Almanzo, Pink Lemonade, and Piglets - causes of inflation, Q2 2021

The year was 1866. Almanzo and his family were enjoying a rare break from farm work and celebrating Independence Day in their local town of Malone, in upstate New York. James Wilder, Almanzo’s Father, was 52 years old. The civil war has recently ravaged the country, and Abraham Lincoln was assassinated just last year. Upstate New York was a place of deep Puritan piety, strong abolitionist persuasion, and work ethic perhaps unmatched anywhere in the world at the time. The pride in country and unshakable values of a farmer in this time and place cannot be overstated.

In this context, Almanzo asks his father a seemingly innocuous question. “May I have a nickel?” But the question is loaded, given that Almanzo has never had a nickel of his own in his young life. James Wilder had been talking to Mr. Paddock, the wagon maker, who would later offer Almanzo a job. Almanzo had joined his friends at the town pump when his cousin Frank began boasting about the nickel he had from his father, and how he’d spent it at the pink lemonade stand nearby. Almanzo said he could have a nickel too if he asked his father, which immediately led to a dare from Frank. Almanzo had no choice but to go ask his father for a nickel.

The most likely answer from Father would have been a simple “no”, in which case Almanzo would have been embarrassed in front of his friends, and the event would likely never have been recorded to history. However, James Wilder is keen to teach his sons valuable lessons in life, and this presented a perfect opportunity to do so. The conversation with Mr. Paddock would have to wait.

James Wilder was a conservative man. Born in 1813, the same year that Napoleon was removed from power for the first time, he grew up in a strict pietistic structure that almost no one today, even in very conservative settings, can imagine. He was a man given to sober thought, and although the agricultural and industrial revolution were in full swing, he was still of the opinion that labor saving devices were mostly counterproductive. Idleness and waste are not sins he’s ever indulged in, nor will he tolerate it in his boys. But every boy needs to learn, and the question today is not about the new thrashing machines available, nor is he talking to a boy who doesn’t know how to work. Among other things, the Wilder family grew potatoes as a cash crop. James Wilder thought the going price of a half dollar for a half bushel of potatoes would provide an excellent illustration for the lesson at hand. Mr. Paddock thought Almanzo too young for a lesson about money and said so. But James thought that Almanzo could easily understand how much work goes into a half dollar. Why wouldn’t he? The boy had helped with every step of the potato growing process. No, the question was not of work, nor of the money itself. It was about pink lemonade, and that is a thing to consider.

Almanzo himself did not understand the nature of the question. He didn’t want the lemonade nearly bad enough to ask his Father for a nickel, but there was that dare, and a boy needs to take a risk sometimes. But his father did understand the question, and he considered it to be a matter of immediate versus deferred consumption. It’s not that pink lemonade is such a bad thing. But would it be better to spend the only nickel you’ve ever had on instant gratification, or to spend 100th of your wealth on it after you’ve raised a litter of pigs? Could the nine-year-old in front of him understand a concept like that? He didn’t know for sure, but Mr. Paddock was needling him, and a man needs to take a risk sometimes. So, he gave Almanzo ten times what he’d asked for, and the rest is history.

Move forward 155 years, and we still love the story. We love that father took the time to gift his son a lesson in a teachable moment. We love that Almanzo did the right thing and bought a good little sucking pig. And we love that he won his dare. But have we lost the lesson?

Almanzo in his lifetime saw vast changes in the use of money. At the time of the story mentioned here, money to Almanzo and most of the rest of the civilized world was a collective and interchangeable term for silver or gold. There were paper substitutes, but they were always tied to a specific equivalent in precious metals, and most people traded goods or services in the real deal – silver coinage.

When Almanzo was 22 years old, the United States adopted a gold standard. In a sense, the government was only making official what was already universally accepted as money. But there was an additional benefit. The government also issued paper certificates for gold which were matched by government stores of real gold. Anyone holding a certificate was considered a creditor to the government, and his paper certificate was exchangeable at any bank for the actual commodity. This had the advantage of making trade more efficient, since paper certificates were easier to store and transport than the metal they were substituting.

