“Inflation is always and everywhere a monetary phenomenon.”— Milton Friedman
“The natural tendency of the state is inflation.”— Murray Rothbard
“Continued inflation inevitably leads to catastrophe.”— Ludwig von Mises
“Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.”— 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
“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
“There are only three ways to meet the unpaid bills of a nation. The first is taxation. The second is repudiation. The third is inflation.”— Herbert Hoover
Inflation sure seems real these days but what exactly is “inflation”? It is of course generally understood as prices of most stuff going up while the stuff itself stays largely the same in terms of value.
An example is the price of a McDonald’s Big Mac. The Economist has tracked Big Mac prices around the world since the late 1980s and found that the Big Mac price rose over this period at about 3% per year: “Burgernomics: The Big Mac Index.” Doesn’t sound like much but a $2.25 Big Mac in 1990 would today cost about $5.60, a 250% increase.
Statista explains that the Big Mac Index is really a way to compare currency exchange rates:
“What is the Big Mac index? The Big Mac index, published The Economist, is a novel way of measuring whether the market exchange rates for different countries’ currencies are overvalued or undervalued. It does this by measuring each currency against a common standard – the Big Mac hamburger sold by McDonald’s restaurants all over the world. Twice a year the Economist converts the average national price of a Big Mac into U.S. dollars using the exchange rate at that point in time. As a Big Mac is a completely standardized product across the world, the argument goes that it should have the same relative cost in every country. Differences in the cost of a Big Mac expressed as U.S. dollars therefore reflect differences in the purchasing power of each currency.”
Over time, this burger data series gives a rough idea of the price inflation of a vital staple of our diet. So, is 3% a year good or bad?
Have your earnings over the past 30 years increased by 250% or more? For many, or even most folks, probably not. Maxxing out credit cards doesn’t really work over the long haul, so maybe tapping your growing home value is the answer?
Inflation “okay” if your income plus borrowing ability grows faster
Not “okay” if your income growth lags price growth and you can’t borrow enough to make up the difference. Kind of an affordability thing in practice, yes?
Price inflation seems to be a fact of life almost everywhere and almost always. It just happens. We notice it when things we really need – like housing, food, transportation, medical care, education – take an increasing share of our earnings. When earnings can’t keep pace, we supplement them as long as possible with borrowing. That’s just how life works.
Pain here starts when our income growth plus borrowings can’t keep pace with price growth (inflation as personally felt). Eventually, if things stay this way, we have to cut back until our earnings and borrowings are able to cover our spending. Cutting back works for a while, especially if you are among the fortunate. But even borrowing eventually runs out of gas and turns into a reckoning.
The bad news is that the day-of-reckoning on this path can come upon us rather quickly. As Ernest Hemingway wrote in The Sun Also Rises: “How did you go bankrupt? Two ways. Gradually, then suddenly.”
Are we there yet? Again, it depends on who you are.
We all know what “inflation” is, don’t we
Well, I thought that inflation was just generally rising prices caused by too much demand and not enough supply, plus shortages caused by all sorts of disruptions and reasons. Oh yes, and government money-printing that creates too much money and thus devalues all money.
Is this something like your understanding also?
Turns out that the real story on inflation is quite different. Under most circumstances, price increases reduce demand and lead to rough price stability at some point. Note that “most circumstances” exclude hyperinflationary collapses such as Venezuela experienced under very rare (we hope) circumstances.
This leaves us with enormous money supply increases as the remaining target for inflation blame. Except that money supply and price inflation do not appear to be correlated over any extended period. Why? This is where it gets interesting.
Suppose the government actually printed up, say, a gazillion new paper dollar bills and stacked them neatly in a bunch of huge warehouses. Today they do this in digital warehouses with a few mouse clicks, but never mind. In either case, the money supply has been hugely increased and we should expect disastrous price inflation to follow promptly if money supply is the bad guy.
Except that the world doesn’t seem to work that way. Money supply stuffed in warehouses doesn’t do much other than collect dust and storage costs. To do any damage, it must first be transferred from the warehouses to consumers and investors. Consumers may spend all of their share or they may save a bit in the bank for later. To get any new money to investors, however, you need the involve banks and their kin as intermediaries.
