to rise. The reason is because the U.S. dollar isn’t backed by anything anymore; as Luskin is well aware. Therefore, its value depends upon our collective belief in its current and future purchasing power and the hope that its supply will be restricted. When its supply is increased, users of the currency lose faith in its buying power and prices rise.

In addition, if current holders of the dollar feel that in the very near future the U.S. has no choice but to monetize trillions of dollars of Treasury debt, the currency will falter as well. I like to use the Enron example to make this point. The share value of a corporation represents the strength of the company. Likewise, the strength of a currency represents the strength of a country. What may happen to the U.S. dollar is notdissimilar to what happened to Enron shares. Once the accounting scandal broke, the purchasing power of Enron shares plummeted. But it was not because of an increase in the number of shares outstanding, but because of an epiphany on the part of investors that the company was totally bankrupt. Logically, shares representing a stake in an insolvent company lost all of their value. Likewise, aggregate prices will soar if global investors lose confidence in the dollar due to the realization that the US is incapable of servicing its debt. If there is the mere perception that a massive dilution to the currency is inevitable, it will cause the dollar to tank and aggregate prices to rise. Inflation is also about the confidence in the purchasing power of the currency.

My contention is that the Fed and government have set out on a deliberate strategy of creating inflation in order to monetize most of the $14.1 trillion national debt—that is growing by well over a trillion dollars per annum. So let’s look at some charts that prove the dollar is being diluted and that prices are rising. First is a chart of the monetary base, which consists of physical currency and Fed bank credit.

No doubt here. The supply of high-powered money has exploded.

But it is not only the monetary base that has expanded; take a look at M2, which has grown as well. as well.

Since the recession began in December or 2007 the M2 money supply has increased by over 18%.

Next is the chart of the CRB Index.

The prices of the 19 commodities included in the index clearly show that prices are surging in response to the loss of confidence in the USD.

But there is nothing better to show the value of the dollar than to put up a chart of the monetary metal. Below is a ten year chart of the dollar price of gold. It is self explanatory.

Now let’s throw up some charts of the U.S. dollar vs. a few other fiat currencies.

Here’s a two year chart of the USD vs. the Australian dollar.

Now let’s look at a two year chart of the U.S. dollar vs. the Canadian dollar.

Finally, we’ll look at a two year chart of the U.S. dollar vs. the Japanese Yen.

The above charts depict three important currencies from three different continents all clearly showing the weakness of the USD. Most dollar defenders point to the relative stability of the dollar index. But it is only against the heavily weighted Euro that the U.S. dollar has maintained its purchasing power.

So it’s isn’t at all that gold and commodity prices no longer give accurate inflation signals as Mr. Luskin claims. He stated during our “Kudlow Report” debate in reference to those rising commodity prices that, “…for the last decade or so it just hasn’t worked that way, the canaries [commodity prices] that we’re using in this mine shaft just aren’t functioning right.”

I’m not sure why Donald has decided to stop relying on market prices to determine the rate of inflation and instead is looking at Government and Federal Reserve inflation metrics. That doesn’t seem to be such a wise move. But he isn’t alone. Keynesians, the Obama administration and the Federal Reserve all share his views. But the sad truth is that global U.S. dollar holders are losing faith in the Fed’s 26 months worth of zero percent interest rates and the massive increase in its balance sheet. They are also losing confidence in the ability of the U.S. to service its debt. That’s why the dollar is in the process of losing its world’s reserve currency status and why inflation rates are rising. And will, unfortunately, continue to do so.