After having an inflation rate averaging near to zero during the gold standard, and dating back to the inception of the United States, the march towards a statutory zero-inflation-rate target in the country began with the march into Vietnam. This war arose from the tensions stemming from the First and Second World Wars. In the Korean War the United States had continued its long rivalry by fighting directly against China, and then it confronted the Soviet Union in the decades-long Cold War. The Vietnam War perpetuated these conflicts, with the United States fighting both Chinese and Soviet military assets across southeast Asia.

Inflation was high during both the First and Second World Wars. It rose again during the Korean War. It comes as no surprise that the subsequent Vietnam War once more involved high inflation for the United States. How do wars cause inflation?

The answer is short and simple: the government finances the war by printing money. To understand how the printing of money covers government budget deficits during wartime, we need to investigate the “monetary regime” that exists at the time of war. US history provides ample opportunity to demonstrate the effect of war on inflation, and the effect of the US involvement in the Vietnam War precipitated an inflection point in the world's monetary regime history.

The first US war-induced inflation took place even before the Constitution was enacted. The American Revolutionary War and the Articles of Confederation led to money printing to finance that war, because the US federal government had no power to raise taxes. The Continental currency became worthless, the monetary regime collapsed and the United States was forced to default on its debt. As Peter Bernholz (2016: 55) writes: “During the American War of Independence against Britain the war efforts of the emerging United States were to a large degree financed by issuing a new paper money, the Continental Currency.”

Bernholz attributes this to the inability of the confederated states to raise taxes or offer such financial help. Bernholz plots (2016: 56, fig. 4.4) a price index that has been computed for that period, along with the stock of Continental currency and the currency price of gold.

My namesake ancestor emigrated to New York to become a US citizen in 1900. His Austrian heritage stimulated my interest in the academic life of his birthplace, from where modern economics arose. He was born in Austria prior to the First World War a decade before Carl Menger became a professor of economics at the University of Vienna in 1873. Menger founded the Austrian School of Economics. His German-language Principles of Economics (1871) showed how people's utility went down for each additional good that they received. With this decreasing (“marginal utility”) value per additional good, he laid the basis for why the price we would pay, per unit of the good, would be lower in markets as the quantity demanded of the good was higher. Menger thereby gave us a downward-sloping demand curve – revolutionary at the time.

This first foundation of the downward-sloping demand curve appeared in the same year in English with William Stanley Jevons's Theory of Political Economy (1871), and then again, in French, with Léon Walras's Elements of Pure Economics (1874). Suddenly, demand was conceived as opposing supply and providing an equilibrium that yielded the basis of value theory, or “price theory”. This theory is still the foundation today of how markets determine equilibrium at the “market-clearing” price, which equates the quantity supplied to the quantity demanded. It laid the first microfoundations of macroeconomics. I learned about this evolution of macroeconomics through independent study of the history of economic thought with Professor Daniel Fusfeld at the University of Michigan, and with Professor George Stigler (Nobel laureate 1982) in graduate school, focusing on Adam Smith's work.

Austrian economics thereby began as an innovation in economics, which had focused till then on determining price only through the firm's cost of production – the “labour theory of value”, in Marxian economics – to a balancing of price from firms and consumers alike. Austrian professors provided the concept of deriving market prices by considering scarcity as it affects both the cost of production by firms on the supply side and the demand for the good from the household “consumer” side.

The inflation tax is caused by central banks financing government deficit spending. Inflation rose in the United States at such an increased pace during the Vietnam War that it broke the gold standard and caused a trend inflation rate above the zero trend of historic metallic regimes. The higher inflation trend of the fiat era put in place fluctuations in positive inflation instead of the more volatile price level changes of the metallic standards, with inflation during war and deflation after war.