Only 54 years later, when Almanzo was 76 years old, Congress enacted laws that effectively took the US off the gold standard. All gold certificates and coinage were to be turned in to the government in exchange for dollars. These were different than the certificates they replaced. These dollars were still guaranteed by the government to be backed by a fixed amount of gold. But there were a couple key differences. First and most importantly – the individual did not own the underlying asset anymore, the government did. Two – there was no built-in way for a private individual or institution to hold the government accountable to its own standard. How would people know whether their paper dollars were actually backed by real gold? Under the previous system, the agencies responsible for issuing paper substitutes had to strictly limit what was in circulation to the amount of gold on deposit since anyone could demand their paper be exchanged with real gold at any time. Under the new system, it was actually illegal to own gold, and the individual could not ask that his dollars be exchanged for the gold that supposedly backed it. Under the previous system, during times of stress or hardship, many people did just that.

Under the previous system, Rapid money supply inflation (printing money) was impossible and therefore unknown. The government could not simply print more money as is common today, for the reason stated above. Price inflation only happened as a result of fluctuations in supply and demand, never as a result of money supply expansion. As an example, pink lemonade at 5 cents in 1866 was quite expensive compared to what else you could buy for the same 5 cents at the time. But that was strictly a function of rarity. Lemons were expensive to import via canal, rail, or road, so if you wanted it, you had to pay for it. But the price of lemonade had little to do with actual money supply.

Surprisingly, the government requiring everyone to hand in their gold in exchange for dollars met little resistance. America was in the Great Depression. Franklin D. Roosevelt, a Democrat, was the new president promising he could alleviate the suffering with his famous “new deal”. The problem was that his new deal required the federal government to inject large amounts of money into the economy in order to jolt it back to life. And the problem with that was that it was impossible to do so under the current monetary system without raising taxes. But FDR was confident he could change that system. It had already been done in Europe, and he thought people were ready for change. Turned out he was right. During his first year in office, the president and a cooperative Congress upended a system that had essentially been in place for all of Almanzo’s lifetime and for long before that. And the people complied by turning in all their gold coinage and certificates. The amount was eye watering – to the combined tune of $770 million dollars.

In theory, this had several advantages. People were more likely to spend dollars as opposed to hoarding gold and its substitutes, which would stimulate economic activity. Since the Federal Government now owned the underlying asset, it was free to leverage it in any way it saw fit for the best outcome which gave them far greater negotiating power both domestically and in foreign policy. Actors on the world stage, both commercial and governmental, were on notice. In retrospect, no one is surprised it wasn’t enough. But the stage was set for unhitching the unwieldy wagon of gold from the eager horse that was monetary inflation. And so, just one year later, in 1934 the Federal Reserve unilaterally raised the price of gold to $35/oz from $20.67. In one stroke, all the dollars that citizens had received a year earlier in exchange for their gold were devalued by a whopping 69%.

Conversely, the government immediately had 69% more value in nominal terms on the gold it had collected. The $770 million of yesterday was now worth an additional $531 million, which could immediately be deployed into the economy. If anyone was expecting a revolt, there was none. The rich could afford the hit and were eager to explore their new roles in an exciting new dollar-based system. The poor were just glad there were government supplied jobs available.

And it worked. FDR’s success in carrying out his plan was eagerly ratified in three subsequent elections. But if Almanzo, who at 77 was over two decades older than his father had been when he paused to teach him about economics, was minded to remember that lesson, he likely saw the writing on the wall. In 1971, just 22 years after Almanzo died, the US abandoned all pretense of a gold standard when Richard Nixon, a Republican, announced that the United States would no longer convert dollars to gold at a fixed value. It was a curiously bipartisan final act in a play set in motion by his predecessor in 1933.

