Stand still, little lambs, to be shorn!

One of the all-time classic "Economic Education Bulletins" published many years ago by the American Institute of Economic Research and re-published periodically with updated data is "Stand Still, Little Lambs, to be Shorn!" *

That essay -- most recently updated in January, 2005 -- explains the "hidden tax" of inflation. Using historical data, the authors calculated that -- during the ten years ending in December, 2003 -- individuals paid Federal income taxes of $9.0 trillion, and during the same period Americans who held savings in dollar-denominated assets (including bank accounts, money market funds, and bonds issued by corporations, municipalities, or the Treasury) lost an additional $3.6 trillion to the ravages of inflation.

In other words, the authors explain, the hidden tax of inflation was like a "huge supplementary tax" equal to 40% of the more obvious income taxes charged by the Federal government each year.

By way of enlightening those who felt that, after the runaway inflation of the 1970s was tamed, inflation was now largely "behind us," the AIER showed that the purchasing power of the dollar in 1980 was only 21.1% of the purchasing power of a dollar in 1945, but that by 2003 this figure had fallen even further, to the point that a dollar in 2003 had the purchasing power of only 9.9% of a dollar in 1945!

We have written about the deleterious effects of inflation many times in the past, particularly in our post from July 4, 2008 entitled "Liberty and Property." There we noted that even economist John Maynard Keynes, in his early years, spoke out against the tyranny of inflation, saying: "There is no subtler, no surer means of overturning the basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose."

Today, largely due to the enormous increases in government spending embodied in the current budget, inflation concern is back in the spotlight. Because of this, it is possible that more than "one man in a million" is aware of the danger of future inflation, although few are probably aware at just how large the hidden tax of inflation has been even before these new developments. The possibility that inflation could be even greater in years ahead should cause all investors to take notice.

Inflation indicators are pointing towards higher inflation expectations. The price of gold, which is currently above $950 an ounce, and the shape of the US Treasury yield-curve, which has recently "steepened" dramatically as the demand for longer-term US Treasuries falls and yields rise, are reliable measures that markets are pessimistic about the future purchasing power of the dollar.

The danger of increased inflation is exacerbated by the reliance of the Federal Reserve upon outmoded theories such as the "Phillips curve," which we have discussed in detail in previous posts, such as this one from August of last year.

Unfortunately, few in Congress seem to understand or even care about such arcane details of economic theory.

In an unusual display of economic understanding, not often found inside the halls of the US Congress, one member of the Budget Committee shows that he has clearly taken the time to become fluent in economic issues and recently asked Fed Chairman Bernanke some very pointed questions about the Phillips curve assumptions of the Fed and their potential for leading to greater future inflation. In a question-and-answer session on Wednesday June 3, 2009, Representative Paul Ryan asks Mr. Bernanke about the "output gap," beginning at about 27:44 on this C-span video of the hearing.

The "output gap" is a corollary of the Phillips curve, as explained in this 2008 article from the Cleveland Federal Reserve. Defined as "the percent by which actual output deviates from its potential," the output gap will be greater during times of recession, when there is a "gap" between potential output and actual output. Proponents of the Phillips curve and the output gap believe that slower economic growth -- or the presence of an "output gap" -- naturally tends to dampen inflation.

As we have explained before, the experience of the 1970s and "stagflation," when a slowing economy did nothing to rein-in runaway inflation, should have cured economists of these mistaken notions. Additionally, as Milton Friedman taught, inflation is a monetary phenomenon, and not caused by economic events. It is directly related to excessive monetary stimulus, simply described as "too much money chasing too few goods."

Nonetheless, when pressed by Representative Ryan in the above video, Mr. Bernanke asserts "I think that there clearly is an output gap" and that "the size of the current output gap will be a drag on inflation." Mr. Bernanke also calls the idea that the output gap dampens inflation after a recession "a reliable empirical regularity." He then goes on to assert: "If you look around you for evidence of inflation, inflation expectations, you're not going to find very much."

These assertions indicate that the Fed will likely continue to keep interest rates essentially at zero, although we believe that the Fed should instead begin tightening to prevent future inflation from their current position of emergency stimulus. This problem is all the more troubling when considered in conjunction with the record government spending and record amounts of debt, which will create pressure in the future for the government to either raise taxes or further inflate the currency -- or both.

The lesson of this discussion, and of the classic essay "Stand still, little lambs," is that citizens should be very aware of the real and corrosive threat posed by inflation. Most important to understand is that ownership of good businesses, through common stock, has historically been a solid foundation for preservation of purchasing power. We have discussed why this is so in many previous articles, especially this one entitled "The Inflationary Fed," in which we linked to studies showing that ownership in companies is superior even to real estate or gold in defending your purchasing power against the ravages of inflation.

For later blog posts dealing with this same subject, see also:

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* Editor's note, 12/13/2012: In the years since this post was first published, AIER has again updated this important essay, and the version linked in the above post is no longer available on their website.  The latest version, updated in 2010, can be found here.


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