Some concepts I can explain to my 9-year old son, Calvin, but economists with advanced degrees seem not to get it. Calvin, named after my favorite ballplayer (Cal Ripken, though my wife hates it when I say that. “We didn’t name him after Cal Ripken, we just liked the name!”), wanted to know how the dollar lost value over time. He wanted to know why things got more expensive over time.

I explained it very simply. He likes to play this card game in which the players get different creatures and each of them has certain abilities. I explained to him how he valued certain cards highly because they are rare and hard to get. If the cards were easy to get and common, then they would be less valuable. This he understood.

So I told him that dollars work the same way. As the government prints more of them, they become less special. They buy less. We call this inflation.

Today, the Federal Reserve is laying the groundwork for massive inflation. “Over the past year,” Grant’s Interest Rate Observer notes, “the central bank’s balance sheet has grown by 133%. It was only yesterday when annual growth of 13% seemed aggressive, if not reckless, and certainly inflationary. Ten times that aggressive-if-not-reckless-and-certainly-inflationary rate of expansion is a fact that takes some getting used to.”

Over the last three months, Federal Reserve Bank credit is up 1,560%, reports Grant’s. It was only in September that the Fed’s balance sheet crossed $1 trillion for the first time. On Nov. 5, it scooted past $2 trillion. By year-end, says the president of the Federal Reserve Bank of Dallas, it could slide right on past $3 trillion. Our Federal Reserve seems hellbent on making Argentina look like Switzerland in terms of monetary restraint.

Why is this ballooning balance sheet inflationary? The Federal Reserve increases its assets by buying stuff — financial assets of banks and others. The Federal Reserve pays for these assets by creating money that did not exist before. That’s it. Simple as pie.

Of course, our government is not acting alone. Central banks across the globe are doing the same thing, if with somewhat lesser vigor, at the moment.

In any event, it means paper money will buy less. We may see nominal prices — for oil and gold and metals — continue to fall in the short term, but long term, I think we’re set up for some huge reflation in 2009.

Best Regards,
Chris Mayer
November 20, 2008

Chris Mayer

Chris Mayer studied finance at the University of Maryland, graduating magna cum laude. He went on to earn his MBA while embarking on a decade-long career in corporate banking. Chris is the editor of Capital and Crisis and Mayer’s Special Situations, a monthly report that unearths unique and unconventional opportunities in smaller-cap stocks. In 2008, Chris authored Invest Like a Dealmaker: Secrets From a Former Banking Insider.

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