Last week on CNBC's "The Kudlow Report" there was a thrilling debate over inflation between Alan Blinder and Arthur Laffer. Mr. Laffer (former member of Reagan's Economic Policy Advisory Board) encapsulated his position that we need to fear the return of inflation by simply stating that "...if you have a huge increase the supply of apples, the price of apples falls." While Mr. Blinder (former Vice Chairman of the Board of Governors of the Federal Reserve System) responded by stating, "If people suddenly want to hoard apples and the apple suppliers provide a lot of apples, you're not going to have inflation of apple prices."

The pertinent analogy being; if the monetary base grows, the supply of money increases and its value falls (inflationary). While the other contention being, if banks don't want to lend money there would merely be a pile up of excess reserves and the increased supply of bank credit would not lead to an increase in money circulating within the economy (non inflationary).

Now I would like to weigh in on this debate. Whenever there is a well promulgated increase in the supply of a commodity (especially currency) it does not have to pervade throughout the economy in order to have its value attenuated. To prove this let's look at what happened to the level of the Monetary base and its affect on the price of gold and the US dollar.

At the end of August 2008, the monetary base began its record-setting expansion from the $842 billion level to its $1.8 trillion peak in May of 2009. In fact, by January 2009 the base had already made the majority of its move, as it exploded to $1.7 trillion. How did the price of gold react to this monetary expansion?

The dollar price of gold increased from just under $840 an ounce to $980 from the end of August 2008 thru the end of May 2009 time frame. That means gold rose over 16% while the US dollar declined just over 14% against the yellow metal.

Mr. Blinder may claim that it is merely a coincidence that gold moved up sharply when the monetary base expanded, because the money was not loaned into the economy. But I will explain why the moves are directly correlated.

An increase in the monetary base is much the same as a huge discovery in a commodity. Let's say there was a major oil discovery in the Gulf of Mexico that was very easily accessible and doubled the existing proven reserves. No one would argue that the price of oil would not react negatively. The price would drop instantly upon the announcement as traders and investors began to factor in the imminent increased supply. The majority of the price decline may not occur until all the oil was drilled and available for consumption. But as long as there was a high probability that the discovered oil would soon hit the market, the price should drop.

It's the same with a buildup in the monetary base. The increased bank reserves account for a latent huge increase in monetary velocity and inflation. Although a huge increase in inflation levels should not occur until the base money was loaned into existence and pervaded through the economy, the value of the dollar would drop in anticipation of that fact. The Fed has now availed banks of a doubling in high powered money and until it is removed the potential for massive inflation exists. In light of that fact, investors have taken down the value of the dollar against gold and most hard assets.

To make matters worse, unlike commodities all fiat currencies have virtually zero intrinsic value, so their worth rests completely on the scarcity of its supply. Therefore a doubling in M2 money supply should lower its purchasing power by 50%, whereas a doubling in apple supplies would not cut their price by half.

Not only was Mr. Blinder wrong about inflation but he was also incorrect when he conveyed complete confidence in Ben Bernanke's ability to remove the excess liquidity before inflation becomes a problem. Mr. Laffer and I argue that it would be politically and economically devastating for the Fed to dump $800 billion of Treasuries in addition to the $3.25 trillion they must sell in fiscal 2009. And, speaking for myself, I believe the Fed needs to worry less about politics and more about providing long term support for our currency.

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