Banks borrow from the government via “reserves”, which are in the form of government IOU’s. The bank gets a bunch of billions of new dollars that it stores in its required Fed reserves account. In principle, the bank is supposed to lend all or much more of this new stash to people who actually do real stuff – like build or expand businesses, or finance others to do real stuff.
But what if banks get cold feet and tighten lending requirements so that almost nobody borrows and builds? Might as well have left all that new money in the supply warehouse where it can do nothing just as effectively.
How can you persuade businessfolks and investors to borrow and spend? Well, a few folks actually carry out some return on investment calculations to make sure that they can earn (if all goes well) enough to cover costs of capital required and to provide an acceptable profit. If capital is expensive, as it has been for much of the past, demand is modest. But if borrowing costs are very low – think “free money” like today, then almost any investment can look great. Asset values soar as a result. Even what was once-upon-a-time pure junk.
Inflation is driven by high rates of “spending” and “lending”
Warehoused money supply is economically dead. It needs to get into spenders hands at relatively low costs and with minimal impediments and nuisances like creditworthiness. It needs huge “stimulus” programs to get spendable “free” money directly into spenders hands. And it needs near-zero interest rates to get banks to lend to borrowers and investors so they will spend their borrowed “free” money.
This stimulus-free-borrowed-money combo has worked so well lately that we now have shortages of goods, above-average demand for many goods, supply chain disruptions to generate even more and varied shortages, and virtually free borrowed money that is pricing asset values into the stratosphere.
What could go wrong? Probably nothing so long as the free money printing, distribution, and spending machine is running full blast. Who is going to quit spending when money is so free and available?
You may see a possible glitch, as I do: What if the spending and investing stops – for things like reasons? Even experts are wrong – occasionally, or even oftener.
What on earth could kill this great party where almost everybody today who counts is winning?
A starter list of potential party-poopers
1. COVID ravages continue or even get worse. Something out there seems to be killing and injuring a great number of people. The rate of these hits seems to be increasing. Why? Who knows? We just have a lot of data from which to choose, most of which points to bad news ahead on the demand and investing fronts.
2. Vaxxed-only workplaces. Vaxx mandates for businesses with over 100 employees have been introduced widely and quickly – frighteningly so. With the “fully-vaxxed” (definition seems to change regularly) workforce population running maybe in the 60% to 80% range, the remainder seems likely to quit or be fired as part of the Great Resignation. The very recent OSHA mandate injunction may not impact the strong drive toward fully-vaxxed workplaces.
3. Major war erupts. Wars have a nasty habit of leading to outcomes other than their immediate purpose. Nevertheless, wars appear to be a popular tool used for various reasons by governments everywhere. They often create huge demand for war materials that gets paid for by government borrowing, typically from itself.
4. More rounds of quantitative easing or equivalent. These have different names – the most recent version being called an “infrastructure” bill where about a third of the new money maybe goes to actual infrastructure. The big money goes directly into spending on stuff like “human infrastructure”, which we probably need greatly, whatever it may be. The whole amount goes into spending that will likely have price inflation effects for some period – creating higher prices without any corresponding value increases. This just devalues the money being printed.
You can probably think of a bunch more such happenings that could potentially whack consumer demand and borrowings, so curbing inflation.
In reading to find out more about what inflation really is, I came across a couple more important questions.
What if the dollar declines hugely in value?
Relax, it already has. And will probably continue for as long as most of us will be around to experience. Value declines with respect to other currencies happen approximately forever. Value declines in terms of purchasing power have similarly been around in one form or another, also forever or longer. As noted above, Big Mac’s that cost about $2.50 in 1990 now cost about $5.00 or so. Why? Price increases, typically driven by cost increases, make price adjustments effectively permanent in the absence of strong competitive pressures.
Creating inflation – should you want to
Simple. Create shortages, lots of, and major. Check. Spend tons of new money, which you (the Fed) can just print as needed, plus ramp up bank lending with low rates. Check. To top these off, do some more huge stimulus packages. Check. But nobody would ever do such a nasty thing, would they?
ZeroHedge had an interesting take on all of this from a data perspective:
“This increase in bank lending is propping up the money supply at an elevated rate, just under 13%. Digging into the details of bank loans, it is clear there is an across-the-board increase in bank lending to the various sectors. Consumer lending, i.e., consumer loans, credit cards and mortgages turned up in June while commercial and industrial loans turned up in recent weeks.”
