Continuation of my previous post ‘Why do we invest’
There are several different theories as to the causes of inflation, for an overview see here.
I have a much simpler view of inflation and it does involve the FED, or any central bank able to print money for that matter. It goes like this.
Start with a clean slate. At the beginning there is nothing except people who want to do business with each other. They think that it would be cool to have some token to exchange their products and services among each other and that it would be much simpler if everyone were relying on the same token instead of everyone producing its own. They call this token ‘money’ or ‘currency’ and found a bank (central bank) whose task it is to print enough money so that there is no shortage of it and everyone has access to it when he needs it.
So the central bank prints some currency and stocks it in its vault. Since you need, say 100$ to do business, how do you get access to it? It requires you to have an account with the central bank into which you have to pledge some of your wealth (note: you can’t put currency in there, as at this point because you don’t have any yet), also called collateral. The central bank then ‘loans’ you this 100$. Obviously, a loan comes with an attached interest rate. In other words, you loan 100$ from the central bank and will have to give it 102.5 back (assuming a 2.5% rate per annum). Where does the additional currency come from, after all, only 100$ were printed so far which you have loaned? Well, you need to ‘take it away’ from someone else by doing business with him for at least 102.5$. And for this not to be an exercise in futility you need to make a profit yourself, so you will charge this someone 105.0 (assuming you are not greedy and are satisfied with 2.5%). Now, your business partner has to come up with at least 105$. He has loaned his 100 from the central bank as well – where else can printed money come from at this stage – and needs to give 102.5 back as you do. If he pays you 105 for your services or products and wants to make a profit for himself as well. He is now forced to do business with another some at 107.5 to be able to pay his bills and still make a profit.
The original 100$ put in circulation by the central bank have now become 107.5$. Those 7.5 $ must be printed as well or would have to be printed if everything had to be paid back. This is unlikely to be the case and here reserve requirements of fractional reserve banking come in. You cannot lend-out the full 100$ you loaned from the central bank, but only a fraction of it. See the drawing at the end of this post.
If you think this sounds like a Pyramid scheme, then you are not alone. This system will break down as soon as no new players that can be used as currency source enter into the game. Whether it is a Ponzi depends entirely on the definition of when you judge a return (or interest rate) to be unusual high.
The above makes it clear that inflation is artificially induced by the central bank and aggravated by the fact that everyone that deals with the currency, i.e. the banks, needs to make a profit in the process. In other words, inflation is a built in component of the banking system which is entirely artificial and could be avoided completely if a alternative to the way money is managed were found.