The bank panics of the nineteenth century and the Great Depression brought about the establishment of the Fed and the FDIC. Today the inflation rate is tied closely by Fed policy to the threat of bank panics for those outside the FDIC. As the Fed buys Treasury debt and mortgage-backed securities, pays Treasury seigniorage to the private banking sector, prohibits positive real interest in money markets, suppresses inflation by keeping the newly printed money as reserves and attempts to provide sufficient liquidity for an ever more sprawling financial system, discerning the link between money and inflation is a challenge.

Although it has been said that inflation is no longer tied to the money supply, in fact the conflation of money and banking policy by the Fed simply makes the connection harder to uncover. The problem is not with the quantity theory of money. It has long shown the common sense of how the aggregate price level rises in tandem with the money supply.

There are important nuances. The price level rises more rapidly than the money supply because higher inflation rates normally increase interest rates and lower real money demand. And increases in economic growth can lower inflation, as more money supply is demanded for growth.

But the 2021 inflation increase had been declared by Ip (2021) as a “bout of inflation that defies old models”. Supposedly this inflation episode cannot be explained by the centuries-old quantity theory. “Modern monetary theory” declares the quantity theory of money to be dead. Nonetheless, it omits, or does not seek to understand, that the increase in money by the Fed was sterilized by the Fed's surge in excess reserves after 2008, which was enabled by its paying interest on excess reserves

As either coinage or paper, the history of metallic-based monetary regimes shows that such money remains convertible to its respective metal until it is debased too far. The issuance of paper money can herald the beginning of debasement. Money lives on as a means of exchange when its value is stable or declining at an acceptable rate. Its second life occurs when people begin to stop using the money and seek alternative means of exchange at a rapid rate. Substituting a nation's unstable currency for another nation's more stable currency can lead to increasingly high inflation, or even hyperinflation. This second phase bodes the end of the life of the currency, when its practical use for exchange diminishes.

Once people anticipate that a monetary regime is nearing collapse, its money becomes increasingly worthless. This hastens the end of the regime and increases the speed at which the system collapses. The only positive action becomes ending the monetary regime and establishing a new one that citizens respect and accept as a means of exchange.

During this life cycle of money, monetary regimes continue to evolve. The common thread is that, whenever the government supplies a stable form of money, it yields revenue for the government Treasury as long as the economy grows. A stable money with a growing economy in turn means a growing demand for the stable money, and an economy grows more readily when the price level is stable. To achieve a stable price level with a growing demand for the money, a government debases the money at the rate of growth of the economy and reaps the revenue from the debasement. This is the original meaning of natural seigniorage.

When a government begins to debase the money at a faster rate than the economy is growing, the price level in terms of the money begins rising, causing inflation. People tolerate moderate inflation, albeit with a decreased demand for the money in real terms. Deflating the money by dividing the stock of money by the price level gives the real money stock. This real money falls as the price of holding money rises. The inflation rate, plus the real return on capital, constitute the price of holding money instead of investing it.

Like gold, diamonds last forever, and often experience similar price fluctuations to gold. These price changes are, in turn, like those of oil, which is also drawn from limited ground-based reserves. The ups and downs of the dollar prices of diamonds, gold and oil tend to follow each other rather closely during periods of accelerated US money supply growth. These co-movements help give insight into an ongoing puzzle about the relationship between oil prices and inflation.

One theory posits that oil prices are relative price changes that cause inflation. Another says the causality is the opposite: that inflation and the expectation of inflation cause oil price increases, and that both are, in turn, caused by the growth rate of the money supply.

In the 1960s and 1970s a popular theory circulated that inflation was not caused by money at all, and that theory has reared its head again, as oil prices and inflation have both risen during the ongoing Covid-19 pandemic and, now, with Putin's war on Ukraine as the pandemic subsides. The oil price theory of inflation is that oil prices are increased by monopolistic “price-gouging” behaviour on the part of the suppliers of oil. The origin of the idea was that oil suppliers are able to form a monopoly, so that they become the only suppliers of oil and therefore are able to dictate a monopolist world price of oil that maximizes their profit.

