An insanely long question on inflation. How can we stop inflation?

What causes inflation?

Inflation seems to be a subject few people understand. The cause of inflation is likely purposely clouded by the people you send to Washington. To understand inflation, we must first review some history.

The USA started printing script, paper money, around the time of the Civil War. The script became promissory notes for an exchange of gold to foreign countries. All U.S. citizens were required to surrender their gold for dollars. All the gold in the USA became the property of the government. An exchange rate of $35 per ounce of gold was established. In international trading, the U.S. dollar became as good as gold.

Even though the U.S. dollar was backed by gold, the British pound sterling was the major currency used in the international commodities market up to World War II. As a result of England’s destruction during the war and the decline in value of its currency, the U.S. dollars took hegemony in international trade.

Everything went along smoothly for a few decades in the world. Trading between nations was conducted in U.S. dollars. After all, the dollar was as good as gold. Then came the 1960s.

For the first time in its history, the USA could not switch back to a butter economy after World War II. After every prior conflict the country was involved in, its military industrial machine was dismantled. The cold war prevented that. The country had to adopt a guns and butter economy, a combination never tried before by a non-imperialistic country.

A strain on the U.S. treasury started when the country engage in another war, began an expense space program, and started a costly entitlement program for the poor all at the same time. The cost of maintaining a military to block Soviet expansionism, fight a war in Vietnam, send men to the moon, and pay welfare checks caused the USA to spend much more money than it collected in taxes. The solution was simply to print more money. By the end of the decade, the USA had printed far more money than the gold supply could cover.

Foreign countries were well aware of the fact that the U.S. had print money that wasn’t covered by gold. In 1971, France demanded gold in exchange for the U.S. dollars it held in its reserves. This move by France started a run on Fort Knox. President Nixon countered this run by taking the dollar off the gold standard.

Without gold, something had to support the value of the dollar. Thus, the International Currency Exchange was established, where banks began trading currency just like investors traded stock on the stock market. It was the demand for the currency on this market that set the value of the dollar.

Although this solved the problem of the country’s gold reserve being depleted, it didn’t correct the fact that the USA had printed far more money than its economy and the world’s economy needed. Inflation, or devaluation of the dollar, followed this move by Nixon. It took well into the 1980s until the U.S. economy earned the excess money spent by the government during the 1960s.

So. How does the International Currency Market determine the value of the dollar?

When Nixon dropped the gold standard, the USA was the largest producer of goods on the world market. When a foreign country needed to buy U.S. goods it needed U.S. dollars to do so. The need for dollars created a demand for the script. As the USA produced more, more script was needed by foreign countries to buy products. This need of dollars supported the dollar’s value.

Nixon realize, however, that it would take several decades for the U.S. economy to earn back the huge government deficits of the 60s. To help shorten that period of time, a deal was struck with OPEC. OPEC agreed to demand U.S. dollars on the international market as payment for its oil. In return, the USA agreed to provide military protection to OPEC nations against any Soviet threat. This trade in oil for dollars became known as petrodollars.

From the mid 1980s through the 1990s, the world went along smoothly once again. The U.S. money supply balanced out with the world’s trade, and everything was hunkydory. But then came an event that upset the balance of nature: the start of the European Union.

The establishment of the European Union, and the issuance of its currency, could not have come at a worse time for the USA.

The industrialization of Asian nations, like China, had created a cheap source of consumer goods for the American public. So much so, that it created a trade deficit between the USA and those countries. As a result, the USA had to buy more foreign currency with its dollars to pay for those imports. This lessened the demand for dollars on the exchange.

Meanwhile, the new European Union became a big exporter of goods to the world, which increased the demand for Euors on the exchange and further lessened the demand for dollars. With less countries buying dollars, the value of the dollar declined on the currency exchange, and Americans had to pay more dollars for the goods it import, which meant inflation.

This isn’t the end of the story, however. Our government is still in the habit of spending money it doesn’t yet have. Government spending is based on projected tax revenue. And, tax revenue is based on personal income. The old formula for calculating projected tax revenue doesn’t fit the inflation cycle the country is facing today.

In the inflationary times of the 1970s the USA was able to produce more products to sell in the international market place. This increased production created more jobs and more personal income.

This is not the case today. Although America’s big business is selling more on the international market, the labor for that production is coming from outside the USA. Because of foreign labor, personal income is not increasing as it did in the 1970s. This is creating shortfalls in tax revenue, which again has the government spending more money than it is taking in, and has it printing money with no value to cover its expenses, as it did in the 1960s. This adds to inflation pressure.

Many foreign countries are viewing this as the same problem that prompted France to demand gold for its dollar reserves, which puts value of the $27 trillion US dollars in the currency exchange at even further risk.

Unless the trade deficit is brought under control we are going to continue in this cycle of inflation, which will lead to further deficits in government spending and more inflation yet again.