“Inflation is taxation without legislation.”

— Milton Friedman

“I do not think it is an exaggeration to say history is largely a history of inflation, usually inflations engineered by governments for the gain of governments. “

— Friedrich August von Hayek

“Inflation is always and everywhere a monetary phenomenon.”

— Milton Friedman

“The most important thing to remember is that inflation is not an act of God, that inflation is not a catastrophe of the elements or a disease that comes like the plague. Inflation is a policy.”

— Ludwig von Mises

“How is the human race going to survive now that the cost of living has gone up two dollars a quart?”

— W. C. Fields

“I remember the $0.05 hamburger and a $0.40-per-hour minimum wage, so I’ve seen a tremendous amount of inflation in my lifetime. Did it ruin the investment climate? I think not.”

— Charlie Munger

“If increased government spending with borrowed or newly created money is a ‘stimulus,’ then the Weimar Republic should have been stimulated to unprecedented prosperity, instead of runaway inflation and widespread economic desperation that ultimately brought Adolf Hitler to power.”

— Thomas Sowell

Inflation. We generally think of “inflation” in terms of price inflation – prices for a given set of goods (food basket) or services (medical care procedure) going up with no corresponding increase in value or quantity. Economists think of inflation in terms of money supply – more money available to buy a given amount of goods and services. Who is right? Both of course.

With all due respect to economists, it is the price of goods and services that we normal folks buy each day that seems to be most important. A Big Mac from McDonald’s that cost about  $1.60 in the 1980’s now costs around $5.00 – for essentially the same Big Mac food product. That’s a price increase of more than 300%  in roughly 35 years. That’s an average price increase of around 9% a year. Who says we haven’t had much inflation in recent decades? Big Mac price inflation anyway.

Why do prices inflate?

It takes about the same amount of labor and Big Mac stuff to make the 1980’s Big Mac as the 2020 Big Mac. This means that the cost of Big Mac labor and the cost of Big Mac stuff have increased hugely over the past three decades. Average hourly wages in current dollars over the past 35 years have increased at an average rate of about 8% a year, depending on who you ask. Cost of the Big Mac stuff probably shows a similar growth rate. This means that our Big Mac purchasing power has been almost constant over this recent period.

So, the good news is that price inflation is being roughly matched by income growth. This is okay, yes? Big Mac-wise, at least. So, why all the fuss lately about inflation exploding?

Inflation data from the U.S. Bureau of Labor Statistics (BLS) comes in roughly two flavors: short-term and long-term. Short-term includes price changes from all kinds of transient situations – like floods, droughts, and minor wars – that give a much-too-sensitive picture for policy-making purposes. Long-term – called “core inflation” – excludes the most volatile components of consumption costs – food and energy. This core data supposedly gives a better picture of long-term price trends, such as the chart below:

Well, this is rather inconvenient, is it not? Core inflation has been declining gradually since the early 1980’s, dropping from roughly 5% annually to around 2% each year up to 2020. These years are still inflation, not deflation, but at a relatively low rate. Only in 2021, when it is rumored that some things happened, did core inflation jump to 5% a year. Back to 1985-90 levels? The horror!

The U.S. Federal Reserve Board (Fed) theoretically controls inflation by setting primary interest rates so as to keep inflation no greater than 2% annually. Seems like the Fed has been doing a pretty good job on this primary mandate over the past 25 years. Recent events have messed up this impressive long-term track record for, well, reasons. Like money supply, aka money printing. And shortages. And the Great Resignation. I have probably missed a whole bunch of other things.

Money supply and inflation do not appear to be correlated

There is much to-do these days about the government’s (Fed’s) money printing activities leading to “runaway inflation”. Is there any strong evidence of money supply increases leading to inflation in past? Well, no:

Source: https://www.longtermtrends.net/m2-money-supply-vs-inflation/

If anything, the chart seems to show an inverse relationship – money supply (black) goes up when inflation rate (red) goes down. Of course, it may be that the money supply effects don’t show up immediately in price indexes but have a 1-to-2-year lag. That works, yes?

In any case, growth in the M2 Money Supply – a measure of the amount of currency in circulation – seems to have been “relatively stable” (no huge jumps or drops) since about 1945. M2, which includes M1 (physical cash and checkable deposits) as well as “less liquid money”, such as saving bank accounts – has grown at about the rate of growth of the U.S. economy as a whole over quite long periods. This money supply growth may well explain the long-term inflation rate of about 2%. A growing economy needs a bit more money each year to function properly and to keep inflation low. About 2% more, roughly, so it appears.