The monopoly was said to be the Organization of the Petroleum Exporting Countries (OPEC). In September 1960 OPEC began as a group of five nations trying to coordinate new oil production. Prices for a barrel of oil were denominated in US dollars, while the Bretton Woods monetary regime locked the US dollar price for an ounce of gold at $35.

The choice of using US dollars per barrel enabled the price of oil to remain stable as long as the gold standard lasted. The dollar oil price from the start of OPEC until the breakdown of the Bretton Woods system fluctuated very little, keeping at a near-constant $3 dollars a barrel from June 1953 to November 1970.

The spectre at the feast manifests in Shakespeare's Macbeth as the ghost of Banquo. A former ally whose progeny is prophesized to become king, Banquo is murdered by Macbeth's men. Banquo's apparition then appears at the feast, seated in Macbeth's chair and seen only by the orchestrator of his murder, who goes mad, bringing the festivities to a premature end.

Modern events can mirror such tales when those obsessed with power do anything to hold onto it. The spectre of inflation has loomed historically as a threat to civilized economic exchange whenever wars or crises have induced high government spending deficits, with tax revenue falling well short of expenditure. Rising inflation is destructive and is caused by government agents clinging to their discretionary power by printing money at increasing rates. Such inflation threatens to fell any economy in which a government incurs high budget deficits. When inflation rears its head, it wipes out the gains in income and wealth that growing economies foster.

Once government deficits become too high, potential future inflation threatens money's value. Inflation had, until recently, been moderate and well contained by monetary authorities (namely central banks). This required the conditions of international peace and fiscal restraint by governments so that central banks were not pressured to finance wartime or crisis spending through the purchase of government Treasury debt and by giving fresh money to governments to spend. When fiscal restraint is broken, central banks typically help finance spending, with the result that inflation either rises or is suppressed – with even worse consequences.

Restraint on the part of central banks is designed to ensure money value through low or no inflation. When low inflation rate targeting became a widespread policy internationally, central banks had clear objectives that everyone could measure and consider in judging their policy success. But, ever since the terrorist attacks of 2001, the US government has run unending and rising deficits as a share of national output. The central bank of the United States, the Federal Reserve System, in turn financed a large portion of this rising deficit by buying Treasury debt, which is how central banks “print money”.

Central banks conduct monetary policy for their governments and have oversight of the private bank system. Central banks evolved from private banking. The development of private banking hinged on how interest came to be a normal return on capital. It has a complex history, because religion has imbued interest with questionable morality. The main problem was that a lack of good regulation allowed “usurious” rates of interest to be charged that were considered too high.

For the first two centuries BC, Ancient Indian, Vedic, Sutra and Jatakas texts referred to usury as interest in a negative way. Religions and governments restricted or banned interest. Julius Caesar imposed interest rate ceilings, and in 349 AD all interest was banned in Rome. Pope Clement V banned interest in 1311 for Christianity. Judaism disallowed some forms of interest but was lax in regulating interest payments. Islamic law continues to ban interest to this day (Visser & McIntosh 1998).

Stable money during the Renaissance allowed private banking to flourish. This required innovative ways to avoid the prohibition on usury. Although the payment of interest was at first concealed, its use broadened steadily in ways that led to modern banking. In the fourteenth century the Genoese city state government borrowed money, creating public debt. The funding for such loans was provided by the private investors who helped build Genoa as a centre for transportation and trade. But, with the charging of interest prohibited by the Catholic Church, they resorted to indirect means for obtaining interest for loans.

A way to receive interest developed through the sale of “bills of exchange” between international branches of the same bank. The exchange of bills (debt owed by an entity) allowed them to be redeemed in a different currency in a different country for a set amount after a certain time, such as three months. Then the redemption was transferred back to the original branch, with the exchange amounts specified in the other country's currency such that a larger transfer was returned to the original branch than had left it. This incremental income acted as the interest payment for the length of the transaction.

