The Debt/Inflation Ratchet

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We are all
familiar with ratchets. A bar with a tapered end locks into place
a gear, so that the gear cannot move backward. Then force is applied
to the gear in order to move it in one direction. Click by click,
the ratchet system prevents the gear from moving backward. Click
by click, the system governed by the ratchet moves in one direction.

is the monetary condition of the world’s economy today. A few items
are so price competitive through innovation that they continue to
move down in price. We see this anti-ratchet effect in computers
and computer-related equipment. Moore’s law is actually accelerating.
The chips are now doubling in capacity every 12 months, not every
18. This is not fast enough to speed up the boot-up process of the
latest Microsoft operating system. (“Intel giveth, and Microsoft
taketh away.”) But, once booted, the computer is faster.


is a kind of war between the price effects of computerization and
the price effects of monetary inflation. I personally experienced
this last week. I installed, and then removed, an ancient Hewlett
Packard Laserjet III printer. I thought I needed it to make a decade-old
program on my computer function properly. I was wrong. A Laserjet
III was a real improvement over the predecessor, which I also owned,
but at 300 dots per inch, it’s not up to par today. Most important,
it is heavy. I mean really heavy. I can hold an HP 1100 (now several
years old) in one hand. It puts out 600 dpi. It doesn’t hold a tray
of paper that the Laserjets III and IV did — a liability —
but it is cheaper and far more convenient. So, I have compromised.
I reinstalled my old Laserjet IV, which holds its price in the used
printer market because of the tray.

improvement in desktop printers has been constant. Prices have fallen;
quality has improved. These are tangible benefits. Consumers are
now used to this in printer technology. We expect advances. But
in few other areas of life are there comparable examples.

week, I also experienced first-hand the other side of the coin.
I watched a Rhino video of what was my favorite TV show fifty-two
years ago, “Space
.” The budget was low even for those days. The sets were
actually cheaper looking than the even older “Captain Video” program,
which seems inconceivable. (I was never a “Captain Video” fan.)
How I could have been a fan of “Space Patrol,” yet also think that
Jos Ferrer’s “Cyrano
de Bergerac
” and Alistair Sim’s “Christmas
” were great movies — which they were — escapes
me. I had the entertainment aesthetics of an adult co-existing with
those of a child.

Patrol” in its TV and radio versions created the original market
for Wheat Chex and Rice Chex, allowing Ralston Purina to replace
the never-popular Hot Ralston cereal. The show was incredibly popular
among pre-teen boys. It ran for five years (daily: 15 minutes),
plus a twice-a-week radio show, plus a weekly half-hour. It was
a phenomenon.

Even more
incredibly, after the show went national, polls indicated that
60% of the audience was adults.

Rhino wisely
retained the show’s original commercials, which are far more interesting
today than the scripts. Nestle was an alternative sponsor. The
actors came on-camera to promote Nestle’s products. The candy
bars — Crunch, etc. — sold for a dime. My wife’s comment
was “This will prove to our children that candy bars really did
sell for a dime.”

product line hasn’t changed. What has changed is the price. Also,
the bars looked bigger on-screen, which I suspect they were. So,
the manufacturer reduced the quantity in order to forestall price
increases. We rarely get an opportunity to compare the same product,
without improvements, over time. Food products are among the few
whose formulas don’t change much, and candy especially. Taste matters,
so manufacturers are afraid to tamper with the formulas. They prefer
to reduce sizes or change packaging. They resist passing along price
increases. So, when we can compare today’s prices with prices a
half century ago, we can see what has happened to the purchasing
power of the dollar.

the show first aired, in 1950, on the local ABC TV station in Los
Angeles, the actor who played “Cadet Happy,” Lyn Osborn, was paid
$8 per show, meaning the pre-tax equivalent of 80 Nestle candy bars.
I have no idea how he paid his rent.


free market monetary system allows users of commercial banking services
to impose negative sanctions against mismanagement. If they suspect
that a bank has loaned out more money than the bank has immediately
withdrawable reserves on deposit, thereby increasing the money supply
and also the risk of a bank run, a bank run begins. The bank is
forced to call in loans and restrict the issuing of new loans. The
money supply then shrinks.

free market imposes restraints on the expansion of money. It does
so bank by bank. It imposes restraints on individual banks, which
in turn impose restraints on the commercial banking system as a
whole. Micro-incentives to restrict the issuing of new loans with
newly created credit money therefore impose macro-restrictions on
the entire money supply.

is the classic characteristic of the free market. A positive result
in the aggregate is attained by individual decisions. Out of the
self-interested actions of individuals emerges an unplanned system
that benefits most of the participants. In short, “out of many,

self-regulating free market system of monetary management has never
impressed Milton Friedman, who is famous for his attack on the gold
standard and his suggestion that what society needs is a government-run
monetary system that will increase the money supply by 3% to 5%
per annum — a lot of flexibility there!