Core inflation at a low rate therefore seems to be unavoidable in a slowly-but-steadily-growing economy. That’s pretty good news, right?

Inflation at around the core annual rate also seems necessary to keep prices in line with underlying costs. Both must grow (and fall) together under normal circumstances, based on what the economy is doing and how the Fed manages the supporting money supply. Possibly a well-oiled, self-adjusting machine, it seems.

So, all is well with inflation – until around 2020

With all going well for so long, you had to know that someone and/or something would eventually appear and mess things up severely. COVID qualifies as a serious something and government responses probably qualify as the someone in this context.

If so, the real question is whether we are dealing today with yet another inevitable but transient period of inflationary economic disruption, such as the double oil-shock years of 1973-1982, or something a lot more serious and long-term. Any bets?

Having made so far a fairly lightweight case for moderate (e.g., about 2% a year) inflation being both unavoidable and necessary in general, we are now facing the possibility of our current inflation blip – 2020-2021 vintage – being far more than a blip: one potentially very dangerous and long-term.

In a recent post on the Strauss-Howe’ Fourth Turning theory, the historical pattern over centuries points to the next few years or so – 2020 to 2030 – as being a very likely final “Crisis” phase of the roughly 80-year cycle of “Turning” phases. Having COVID and our so-far-damaging responses to it show up just as we may be entering a Crisis Turning period seems highly ominous, to say the least.

Some think that “lost in translation” applies here but it is actually a very valid caution for today

Systems dynamics makes the situation potentially much worse than just awful

There is yet another factor in all of this potential nastiness: the behavior of the severely disrupted global economy as a dynamic system. Systems theory looks at economies (and many other system structures) in terms of interaction loops that track flows and the impact of changes. There are two primary types of such “loops”:

  • Positive feedback loops enhance or amplify changes; this tends to move a system away from its equilibrium state and make it more unstable.
  • Negative feedback loops tend to dampen or buffer changes; this tends to hold a system to some equilibrium state, making it more stable.

Complex systems behave in even more complex ways, as you might expect:

Positive feedback loops can go into two directions: they can be either “exploding” or “imploding”. If only positive feedback mechanisms are governing a system’s dynamic behavior, this kind of positive loop is called “exploding”.

Negative feedback refers to a case where outputs from a system subsequently fed back into it minimize or reduce the effect of subsequent iterations. While technically incorrect, many people refer to a negative feedback loop as a self-perpetuating downward spiral where some initial bad event is compounded and made increasingly worse by the behaviors that result from the initial event. This is, however, an example of a positive feedback loop enhancing a negative outcome. You knew that, right?

World Finance in an article on markets and market behavior “Feedback Economics” offers this explanation that might help a bit:

“Most events in the economy can be explained, simply and elegantly, through positive and negative feedback. In some cases, positive feedback can only operate easily in one direction – being able, say, to cause a self-reinforcing increase in some variable, but not a self-reinforcing decrease. We see sustained trends as a result. Long-run economic growth is like this, with new technology leading to more economic output and this leading to more new technology; usually with no reverse process that causes technical know-how to disappear and output to decline. Something similar happens to inequality in economies with little or no redistribution: advantage in wealth leads to advantage in the marketplace and this, in turn, leads to further advantage in wealth, with no converse process arising naturally from the market to cause the gap to narrow.”

“In other settings, positive feedback can operate in either direction, causing either a self-reinforcing increase or a self-reinforcing decrease. In share and house prices, extravagant bubbles arise when people expect price rises to continue and dramatic busts occur when they expect price falls to continue. These phases, each driven by positive feedback, alternate with one another over time, with the other kind of feedback – negative feedback – usually being responsible for the turning points. This latter occurs, for example, when enough investors realize that price increases have gotten out of hand and begin selling, causing the market to turn.”

“Similar dynamics drive the ups and downs of unemployment and the alternating phases of inflation and deflation that are observed in market economies.”

You can’t predict the behavior of a complex system without looking at it from a systems dynamics viewpoint. This is where things can get really and permanently nasty: hyperinflation.

The systems dynamics version of this question is whether current events and situations are becoming an exploding (self-reinforcing) positive feedback loop. Two recent hyperinflation histories – Zimbabwe and Venezuela – are described briefly in the Related Reading section below as reference points.

Bad stuff happens — just getting enough cash for a brewski

What are the chances of hyperinflation occurring?