In the Goldfinger movie of 1964, as based on Ian Fleming's 1959 book, the eponymous Goldfinger accumulates as much gold as possible for “50 years” and then attempts to render the US Fort Knox gold stock radioactive. With the Fort Knox gold reserve unable to circulate, the idea is that the value of the remaining gold stock should increase dramatically. This would be the result of an act of terrorism (“economic chaos in the West”) to enhance Goldfinger's personal wealth.

Although this might bring to mind the real and equally fiendish efforts by Russia's president, Vladimir Putin, to monopolize oil and gas wealth, consider the question of whether the act of making radioactive the gold in Fort Knox would devalue that gold at all. If everyone respected that the United States had the same amount of gold before and after Fort Knox became radioactive, then the price of gold would be unaffected. The gold would still be in Fort Knox, and it would still be valued at the international price of gold.

Friedman (1994) tells the story of Yap, an island in Micronesia that during the twentieth century used stone wheels (“fei”) for money hewn from limestone rock on an island 400 miles away. One large wheel had been made for an islander and was being delivered by boat; the boat capsized, and the wheel sank to the bottom. The islanders acknowledged that the islander owned the wheel in the sea and gave monetary credit against the value of that wheel even though it could not be retrieved.

The stone wheel story illustrates how an asset's value holds, even if it is not in circulation. The world may be less trusting than the people of Yap, however. It might not respect the US ownership of the Fort Knox gold if it was radioactive, which, like the Yap stone, could no longer circulate. If not, then this would effectively decrease the quantity of the gold from the rest of the world stock of gold. The decrease in the gold supply would make the remaining gold more valuable, as Goldfinger envisaged.

A decrease in gold, as in Goldfinger's scheme and Friedman's sinking of a stone near Yap, actually occurred in the United States when the SS Central America, or “the Ship of Gold”, sank in September 1857 with thousands of pounds of gold that New York bankers were awaiting.

Central banks faced a dilemma after the 2008 debacle over how to keep the global financial system from the type of broad financial collapse experienced in the Great Depression. The prolonged US negative real interest rates after 2001 set the tone for the globalized capital markets. As they did during the Vietnam War, countries responded after 2008 by following US-centric negative real interest policy.

Bretton Woods members supported the United States during the Vietnam War by buying up the US dollars used to finance it. This stabilized the fixed exchange rates of the Bretton Woods era with the US fixed price of gold. After 2008 democratic, globally integrated countries around the world followed US real interest rate policy to stabilize the floating exchange rates of the fiat era.

International central banking innovated policy to mimic the United States on real interest rates. By maintaining the same real interest rates, exchange rates could remain stable. If real interest rates were higher in a country than in the United States, capital would flow into that country and cause its currency to appreciate.

Countries followed US real interest rate policy across both developed and emerging markets. For example, China followed the US policy until 2014, after which it disengaged from the democratic capital policies of the international financial system, while still holding trillions of dollars of US debt (Csabafi, Gillman & Naraidoo 2019). Other international central banks had to react quickly to induce negative real short-term interest rates so as to avoid currency appreciation through capital arbitrage.

Arbitrage happens when, for example, capital savings can earn a real return of 2 per cent in a European market and only – 1.75 per cent in the US market. Then financial industry traders can move the capital from the United States to Europe to get the higher return on capital. Capital flowing into Europe would push down the return on capital in Europe. An equilibrium results whereby arbitrage possibilities are eliminated by equalizing the real return on capital, net of any arbitrage cost, across global capital markets.

Defining inflation was not always easy. Irving Fisher began this task in earnest in the early twentieth century. He organized the first meeting of the Econometric Society in 1930, was elected its first president and oversaw the first issue of the society's renowned Econometrica journal, which published the proceedings of its first meeting. The society's constitution was also published there, declaring that it was “for the advancement of economic theory in its relation to statistics and mathematics”.

Fisher had long been interested in price stability. He devised a statistical index that could be used to measure changes in the aggregate price level, called Fisher's (1921) “ideal” index. The next year he published a treatise on price indices, The Making of Index Numbers (1922), that included implementing the index to provide a historical sequence of data on the US price level during the high-inflation war years of 1914– 18.