is a classic accusation of “market failure” by an academic economist.
The free market has somehow failed to maximize consumer benefits
by providing a system that restricts abuse. It has failed to produce
an optimum money supply. Yet, unlike a gold coin standard, which
encourages depositors’ runs on overextended banks to get the gold
they are owed (deposits), as well as other commercial bankers’ runs
on overextended banks to get the gold they are owed (checks), Friedman’s
system has no independent, exogenous (outside) negative sanctions
against fractionally reserved commercial banks’ self-interested
inflating of the money supply. The government must provide guidance
and sanctions for disobeying government guidelines.

brother-in-law, Aaron Director, who was also a University of Chicago
economist, took another view: a fixed money supply with falling
prices due to increased production. Friedman’s recommendation has
always had a wider appeal than Director’s among academic economists,
although no one has suggested any way to get the government or a
central bank to follow the 3% to 5% guideline.

result of government controls and central banking has been the disappearance
of the ten-cent candy bar. Another result has been the creation
of a debt structure that encourages further monetary inflation.
I call this the ratchet effect.


new money unexpectedly is released into the economy by the central
bank, those who get early access to the new money have a competitive
advantage. They can buy at yesterday’s prices. So, new users of
fiat money can buy a disproportionate share of the economy’s existing
goods, not because they have become more productive, but because
they have in their possession the newly created money. Nice work
if you can get it!

do you get it? By going into debt. The central bank creates new
money to buy government debt. The government immediately spends
this money: checks. Those who receive these checks then deposit
the money in their bank, or else they cash the checks and spend
the money. Banks wind up with the new money. They lend out more
money, which in turn gets deposited: fractional reserve banking.
So, for two groups of people — recipients of government funds
and recipients of bank loans — the inflation process makes
them winners.

we see, year by year, is an increase in the money supply, an increase
in government debt purchased by the central bank, an increase in
government spending, and an increase in private debt. All of this
takes place because the monetary system allows the central bank
to use government debt (or any other asset) as the nation’s monetary
base: the legal reserve for the commercial banking system’s deposits.

produces hope for a future income stream. People will pay money
today to buy an expected income stream. They buy bonds: expected
income streams. They buy real estate: expected income stream. They
buy annuities: distantly expected income stream. Create an income
stream, and you have created wealth. When people bid to buy this
wealth, we call this process capitalization: the capitalization
of an expected income stream.

income streams are monetary. But people’s goal in creating streams
of income is the creation of consumable income, not digits or pieces
of paper with dead politicians’ pictures on them. So, people’s expectations
regarding future prices are important in establishing the level
of present demand for monetary income streams.

the process of monetary depreciation is slow enough, people tend
to forget what is happening to the value of their locked-in streams
of future monetary income. I think of those Nestle candy bars. I
also remember going to a movie on Saturday morning in 1951: 15 cents
each way for the bus, 25 cents for the movie ticket, and 10 cents
for a Butterfinger candy bar. That bought me a day’s entertainment,
10 a.m. to 4 p.m.: a western, six cartoons, a serial, a newsreel,
and two adult features. Plus, previews of coming attractions.

Federal Reserve has acted to undermine the value of streams of monetary
income. In response, voters have pressured politicians to establish
cost-of-living escalators for Social Security payments. So, the
government’s statisticians do whatever they can to juggle the data
in such a way as to deflate the consumer price index. They prefer
to include computers in the official basket of goods rather than
candy bars. Moore’s law is their friend.

Median CPI, published by the Cleveland Federal Reserve Bank, is
not subject to political jiggling, because it is not used to establish
the government’s official cost-of-living estimate. So far this year,
the increase in the Median CPI is moving at 3.7% annual rate.

discount the future. Income received in the future is not worth
what the same income is worth to us today. We also tend to have
confidence that the future will take care of itself. This is the
right attitude with respect to the bad things that might happen,
but probably won’t. “Take therefore no thought for the morrow: for
the morrow shall take thought for the things of itself. Sufficient
unto the day is the evil thereof” (Matthew 6:34). This optimism
encourages entrepreneurship. But there is a downside to this attitude
in a world of central banking and government debt: neglect of the
declining future purchasing power of money at the expense of looking
at our net worth today.

look at rising prices for housing, and as home owners, we rejoice.
We feel richer. We do not emotionally perceive that for every rise
in our homes’ value, we must pay rising rent: the forfeited value
of the income that we could receive if we sold the home and invested
the returns. We think, “I’m rich!” We then think, “I could be richer
if I borrowed money, bought another home, and got renters to pay
it off.” If we buy right, this is true.