But what about James Wilder? What about what he said all the way back in 1866? Is all that work still contained in a half dollar? How does the value of money today compare to that era?

What we will shortly discover is that James’ statement about the interchangeable value of work and money was based on the presupposition of the money itself being stable in value. Precious metals derive their value from three intrinsic qualities. 1. They are useful. There are many industrial applications for metals such as gold, silver, or copper. 2. They are rare. Air, dirt, or water are valuable to us, but are not suitable for use as money because they are so plentiful. 3. They require energy to extract. No one wants to work for free, so if you want some of that pretty metal, you will need to pay someone for the work of digging it out of the ground and refining it. And because precious metals are also dense in mass, they historically became the natural way to store wealth in a small space. The fact that they degrade slowly adds to the appeal. Pink lemonade and pigs are both valuable but come up short as a medium of value exchange or storage. A pig does not sit quietly on a shelf, and lemonade has a way of losing its flavor over the course of years. Hence, precious metals, in coinage or its substitute paper, have a long history of being used as money, and of having stable value. Since it requires much effort to extract, refine, and mint a coin, one cannot separate a silver coin from the cost of replicating it, therefore it contains within itself the properties representing a man’s work. James Wilder understood work and money to be interchangeable.

Yet last week I received a check from the Federal government. The only work I did relative to that money was to open and deposit it. In 2021, the US as a nation is conducting an experiment on a massive scale. We are exploring a question: Is it possible to decouple money from productivity? I have a feeling Almanzo would have taken his stimulus check and bought a horse.

The experiment has really been ongoing since 1933. Like the proverbial frog in hot water, people have been going about their business without giving a lot of thot to the steady erosion of the value of their money. While the price of potatoes might vary, everyone knows you can’t buy a half bushel for anywhere near 50 cents today. Yet few people stop to ask why. Perhaps they’re too busy. Perhaps it’s too hard to think about the implications. Or perhaps the simultaneous rise in living standards has camouflaged the effects. Whatever the reason, it may be possible that we are much closer to a precipice than we realize. 2021’s inflation taking off may be a warning to the poor frog.

The Federal Reserve is the central bank of the United States and holds vast amounts of responsibility as it relates to monetary policy. The bank was established as a nonpolitical institution in 1913 and given two mandates as it relates to the US economy: 1. Pursue full employment. 2. Pursue stable prices (i.e., contain inflation). To my knowledge no one ever told them which order to pursue them in, or as is the case today, how to proceed when those two mandates become mutually exclusive.

Historically, a small amount of price inflation has been considered healthy, as a beneficial tradeoff for an energetic economy. Interest rates that fluctuate with the demand for capital (money for business investment) were seen as the regulating and offsetting factor.

But there are many other factors at play. When interest rates rise, capital becomes more expensive to deploy, and businesses want to pay less for labor. But with minimum wage laws providing a floor on wages for workers, this is not always possible, and the alternative for businesses is to either lay off workers or suspend hiring. This causes unemployment to rise, which is of direct concern to the conscientious folks at the Federal Reserve who want to fulfill the first of their two mandates. And while the Federal Reserve Bank is nonpolitical, the elected officials who appoint the federal reserve staff to their stations are anything but. High unemployment that is not dealt with may result in an unwanted career change for all parties involved, so something must be done. What to do? The most direct route from low employment numbers to high is to fiddle with interest rates. And fiddle they do. The Federal Reserve has various mechanisms for influencing interest rates in the marketplace. But all of them tend to produce the same result. Inflation.

When interest rates are artificially influenced by the Fed, there is only one sensible thing for any business to do, and that is to restructure their business models to reflect the lower rates. After all, no one is going to borrow at any higher rate than necessary, because to do so would cause them to lose some of their competitive edge in the marketplace. And lower interest rates translate directly to companies being able to assume more risk. A company can simply take on larger and larger amounts of debt as interest rates drop. All this borrowing and deploying of capital has a wonderful effect on the economy, and on employment numbers, which certainly helps those in DC with their retirement plans. But it also drives another engine. Have I mentioned inflation?