The rate of change in the aggregate price level is the definition of the inflation rate. Fisher and others since him have applied this measure, or similar ones, to the US economy and shown how the index changes over time. This is typically presented as the rate of change at an annual rate.

This annual rate of inflation measures the change in the price index relative to a year ago. It is measured relative to the average price level over the current month compared to that average in the same month a year ago. Alternatively, the comparison can be to the average price level over the current quarter of a year relative to the average over the same quarter a year before. Equally, it simply can measure the percentage change in the index over a calendar year. This allows the calculation of an annual percentage change in the price level, as given from one month to the same month a year later, from one quarter to the same quarter a year later or on a calendar year basis.

Fisher showed how money changes in value in terms of the actual goods and services that people can buy with money. If you hold a dollar bill, then you can purchase one dollar's worth of goods.

Bad bank policy increases inflation rate volatility. Even worse bank policy causes inflation rates above market interest rates for decades. Savers suffer the consequences.

Without a comprehensive US bank insurance system throughout its history, except for that of the FDIC, Figure 4.3 shows that the US inflation rate was erratic with sharp fluctuations from 1774 to 1873, which marked the beginning of the gold standard. The US bank panics of the late 1880s experienced less inflation volatility until 1914, after which successive wars all coincided with highly volatile inflation rates. After the Balanced Growth and Employment Act of 1978 was passed, US inflation rate volatility decreased from 1983.

As capital markets developed after the civil war, private bank insurance began to shape itself through the clearing house system. After the failure of the Fed to provide similar insurance during the Great Depression, the FDIC was established, and the Fed maintained reserve requirements for banks, while mainly taking the role of financing fiscal deficits during war and crises through additional money creation.

The panic of 2008 revealed US complacency over bank policy. Financial market development saw increasing avoidance of both the deposit premium payment for the FDIC insurance and the reserve requirements of the Fed. Reserves in the Fed of 1 per cent of all commercial bank deposits in 2008 offered little support during the bank panic, and the banks experiencing panic were not covered by the FDIC.

In the good times, after inflation rate targeting took hold in 1983 up until 2008, the Fed entertained a “come as you are” party that left bank insurance policy in tatters. Its 2008 “macroprudential” banking policy launched a “Moonshot”, with the Fed newly hoarding excess reserves in a haphazard attempt at bank insurance policy for those outside the FDIC. As a result of excess reserves mounting up irregularly, rather than all being lent out as in previous history, the Fed temporarily shifted volatility from the inflation rate to capital markets.

This new volatility has been in the ascendant the entire time since the Fed's attempt to establish a bank insurance policy through excess reserves. The consequent capital market volatility affects the whole economy, deserving the “macro” part of the “macroprudential” moniker, but leaving “prudential” questionable at best.

Bagehot describes how the Bank of England should use its reserves to stem bank panics. His rule was to lend generously, at higher than existing market interest rates, to any bank needing reserves. This dictum is that the Bank should act as the lender of last resort. To do this the Bank needs to keep gold reserves both for the money supply and for some fraction of the deposits of the entire private banking system, such as an apprehension minimum of 37 per cent, in his example.

Bagehot says this minimum level is arbitrary, subject to change and something of an art to identify. But, regardless of the minimum fraction of reserves that are held in relation to deposit liabilities, the total reserves held are fewer than they might otherwise be because the Bank of England acts to pool all the reserves together. The Bank pools risk so that it can direct reserves to banks in sudden need, so each private bank's reserves that are held at the Bank are smaller than if there were no such central bank, as in France and the United States at the time. Speaking of the joint-stock banks, Bagehot (1873: 107) says: “Not only did they keep their reserve from the beginning at the Bank of England, but they did not keep so much reserve as they would have kept if there had been no Bank of England.”