“The Dallas Federal Reserve produces some interesting data points on the PCE [personal consumption expenditures] deflator. They break out the percent of categories rising at various rates. Roughly 48% of the PCE is rising at 5-10%, while only 4.2% of components are under 2%. While there are 18.8% of the components that are declining in price, this is almost matched by the 15.1% of items that are rising in price at a rate greater than 10%. So, this means about 63% of the PCE is rising at a rate greater than 5%, or more than double the Fed’s 2% inflation target. Inflation is clearly broadening out.”
These data points seem to indicate that significant price inflation is going to be with us for an extended period unless one or more of the party-poopers listed above ruins the party.
What is “debt monetization” or money printing?
Wikipedia gets into the nitty-gritty of money printing if you really want to know:
“Debt monetization or monetary financing is the practice of a government borrowing money from the central bank to finance public spending instead of selling bonds to private investors or raising taxes. The central banks who buy government debt, are essentially creating new money in the process to do so.”
“This practice is often informally and pejoratively called printing money or money creation. It is prohibited in many countries, because it is considered dangerous due to the risk of creating runaway inflation. To prevent inflation getting out of hand, central banks often keep a close eye on the Consumer Price Index, as to not create too much new money.”
“However current central bank policies in responses to the COVID-19 pandemic (such as quantitative easing) are considered to be very similar to debt monetization, although with subtle and important nuances.”
Can moderate inflation ever be a good thing?
The answer here, as with so many things these days, is a firm “yes” and “no”. I probably need to explain this one a bit.
Inflation in prices is a necessary part of the process of the economy adjusting to a new set of conditions and situations. Economies are almost always in the process of adjusting to one thing or another. Some adjustments are small or localized while others are major and often nasty. It’s how the world works.
Prices tend to go up when demand exceeds supply for an extended period. Prices tend to go down, but with stickiness of course, when demand falls and competition goes to work on prices. In theory, at least.
But, significant price inflation is often driven by governments doing whatever it is that governments do. This doesn’t necessarily flow from sound practices or analyses, as you may have noticed. Inflation will diminish, and possibly even reverse, if the upward drivers change or go away. Political drivers are very likely to change as politicians and their kin find new issues, opportunities, or needs.
While the price adjustment processes are usually quite painful for the majority of us folks, they are necessary and therefore “good” in a technical sense. Adjustments that don’t get made in a timely manner tend to build up into crises that subsequently break, with considerable and often unnecessary damage.
So, moderate inflation making necessary economic adjustments is good even if routinely painful (bad).
Inflation today is definitely real and becoming significant. It will hurt a lot of people at the lower end of the income range but borrowers will get to pay back loans in inflated (lower value) dollars so long as their income stream is high and stable. Lenders will be in pain from this and will eventually adjust with higher rates or tougher credit requirements. Demand for Big Mac’s will drop enough at some point to stop price increases and maybe even reverse them. So, is it good or bad? Inflation in the end is simply a natural process of economic adjustment to changing conditions – both economic and government policy.
Tony Yiu writing in the Alpha Beta Blog via Medium.com argues that there should be a lot more inflation: “Where Is All The Inflation? Why Isn’t The U.S.’ Massive Money Printing And Fiscal Stimulus More Inflationary?”:
“So why have we barely seen any inflation? The money supply (blue line in the following plot), as measured by M2, has expanded significantly recently and yet inflation (red line) has barely budged:”
“In fact if you look closely at M2 (money supply) growth and the inflation rate, they are negatively correlated especially during recessions (the gray bars). If inflation is what you’re after, not only do you need to expand the money supply, but you also need to get the holders of all that money to spend it.”
“But when there is significant economic uncertainty, the desire to buy things that aren’t necessities goes down significantly, especially for assets that produce returns over long periods of time. Rather, the gut reaction is to hoard cash and bolster near-term liquidity.”
“But isn’t QE basically the Fed running a big money printer? So if there’s all this newly printed money out there, why aren’t people spending it (and causing inflation)?”
“The answer is because the banks have all of it and they’re not in a hurry to make a ton of new loans.”
Unfortunately, the ramping up of borrowing and spending takes time, especially in times of great uncertainty, which we are rumored to be experiencing. Looks like we are at last on the way in late 2021. See the ZeroHedge quote above.