But leverage
through debt is a two-way street. The debt meter keeps ticking
even after the income stream dries up. If I pay $10,000 down on
a $100,000 home, and I can sell it a year later for a net return
of $110,000, I have made 100% on my investment, if I also rented
it for what my costs were. But if I pay $10,000 down, and the
price falls to $90,000, I have lost 100% of my investment, and
maybe I could not rent it, either. So, in order to keep from getting
hammered by the negative capital value effects of deflation on
leveraged contracts — mortgages — debtors vote for politicians
who promise to keep monetary income high, and thereby protect
us from the risk of default.

my view, the housing market is the ultimate example of “moral hazard”
that we face today. The housing market is too big to fail, meaning
too big to be allowed to fail. Yet the only thing that the government
and the Federal Reserve System can do to keep it from failing is
to adopt a policy of money creation. This is what they have adopted.
The voters want it.

for non-payment of one’s mortgage is an immediate problem. Pension
living is in the distant future. We look at today’s wealth, or the
reduction thereof, and we make our political decisions accordingly.
We discount the negative long-run consequences of today’s political
decisions. We are willing for the Federal Reserve System to sacrifice
the value of future dollars in order to sustain today’s monetary
income stream, and hence the present market value, of our homes.

is the Great American Ratchet. We have borrowed money to capitalize
our lifestyles. We have indebted ourselves to buy a consumer good
that we pretend is a capital good. A house is a consumer good today
— real income, not monetary income — but will become a
capital good for us years from now: a salable stream of monetary
income, but not necessarily real income. We buy real income today
by going into monetary debt.

we are present-oriented, we have made a risky exchange: real consumer
income today in exchange for promised monetary payments (a mortgage).
We justify this because we think that the government will keep the
supply of fiat money flowing. It undoubtedly will do just that.
But in pursuing real income now in exchange for making a promise
to pay a fixed amount of money over the life of a mortgage, we are
joining the nation’s largest pressure group for the politics of
inflation. We are undermining our future stream of real income as
retirees. We justify buying the home as a capital investment, yet
this investment is no better than what the purchasing power of money
will be when we finally decide to convert our consumer good into

is a self-reinforcing process. It takes ever-more debt to buy a
home, and any increase in the monetary value of the home (equity)
serves as a lure for taking on more debt. Interest payments on homes
are deductible from gross income for income tax purposes.

ratchet of debt and inflation continues upward, fueled by the public’s
confusion. Home buyers do not clearly distinguish real income from
monetary income, consumer goods from capital goods, and present
real income from future real income. Man’s inherent present-orientation
favors real income now over monetary income later. This favors real
income now paid out of future income later: debt.


will do what the rest of Americans won’t: share rental space among
more than one family. While this is illegal in most communities
due to zoning laws, the Mexicans’ definition of a family is broader
than the Anglo and African-American definition. So, they legally
get away with it. “This is my cousin, Manuel.” His third cousin,
twice removed. They pool their incomes to meet the monthly mortgage
payment on one house. Thus, Mexicans are steadily buying up African-American
housing. African-Americans for decades in California used the block-cracking
technique to scare whites into selling at low prices. Now Mexican-Americans
are using the multiple family technique to buy out African-Americans.

is no myth. Almost 50 years ago, my grandparents were warned to
sell by their long-term black housekeeper, who had cared for me
as an infant for 6 months when my parents were in Washington, D.C.,
waiting for my father to be shipped out by the Army. She came to
them and said that their neighborhood had been targeted for transition.
How she knew, I don’t know; maybe church members were involved.
My grandparents refused to listen, and they lost a lot of the equity
in their home. White flight can be used against home owners by organized
African-Americans. But family pooling of funds can be used by Mexicans
to gain their real estate goals, given the mortgage system.

Asians are using personal productivity to generate the income needed
to buy up homes from the Anglos.

California is changing color. About 500,000 whites left the state
in the 1990’s. They are being bought out: from below (block-cracking)
and from above (higher bids).

American dream is to own your own home. It is a worthy dream, but
government guarantees have subsidized this dream. The dream now
guarantees the decline in purchasing power of the dollar. The only
alternative to this scenario is a fall in real estate prices as
a result of a wave of defaults. When monetary income no longer allows
existing home owners to pay off their mortgages, the real estate
market will break. But will it break? Not if Alan Greenspan has
anything to say about it. Surely, he does.


debt/inflation ratchet cranks ever higher. The central bank system
subsidizes government spending and, by way of funding this system,
universal debt. It has subsidized a gigantic consumer debt market
that is incorrectly regarded as a capital goods market: housing.

say, “Don’t fight the Fed.” If this applies to buying stocks, then
it is surely true of buying homes. But we must not be naive. The
subsidized housing market is a dagger at the heart of people’s retirement
plans. The golden years of retirement are now a myth. A declining
dollar is going to destroy the dreams of a generation of baby-boomers.
They will be joined in the long line of disillusionment by their
grandchildren, who will not be able to get a down payment on the
American dream.

governments control the money supply, you can be sure of one thing:
the long-term depreciation of the value of official money. The politics
of now, when coupled with the reality of long-term debt (payment
tomorrow), guarantees the destruction of money. This is not a market
failure. It is a government failure. There are more debtors who
vote than creditors who vote. Even when the debtors (mortgage signers)
are also creditors (pension asset owners), they discount the future
at the expense of the present. The present political power of the
economic present is far greater than the present political power
of the economic future.

ratchet clicks upward, day by day.


North is the author of Mises
on Money
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