What is Inflation?

This is an important question, because our central banks are the ones behind the rise in inflation, not OPEC, oil companies, or greedy corporations. If one must point the finger, point it at central bankers.

“Inflation is always and everywhere a monetary phenomenon.”
Milton Friedman

Now, in its strictest sense, inflation is not what one hears reported on TV; it is not a rise in the price of oil or the price of food or the rise of any good or service. Quite simply, inflation is a fall in the price of money.
Dictionary.com says:

Economics. a persistent, substantial rise in the general level of prices related to an increase in the volume of money and resulting in the loss of value of currency (opposed to deflation).

However, this definition confuses cause and effect. A correct definition would be:

Economics. an increase in the VOLUME of money, which eventually leads to a persistent, substantial rise in the general level of prices and results in the loss of value of currency.

But, the average person has an eye firmly attuned to the price levels of goods and services, because that is what one can see and observe. One normally looks for signs of inflation there. Furthermore, the economy is complex. Money supply doesn’t lead straight to consumer price inflation, one for one. The inflation picture is muddied by concepts like the velocity of money, globalization, global wage arbitrage, commodity prices, oil intensivity, and on and on.

However, don’t be deceived, the rise in the prices of goods and services, including commodities, is the EFFECT of inflation, not inflation itself.

Printing money
Let me give you an example. Say the economy is flat on its back and consumers are not spending. The Fed sees this and says, “we need to inject some money into the economy and stimulate demand.” What that means is the Fed will then place bids on Treasury securities to buy them in the open market just like any other market participant. The difference is where the money comes from.

Out of thin air.

That’s right, the Federal Reserve pays for the securities, not with money it already has like you and me, but with money it prints on its electronic printing press.

If you think that’s like counterfeiting, well, in a way it is. But, that’s neither here nor there, because the net effect of the Fed’s transaction is to INCREASE the money supply. If there were $100 in circulation, when the Fed creates another $20, there would be $120 in circulation. This is inflation.

Price of money
What do you think happens to the price of money when the Federal Reserve injects money out of thin air?

Well, there are a fixed number of goods and services for sale. There used to be $100 to divvy up amongst those items. Now, there is $120 to divvy up. That says that each good or service is worth MORE dollars and each individual dollar is worth LESS. This is the effect of inflation.

So, printing non-existent money and injecting it into the money supply causes the price of goods and services, expressed in a unit of the currency to rise. It also causes the currency’s value to fall.

The complicating factor that bamboozles people is that the economy is not simple. We live in a global world that relies on different currencies based on fractional-reserve banking. We buy trillions of dollars of goods and services every year. The net result of these complications is that the mechanism behind inflation is obscured. Moreover, in a growing economy where output increases, money supply can increase at the same level as output. The money supply and output will rise at the same pace and prices will be unaffected.

Follow the money
Another example here will help explain. My last post was about M3. M3 is a monetary aggregate the Fed used to publish so that economists could gauge the rate of growth in the money supply.

Now, M3 was sharply higher in the 1970s and lower in the 1980s. The result was as one would expect: faster increases in prices of goods in services in the 1970s and much slower increases in those prices in the 1980s. So far, so good.

Then, we headed into what looked to be a severe recession in 1990. The S&L crisis and the huge debt it left behind was a financial disaster. The economy tanked. After the economy started to recover, we experienced a jobless recovery. What to do?

Print money!

Alan Greenspan’s Fed turned on the printing presses and monetary aggregates shot up. Yet, CPI went nowhere. Inflation remained tame. So, Greenspan kept printing more money. Every time there was a crisis. Boom, print money. Asian Crisis in 1997? Print money. Russian Devaluation in 1998? Print money. Y2K? Print money. 9/11? Print money. And so it was.

Why didn’t inflation increase as would be expected?

It did increase — just not in consumer prices. The increase in money supply increased asset prices. And people look at asset prices differently. When consumer prices like car prices, furniture, and oil increase, consumers are outraged and want something done about it. But when asset prices increases, many people are overjoyed. The difference is that not many people own car dealerships and furniture stores. Many, many people own houses and stocks. Sellers of an asset love inflation, buyers do not (unless they intend to flip and be a seller later).

But a lot of why consumer price inflation did not increase until recently has to do with globalization and global wage arbitrage. After the Berlin Wall fell in 1989, Western Europe had a huge store of well-educated, low-cost workers to choose from. They moved a lot of manufacturing over to Eastern Europe. If you lived in Western Europe, you would notice manufactured goods by Miele, Krups and Braun that used to ‘Made in Germany’ were now made in Hungary or Romania. (One reason East Germany suffered at this time was Unification made East German workers expensive relative to workers from other former Soviet Bloc countries).

