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"Unexpected, this is. And unfortunate."
--Yoda (Return of the Jedi)

A triumph of the modern State has been convincing people that inflation should be defined in terms of changing consumer prices. Higher consumer prices mean higher inflation.

Prior to the early 1900s (amazing how that period keeps coming up), inflation was classically defined in terms of quantity of money and credit. More money and credit meant higher inflation.

It doesn't require a PhD to sense a relationship between money/credit quantity and prices. Create more money/credit and higher prices should result.

So, doesn't that mean that the modern and classical definitions of inflation are equivalent?

Nope. Today, most money in the system actually takes the form of credit. And the ultimate suppliers of credit in modern systems are central banks. The supply chain generally works like this: central banks lend to big commercial and retail banks; big commercial and retail banks lend to big borrowers such as investment banks big corporations, hedge funds, and regional banks; investment banks and regional banks lend to smaller borrowers such as smaller companies and local banks; local banks lend to individuals and small firms.

It is important to understand that the credit creation process proceeds with successive creditors lending out more than the value of their capital. Banks, for instance, can lend out $9-10 for each dollar in deposits. Investment banks lever up at 20-1 or higher ratios.

The degree of systemic leverage resulting from this approach should be easy to sense. Indeed, when credit is really flowing, $1 from a central bank might pyramid into $50 to $100 of new credit money created in the system.

The classical definition of inflation, you see, focuses purely on the amount of money/credit created by this pyramid scheme.

Here's the thing. We never know where all this money and credit, once created, is going to go--at least right away. Suppose, for example, that big banks borrow $100 billion from the Fed. Instead of lending it, however, they decide to invest it--in stocks, bonds, mortgage backed securities, etc. Little of this money makes its way to the retail end of the supply chain and into the hands of consumers--at least in the short term.

Suppose we have two categories of prices: consumer prices (milk, break, cars, etc) and financial prices (stocks, bonds, etc).

Given the above scenario, which category of prices is more likely to increase: consumer or financial? The financial category, of course, because of increased demand for stocks, bonds, etc. flowing from banks.

Do you see the implications? In our example, $100 billion in new money has been created. But since there has been no measurable effect on the 'consumer price index,' officials proclaim that no inflation is present.

This is precisely what's going on currently. Trillion$ in new credit money have been pumped into the system, but most of it has stayed with the banks, who have used it to buy financial assets. The S&P is up nearly 100% from the March 2009 lows when new money creation went into hyperdrive.

And yet officials report that there is little inflationary pressure because consumer prices haven't moved much.

If you've been wondering how those 'fat cat' bankers get so fat time and time again, you're looking at the primary reason. Our system is rigged to provide financial institutions with 'high powered money'--particularly during times of crisis. This is money created out of thin air that has high purchasing power for those able to use it first. Since big banks are upstream in the supply chain, they get first dibs on it from the Fed. So they use it to buy financial assets and bid prices up.

By the time this money filters downstream to the retail end of the supply chain, much of its purchasing power has been lost because there's much more of it. This pushes prices of consumer and finanical goods higher. Any money held by consumers prior to this inflationary process declines in value as well due to increased money supply.

The implications of this process are many: widening gaps between rich and poor, middle class families increasingly troubled making ends meet, serial financial market bubbles followed by deleveraging busts...

It starts with the Jedi Mind Trick of inflation.

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