Hyperinflation appears to occur when a currency becomes largely worthless for any number of reasons – excessive money-printing, currency manipulation, wars, … . Such major causal events can generate an exploding positive feedback loop in which bad actions create and reinforce additional bad actions, making bad situations much worse. These can become impossible to reverse, as the Zimbabwe and Venezuela examples below illustrate.

Can this sort of hyperinflation thing happen in the U.S. as things stand today?

Jim Probasco writing in Investopedia describes hyperinflation against a backdrop of today’s relatively benign (so far, at least) inflation: “Are We Headed For A Hyperinflation?”:

“Hyperinflation, generally described as a series of rapid, excessive, and out-of-control price increases, is rare in developed countries. That’s because a true hyperinflation has to meet a high bar—an inflationary rate of 1,000% or more per year, according to most economists.”

“The U.S. Federal Reserve System (FRS) says an annual inflation rate of 2% is ‘most consistent with the Federal Reserve’s mandate for maximum employment and price stability.’ The inflation rate in the United States in 2019 was 1.81%. The projected rate is 0.62% for 2020 and 2.24% for 2021. The highest annual rate of inflation in the U.S. since 2010 was 3.14% in 2011.”

The answer to the will-we-get-hyperinflation question posed here is a firm “yes” and “no”.

The “no” answer regards the current price increases as being similar to the much greater price increases of the late 1970’s. Lots of turbulence and disruption for a while but then a strong and wise response by Fed Chair Paul Volcker that put an end to that transient major inflation situation. Decades of price stability followed.

The “yes” answer reflects concerns that we have no Paul Volcker around today to guide with such firmness and wisdom. Instead, we seem to have … let’s see, how to put this nicely? Umm … nicely makes my head explode. Never been much good at nicely so I’ll just do what I do.

The folks in charge of almost everything today appear to be some nasty combination of incompetent, malevolent, clueless, and misguided. For starters. You can probably expand this list to achieve additional accuracy.

Core inflation excludes food and energy prices, which products hardly anybody uses these days anyway. So, until very recently, low inflation happened. Today, however, there seems to be great efforts being made almost everywhere to drive non-core food and energy prices up hugely. This helps make cries of massive inflation more credible to those few of us who still insist on eating, driving their cars, and heating their houses. Then, if you are among the malevolent folks, it is much easier to create such inflation in two sharply-focused economic areas than across the entire spectrum of stuff people buy. Especially in times of COVID.

Mismanaged inflation can get very dangerous indeed

Everything about the COVID responses so far seems to me to be somewhere between very wrong and catastrophic. It is pretty hard to be so consistently wrong or worse. It probably takes years of practice and some serious education. Not generally a problem unless such folks get into power. Like today. Now we have the missing ingredient for a potential hyperinflation explosion: major mismanagement. So, things seem very dangerous today, inflation-wise.

Bottom line:

Inflation has become a huge concern lately. As defined both by products price increases and by money supply increases, inflation has jumped noticeably after many years of relative stability. Is this just yet another blip in our COVID-scrambled world, or something much worse? A pretty important question today. Outlook so far: inflation is not (yet) dangerous unless government spending or some other misguided government action blows up the normal economic price-corrective processes. That never happens, right?

Related Reading

Zimbabwe hyperinflation illustrates how to get it really wrong. Wikipedia describes the relatively recent Zimbabwe hyperinflation in this way:

“Hyperinflation in Zimbabwe was a period of currency instability in Zimbabwe that, using Cagan’s definition of hyperinflation, began in February 2007. During the height of inflation from 2008 to 2009, it was difficult to measure Zimbabwe’s hyperinflation because the government of Zimbabwe stopped filing official inflation statistics. However, Zimbabwe’s peak month of inflation is estimated at 79.6 billion percent month-on-month, 89.7 sextillion percent year-on-year in mid-November 2008.”

“In April 2009, Zimbabwe stopped printing its currency, with currencies from other countries being used. In mid-2015, Zimbabwe announced plans to have completely switched to the United States dollar by the end of that year.”

“In June 2019, the Zimbabwean government announced the reintroduction of the RTGS dollar, now to be known simply as the “Zimbabwe dollar”, and that all foreign currency was no longer legal tender. By mid-July 2019 inflation had increased to 175%, sparking concerns that the country was entering a new period of hyperinflation.[5][6] In March 2020, with inflation above 500% annually, a new taskforce was created to assess currency issues. By July 2020 annual inflation was estimated to be at 737%.”