Then there are China and India. Since this time, China and India have been opening up to the world and unleashing the availability of a huge supply of labor that wasn’t previously available to the Western world.

No matter how much money the Fed, the Bank of Japan, and other central banks pumped into the economy, prices didn’t budge. The money was absorbed by manufacturers, who had an seemingly unlimited supply of low-wage workers to choose from.

The Dollar problem
All of this changed after 9/11. After the Fed lowered interest rates in 2001-2003 to 1%, the U.S. Dollar cratered. As it cratered, commodity prices skyrocketed. Oil, gold, copper, platinum, corn, wheat, rice, silver, nickel and you name it: all commodity prices increased. The increase was in part due to the decline of the dollar and in part due to burgeoning demand.

Irrespective of the reason for commodity price increases, the effect was clear. Inflatio
n. Not only are commodity prices increasing, but now so too are the prices of manufactured goods. China and India and other lower wage centers can no longer absorb the huge increases in raw material prices.

And so ends our inflationary experiment. The 1990s was an aberration due to an unprecedented wave of globalization and the entrance of new workers into the global market economy. But, global wage arbitrage is at an end and producer prices are rising along with commodity prices.

Money supply growth cannot continue unchecked for years and years. Eventually, it feeds through to higher prices. And we now see the result.

  1. Anonymous says

    Intersting post. Economics affects our lives in hundreds of ways that we often don’t
    realise. It ‘s true that US economy is in real bad shape right now
    and obviously, it is going to get very, very bad and it may get
    worse. Interest rates are going up regardless. That’s what happens
    when you have inflation. So, interest rates are not the issue. Gold
    went up along with interest rates during the 70s. Now, whether we have
    inflation or deflation, I truly don’t know. However, it’s safe to
    assume that if we do get deflation, that it’s not going to be some
    minor thing. As far as your money goes, the kind of inflation we’re
    experiencing can be a real killer. It drives up interest rates. It
    destroy purchasing power. It can destroy your nest egg. It can affect
    wages, housing, etc. I think it’s also a big help if we can have more
    knowledge and awareness and be able to track the to track the impact
    of the fiat money systems that affects their lives. I found the
    website https://www.viritix.com or Viritix Inflation Tracker which I think can
    help us understand more about inflation and how it affects them, it
    aims to track inflation and give individuals an indication of how
    inflation is affected by what they spend their money on’. Do visit the
    site and let us know how you get on.

  2. anonymous 2 says

    how about banks role in expanding the money supply. when they loan 10x their hard capital base that expands the money supply and is a source of inflation too right? All of those individual loans to say all the home owners has to have a massive sum attached.

  3. Edward Harrison says

    anonymous2, you are correct that banks expand the money supply through loaning out money on top of the money created by the central bank. This is what they are supposed to do and it is why money supply, credit, and inflation increase. However, without the high powered money created by the central bank, much of that credit could not exist. So, the original inflation rests with the central bank.

    But, as you say, it is the financial sector that transmits the inflation into the real economy. We are seeing the Fed attempt to inflate by creating money now. But because banks are in such terrible shape, they are not re-lending the money. The money multiplier is crashing and consumer price inflation is not happening.

    That isa problem for a central bank looking to avoid deflation.

  4. Ralph Musgrave says

    While inflation (in the sense of an excessive rise in prices) may be caused more often than not by an excessive money supply, this is no always the case. There is widespread agreement that the inflation in the UK in the 1970s was caused by (or at least greatly exacerbated by) a wage price spiral: i.e. excessive wage demands by a politically too powerful and economically illiterate trade union movement. I therefor agree with the above Dictionary.com definition of inflation.

    Second, I flatly disagree with the idea that an increased money supply caused by government buying its own security will result in inflation. First, look at the evidence: this is exactly what Japan has spent ten years doing with little effect (on inflation or anything else). Second, there is a simple theoretical reason for thinking that “quantitive easing” (i.e. what Japan did) has little effect. The reason is thus. Securities are chunks of wealth that the owners regard as SAVINGS. Savings are portions of an individual’s wealth that they DO NOT INTEND SPENDING. Thus if for some reason someone induces an owner of a tranche of securities to convert them to cash, that cash will NOT GET SPENT. The cash will just get dumped in a deposit account. Thus there will be no effect on demand and thus no effect on inflation.

    When the Japanese government induced Japanese citizens to convert their securities to cash, a significant proportion of Japanese security owners went out and bought foreign securities with the proceeds! I could have told them that would happen.

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