Inflation, as it turns out, is the unwanted cousin at the family reunion. And like him, he always shows up. Also like him, as long as there is free food to feast on, he won’t go away, and he just sits there and gets fatter.

Inflation itself is a hard thing to get our minds around, because it can take so many forms, and everyone has their own name for the different forms. The most understood form is price inflation, which is just what it sounds like – prices for goods and services go up. But there are more cousins at this party. There is equity inflation which causes stock markets to soar even when the companies represented by those stocks are not profitable. There is asset inflation which might explain the price of gas suddenly rising even though there are not more people buying gas. There are other forms that involve foreign entities buying stocks or bonds that are even harder to understand. And finally, there is monetary inflation, the quietest and sleaziest of all the cousins, whereby the Fed simply “prints” money to inject into the economy. And because he is so quiet, few people realize he is actually the instigator of all the other forms.

This money has traditionally been funneled to financial institutions, who in turn were incentivized to loan it to businesses and individuals. For a business or individual, cash on hand is an asset. For a bank, it’s a liability unless it’s deployed. So, they want that money out there working. However, in an ultra-low interest environment such as we have now, those loans become more and more risky, since banks need to extend themselves further and further out the risk curve in order to deploy all the capital on hand. At some point the desire to deploy capital is offset by raw fear that all these risky loans are going to go bad on them, and banks begin to collectively pull in their horns and sit on cash, liability or no. This is known as “credit tightening” and usually happens too late to do anyone any good. But when it does happen, the Fed has a problem. Now they are printing money that is not being deployed. Such was the case late in the Trump administration and is ongoing today.

What to do? The answer is obvious. Deploy the cash directly to the individuals. And that, my friend, is why you are getting money in the mail that you did not work for.

It’s becoming increasingly obvious that the result of monetary inflation is price inflation. By careful observation we can understand, just as Almanzo could have in 1866, that if there is more and more supply of money, without a corresponding increase in productivity, the prices of goods and services must necessarily go up. If our money is not in finite supply, then we might as well use air or water as our medium of exchange. And what would the price of a half bushel of potatoes be if it were priced in air?

Imagine for a moment what would have happened if James Wilder, instead of giving a half dollar to Almanzo to invest, had announced to all the boys in town that he was going to hand out nickels to every one of them, on the hour, for the rest of the day. Since the boys, being boys, knew they didn’t have to expend any effort for the reward they were receiving, they would likely have turned that gift into immediate consumption. The local “economy” would have suddenly gotten very “hot”. The lemonade man would have quickly figured out there wouldn’t be enough lemonade to go around and would have immediately raised his price to 50 cents. The man selling suckling pigs would have raised to $5, and so on. Without a corresponding increase in productivity, demand in that example economy has risen without any increase in the supply. The only way to compensate for this lack of equilibrium is to raise prices.

This is exactly what is happening before our eyes. Ask yourself how it is possible that unemployment numbers are going up while every employer in the country, almost without exception, is desperate for good help? How is it that the grocery bill keeps going higher without any obvious reason? Are there significantly more people than last year? Is there less food to buy? Or could it be that there is simply more money floating around competing for the same amount of goods? For you see, fewer people willing to work (produce), coupled with those same people having more money, can only have one effect on the price of things you and I need to buy. The long-term effects of so many people being happy to collect their check, buy lemonade, and sit on the porch cannot be good. The Bible has a name for that behavior. It’s called “disorderly”. “For we hear that there are some which walk among you disorderly, working not at all, but are busybodies. Now them that are such we command and exhort by our Lord Jesus Christ, that with quietness they work, and eat their own bread.” (II Thessalonians 3:11-12)

We might do well to get out that old copy of Farmer Boy by Laura Ingalls Wilder, sit down and read it, and relearn the principles that James Wilder taught so well.

From the team at Arrow Services