The Alpha Beta Blog had another useful but quite long article on the relationship between money printing and inflation. Really important stuff to know these days. You may want to read the whole article: “Where Did All The Money Printed Through QE Go? As Usual The Banks Took It”:
“The answer lies in the way QE works, quoting one of my previous posts on QE: Here’s what happens. When the Fed wants to buy say $20 billion in mortgage bonds from a bank, all it does is record a liability of $20 billion, adds $20 billion in electronic dollars to the bank’s reserve account (All banks have a reserve account at the Fed. They must have at least the minimum required amount in this reserve account to ensure that they can meet the demands of depositors. Excesses above the minimum can be used to make loans.), and takes ownership of the mortgage bonds (as an asset on its balance sheet). Literally all it takes is a few keystrokes and maybe a telephone call or two.”
“I call it magic money because there’s nobody on the other side of the financing part of the transaction. Normally when a company wants to buy say a factory with money it doesn’t have, it needs to first find a bank willing to lend it that money. Here, the Fed doesn’t have to worry about where to get the money, it just creates it (hence the printer analogy) and buys the assets.”
“Once the transaction is completed, the bank suddenly has $20 billion more in reserves that it didn’t have a day ago — reserves (a.k.a. money) that it can now lend if it chooses to.”
“So when it prints money, sadly the Fed is not just handing it out to you and me. Rather, it is taking bonds and other fixed income assets out of the market (which lowers borrowing rates) and swapping them for bank reserves. In other words, the banks have all that ‘printed money’.”
“That’s an important point — that the composition of privately held financial assets is being changed by QE. But the quantity of say bonds plus money more or less remains the same (technically, post QE it will be more because by buying bonds, the Fed has pushed up the value of the remaining bonds that it didn’t purchase). So post-QE, the total sum of cash and financial assets is still the same, and the ratio of that sum to the quantity of goods and services is roughly unchanged as well.”
“The Fed is printing money to buy financial assets, which are kind of like pseudo-money — in other words the Fed is taking pseudo-money out of the system and replacing it with actual money in the form of bank reserves. This is different than if the Fed were to straight up start purchasing planes, cars, or computers with printed money. That would change the ratio — the sum of cash and financial assets would increase from the printed money (and the additional lending and incomes that it would likely cause) and the quantity of goods and services would decrease by the amount that the Fed purchased. In this case, there would be more money chasing fewer goods, and it would result in inflation. But that’s not what’s happening.”
“All The QE Money Is Held By The Banks. QE creates excess reserves (since the banks are paid in reserves when the Fed buys their bonds and other assets), which banks can then decide whether or not to lend out. If they do lend it out, then there would be more debt, more money in the hands of businesses and consumers, more spending, and ultimately more inflation. But banks want to make money too. Whether they choose to lend out their excess reserves depends on:
> Their economic outlook, or more specifically their outlook on the bankruptcy risk of their potential borrowers.
> The risk adjusted return they can earn on loans made versus the interest raid they get paid on their excess reserves (which is risk free). If the rate that banks earn from the Fed on excess reserves is high enough, they have little incentive to make loans, which have more risk.
> Loan demand of consumers and businesses.”
“Judging by the number of banks tightening lending, their outlook on the economy (and on the credit quality of their existing loan books) is not great [late 2020].”
“Conclusion. I know the natural inclination is to scold the greedy banks for hoarding all that money. But it’s important to keep in mind that the money is not completely new money, rather it’s a replacement for the bonds that used to be held by the bank (and were bought by the Fed) — in other words, it’s swapping money in and ‘pseudo-money’ out.”
“And it’s also important to keep in mind the objective of QE — for a lack of a better word, QE is designed to starve the market of yield across all durations (by reducing the supply of safe bonds), and force investors into riskier assets, pushing up the prices of those assets.”
“And by taking interest-bearing bonds away from banks and replacing them with reserves that earn only a minimal amount of interest, the Fed incentivizes banks to make more loans when opportunities to earn a reasonable risk adjusted return present themselves (but apparently, so far they have not).”
As you can see, this is all pretty complicated but the bottom line is not: inflation can be caused by money printing only if the government wants money printing – for reasons. Printing money is so easy. Getting it spent and borrowed is the tough part.