“A solution effectively adopted by Zimbabwe was to adopt some foreign currency as official. To facilitate commerce, it is less important which currency is adopted than that the government standardize on a single currency. The US dollar, the euro, and the South African rand were candidates; the US dollar had the most credibility and was the most widely traded within Zimbabwe.”

“In 2019, the new Finance Minister, Mthuli Ncube, presided over the conversion from foreign currency to a new Zimbabwean currency, and the resultant return of hyperinflation. It was estimated that inflation reached 500% during 2019.”

Venezuela hyperinflation shows how to get it really wrong another way. Venezuela, once one of the richest countries in the world thanks to its oil production, became a hyperinflation recordholder as described by Wikipedia:

“Hyperinflation in Venezuela is the currency instability in Venezuela that began in 2016 during the country’s ongoing socioeconomic and political crisis. Venezuela began experiencing continuous and uninterrupted inflation in 1983, with double-digit annual inflation rates. Inflation rates became the highest in the world in 2014 under Nicolás Maduro, and continued to increase in the following years, with inflation exceeding 1,000,000% by 2018. In comparison to previous hyperinflationary episodes, the ongoing hyperinflation crisis is more severe than those of Argentina, Bolivia, Brazil, Nicaragua, and Peru in the 1980s and 1990s, and that of Zimbabwe in the late-2000s.”

“In 2014, the annual inflation rate reached 69%, the highest in the world. In 2015, the inflation rate was 181%, again the highest in the world and the highest in the country’s history at the time. The rate reached 800% in 2016, over 4,000% in 2017, and about 1,700,000% in 2018, and reaching 2,000,000%, with Venezuela spiraling into hyperinflation. While the Venezuelan government “had essentially stopped” producing official inflation estimates as of early 2018, inflation economist Steve Hanke estimated the rate at that time to be 5,220%. The Central Bank of Venezuela (BCV) officially estimates that the inflation rate increased to 53,798,500% between 2016 and April 2019. In April 2019, the International Monetary Fund estimated that inflation would reach 10,000,000% by the end of 2019. Several economic controls were lifted by Maduro administration in 2019, which helped to partially tame inflation until May 2020.”

Economics writer and investment advisor Mish Shedlock recently argued that inflation is a choice (of the Fed) in “A Former Fed Governor Blasts Jerome Powell, Says Inflation is the Fed’s Choice”:

“Last year, in another break with precedent, the Fed loudly and explicitly endorsed a blowout in federal spending. Congress swiftly agreed. Federal spending increased from an average of about 21% of gross domestic product in the prior decade to more than 30% in fiscal 2020 and 2021. National debt relative to GDP increased from 79% in 2019 to more than 100% today. Most troubling, the Fed bankrolled the fiscal profligacy, purchasing more than half of the new Treasury debt issued this year. Call it monetary dominance.”

Another short piece by Mish Shedlock on the system fragility that is driving up prices and costs in many products: “2022: The Year Of Breakdown”:

“The greater the optimization, the greater the fragility as the breaking of any one link brings the entire system to a halt. Throwing in equipment and labor that the system isn’t designed to use will fail.”

“Virtually every essential system has been stripped of redundancy, resilience, reserves and adaptability as the means to fully optimize inputs, processes and outputs. The system works well if every link in the dependency chain is working perfectly. Should one link go down, the entire system goes down.”

“Cost-cutting has stripped systems of back-up staffing and expertise. Full-time workers have been replaced by gig workers, contract workers, part-time staff on call, etc. Experienced staff cost too much so they’ve been let go as well, so there is no depth in numbers or knowledge.”

“Management is top-heavy with MBAs and bean-counters with little pragmatic experience or knowledge of the systems they’re managing. Management is optimized to advance those who can generate big profits, not those with experiential skills needed to meet crises in real-world dependency chains, production, breakdowns, etc. So when the system comes apart, managers simply don’t have the knowledge or skills to solve real-world problems.”

“Unfortunately the vast majority of our systems are managed by people who lack the long experience and hands-on skills needed to meet cascading crises.”

“Systems are now so complex and opaque that they are in effect optimized to fail in ways that are impervious to quick fixes. Bureaucratic mission drift, virtue-signaling, the erosion of accountability, multiplying platforms and software and the endless expansion of compliance and regulatory burdens have loaded every system with numerous points of failure and procedural friction that contributes little or nothing to the organization’s core mission. As resources are devoted to make-work procedural black holes, the mission decays and collapses at the first crisis.”