The Design Feature of Inflation in a Fiat Currency System

In the 1930s, the Federal Reserve was established with a specific purpose: to manage inflation. Contrary to the stable periods in the USA between 1800 and 1930, when paper currency could be exchanged for gold or silver, the Federal Reserve was designed to ensure that fiat currency could coexist with controlled inflation. This article will explore the reasons why inflation is a necessary feature of a fiat currency system and its broader implications on the economy.

Why Inflation is a Design Feature of Fiat Currency

For decades, before the adoption of fiat currency, the US experienced no inflation since the value of paper currency could be exchanged for precious metals. However, with the shift to fiat currency, the dynamics of the economy began to change. Sound money policies, such as the direct exchange of currency for gold and silver, no longer applied.

Keynesian economists argue that inflation can be an economic stimulant. By allowing the value of the fiat currency to erode gradually, it serves a critical purpose: it is effectively a form of wealth tax. This mechanism ensures that the value of assets, particularly bank savings, slowly diminish over time.

From an economic standpoint, fiat currency is not merely a store of wealth; it is a tool for achieving specific goals. Administrations can manipulate the value of fiat currency by printing more money, which dilutes the value of bank accounts and savings. For instance, retirees in the 1960s witnessed a significant reduction in the purchasing power of their life savings as inflation soared in the late 1960s. The effects were stark: what once was a substantial nest egg was reduced to a mere 20% of its original purchasing power.

Implications of Inflation

Debtors, particularly the US government, benefit immensely from inflation. With fixed-rate debt, they can pay off their loans with currency that has depreciated over time. This effectively allows the government to seize a significant portion of the savings of prudent citizens. The concept is straightforward: a $10,000 loan can be repaid with currency that is now worth only $7,000 due to inflation.

In addition to the government, financial analysts who are adept at navigating the complexities of the market also thrive under inflation. The 1970s saw a rise in strategies like leveraged buyouts, junk bonds, and tax avoidance schemes. These schemes were designed to either fleece the unsuspecting or transfer tax liabilities to unwitting participants, exploiting the volatile nature of inflationary periods.

Rapid Devaluation of Fiat Currency

The devaluation of fiat currency has been a consistent trend over the years. Since Franklin D. Roosevelt's confiscation of all circulating gold in 1935, the paper currency has declined in value by 99%. At the current rate of inflation, the currency's value will decline by another 99% in approximately 60 years, or by 90% in just 30 years. These projections are sobering, especially for those planning for future financial stability.

To put this into perspective, parents who are saving for their children's college education or planning for a comfortable retirement must consider the long-term effects of inflation. Over the next few decades, the purchasing power of their savings could be severely diminished, making long-term financial planning a complex and challenging task.

Positive Aspects of Inflation

Despite the negative implications, inflation also serves several positive roles in the economy. It encourages people to invest in long-term assets, rather than hoarding cash that only loses value over time. Inflation can make the labor market more efficient by allowing wages to adjust, without the need for disruptive wage cuts that could alienate workers. Moreover, inflation can act as a buffer during economic downturns, helping the Federal Reserve to stimulate the economy without relying solely on unconventional measures like helicopter money.

Overall, while the design of inflation in a fiat currency system may seem counterintuitive to traditional wealth preservation, it serves as a key mechanism in modern economic management. Understanding and adapting to its effects is crucial for navigating the complexities of financial planning and economic stability.