Origins of Financial Crises

CPI Train Wreck
In introductory economics courses, students are told that inflation is a rise in the general level of prices of goods and services in an economy over a period of time. The preferred measure is the Consumer price index (CPI) or, more recently, the Personal Consumption Expenditures price index (PCE). Both are calculated as the value-weighted price of a basket of carefully selected goods.

This is actually a misleading view on inflation. More accurately, rising prices are the symptom of inflation, not the cause.

The reality is that inflation is an increase in the money supply.

As expected from an increase in the supply of any commodity (ceterus paribus), the value of each unit will decrease. It is the value of the money that is changing, not the value of the goods and services. For this reason, it is a waste of time to try to accurately measure the value of money by measuring the prices of goods and services.

The prices of individual goods or services change constantly irrespective of their value. Sometimes the basket of goods is altered because of a price change in a particular category that is deemed to be distortive.

In fact, it is absurd that the Fed would use any other measure than the amount of money in the economy. The math involved is much less complex and certainly not as prone to error.

Peter Schiff, an American author, businessman, financial commentator, and a 2010 candidate for the U.S. Senate, used a witty analogy. Imagine a person, let’s call him Central Frank (I added the name), is standing on train tracks. Understandably, Frank does not want to be on the tracks when the train passes.

But Frank is not a very bright person.

Frank decides that seeing the caboose is the best way to tell that the train is coming. We have warned Frank that he should be looking for the front of the train, the engine, if he doesn’t want to be pulverized.

But Frank is stubborn in his view and insists that he use the caboose indicator.

Is Frank’s plan likely to work?