Therefore, the British system of banking circulated more capital than other countries. In contrast, the “natural” banking systems of France and America at the time were designed around each bank keeping sufficient reserves to ward off its own individual bank failure. This natural, traditional system is equivalent to self-insurance by each bank rather than the pooling of risks of reserve demands into a central bank, as the Bank of England did. Bagehot (1873: 107) writes: “I have tediously insisted that the natural system of banking is that of many banks keeping their own cash reserve, with the penalty of failure before them if they neglect it. I have shown that our system is that of a single bank keeping the whole reserve under no effectual penalty of failure. And yet I propose to retain that system, and only attempt to mend and palliate it.”

Federal Reserve officials supply regulations to help banks. Although the information is difficult to find in Fed minutes, just ten banks hold almost all the excess reserves of the Fed system. These ten banks were in receipt of the new interest on excess reserves that the Fed decided to pay them from 2008.

Excess reserves are those reserves that are over and above what is required to be held at the Federal Reserve. Traditionally, banks had tried to keep the exact amount of required reserves, due at the Fed each week, with zero excess. From the second quarter of 1984 to the second quarter of 2008 excess reserves averaged $1.3 billion, a minimum that could be feasibly achieved.

Once the Fed began paying IOER, excess reserves averaged $1.75 trillion from the third quarter of 2008 to the third quarter of 2020. That is more than a thousand-fold increase, going from billions to trillions of dollars. This happened even though the interest rate paid was very low, and below the inflation rate.

Figure 11.1 shows how excess reserves quickly built up at the Fed, rising from zero to $2.7 trillion by the third quarter of 2014. They began to trend down after that, until rising again during the Covid-19 pandemic till the excess reserve data series ended in 2020. Since then these “excess” reserves are now just called reserves, and shot up to above $4 trillion in 2021.

The data series on excess reserves ends in September 2020, when the Fed changed its reserve requirement to zero. Therefore, reserves could no longer be called “excess reserves”, since a reserve requirement no longer existed. In addition, the Fed's name of “interest on excess reserves” was officially changed in July 2021 to “interest on reserve balances” (IORB).

The Fed had required reserves for banks for over a century, from 1914 until 2020, with a continual decline in the requirement evident as banks avoided it. Feinman (1993: 570) describes how depository banks had to keep 10 per cent of reserves on “transaction deposits” that were viewed as being subject to immediate demand:

The Bank of England is located around the corner from Lombard Street in central London. When visitors walk in through the door, very few ever view the vault's gold, the value of which is second only to that of the Federal Reserve Bank of New York.

The United States also holds gold, in its US Mint depository at Fort Knox, made famous by the movie Goldfinger. Movies about gold made in the 1960s were filmed when the Bretton Woods system bound together the Western alliance in a US-based metallic gold monetary standard. The US gold backed the US dollar, just as the Bank of England's gold backed sterling after the Bank Charter Act of 1844, passed by the government headed by Sir Robert Peel, as described in Bagehot's Lombard Street (1873).

Once the Bretton Woods system had broken down, we might expect that the gold would be dispersed, and be used to finance normal spending by governments. In the United States, the Gold Reserve Act of 1934 required the Fed to transfer ownership of its gold to the US Treasury. The Treasury owns the gold in Fort Knox, issues US debt in order to borrow to cover deficits when its spending exceeds tax revenue and could sell the gold assets to cover some of the government deficits.

In the event, however, the main repositories of gold during the gold standard period retain much of the same gold today as they did when currency was redeemable in gold. Central bank gold stocks have not been sold off. They languish indefinitely in vaults at the cost of security and storage space, despite the paper-based fiat world in which we live.

The US Federal Reserve Bank of New York has the largest depository of gold in the world. The New York Fed holds only about 5 per cent of US Treasury gold, however, which in total is worth about $11 billion in 2018 prices. The rest of the gold is held for other countries.

The US Mint stores the remaining 95 per cent of US Treasury gold, weighing in at 8,133 metric tonnes.