What Really Causes Inflation?

Over the last three days, I have listened to politicians from both political parties spout the rankest nonsense about the causes of inflation.  Among the nuttier ideas were corporate greed, currency speculators, low taxes, high taxes, lack of stimulus, too much stimulus, Putin, Covid, the war in Ukraine, and supply chain issues.  Today, a lawmaker added to the list by saying that a woman’s lack of access to abortion causes inflation.

The late Milton Friedman is probably spinning in his grave.

About the only thing that everyone agrees on is that the Federal Reserve prints too much money, which forces me to point out a few facts:  We can start with the fact that while the Federal Reserve is very powerful and can, indeed, pump more money into—or out of—the economy, it is actually the Treasury Department that prints money.  That doesn’t really matter, since the vast majority of money in our economy does not exist as real paper currency. 

Note.  It might surprise you to learn that 60% of all U.S. currency is held overseas and the majority of that money is in the form of $100 bills.  If you are imagining dictators and drug lords with pallets of plastic wrapped bills….Well, yes. 

Let’s start with the basics:  Inflation is too many dollars chasing too few goods.  Consider the following overly tortured scenario:  As you are flying across the Pacific, a looming storm forces the pilot to land on a South Pacific Island to wait until the storm passes.  The islanders refuse to allow anyone to disembark, so you and the rest of the passengers are forced to wait on the plane for hours and hours.  Eventually, to help alleviate hunger, the stewardess gives every passenger the equivalent of $5 in the local currency, enabling each passenger to buy a hamburger from one of the locals who brings the food to the plane.  If there are a hundred passengers and the cook brings an equal number of hamburgers, as you can imagine, the native will realize that he can charge $5 apiece for the burgers.

But what happens if the entrepreneur brings 150 burgers to the plane.  Since he’s unwilling to leave with unsold food, he will more than likely drop the price.  A few people won’t want a burger, a few more will want more than one, and the majority will only want one.  A few enterprising passengers will probably even pool their money and try to buy three burgers for $10.  However the bargaining goes, the price of a burger is likely to drop when more burgers are available.

Consider what would happen if the stewardess had given each passenger the equivalent of $10 in local currency and the burger man had brought only 70 burgers to the planet the price would probably rise rather quickly.  Passengers would pool their money and divide the available food, sending the price for each burger substantially higher than $5 apiece.  This is an example of too much money chasing too few goods.

As Milton Friedman famously said, “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.” 

Sure, corporations are greedy—they are supposed to be greedy.  And if someone is speculating that a commodity will go up in price, someone else is speculating that it will go down and neither bet changes the resulting price.  These actions don’t cause inflation because neither corporations nor speculators are able to print money and increase the supply of money.

Think back to the start of 2020:  While we began the year with a roaring economy, the very real fear of Covid forced a widespread economic shutdown.  When businesses shuttered their doors and employees stayed home, our government began a liberal policy of subsidizing both consumers and businesses.  Calling the massive injection of money into society liberal is an understatement.  During the financial crisis of 2008, the government spent—depending on which numbers you choose to use—between $700 billion and an even $1 trillion.  By comparison, the direct stimulus checks of 2020 and 2021 alone cost more than $2 trillion—twice the amount spent to combat the 2008 financial crisis. 

A tremendous amount of new money was injected into the economy, yet at the same time, Americans were unable to spend it.  As restaurants and businesses shut their doors, the GDP of the United States contracted by 3.5%, in the first such contraction in decades.

Surprisingly, there is a relatively simple formula to figure out how much inflation is likely to occur in an economy:  the Quantity Theory of Money:

In this formula, M=the monetary supply, v=the velocity of money (how many times money changes hands during a year), P=the price level (inflation), and Y_R=the Gross Domestic Product (the value of all goods and services produced in the country during a year).  In the year and a half after the start of the pandemic in 2020, both the velocity of money and the GDP of the country contracted, while the amount of money in the economy increased dramatically.  It doesn’t take a slide rule to see that P (inflation) had to increase to keep pace with the increase in money.

At the same time that this new wave of money entered the economy, the amount of goods and services available to purchase diminished because factories were shut down, employees didn’t go to work, and the supply chain tied itself into knots while ports became jammed with unloaded ships and containers waiting for trucks to deliver the goods to your local stores.  Despite fewer people were working, the savings rate of Americans grew during this time.  Pent up demand for goods increased over time….and then the stores reopened and people began to satisfy their desire to purchase new goods.  If you go back to our analogy of the hungry passengers on the plane, it became a situation where each passenger was starving, had a basket full of money, and the vendor only showed up with two dozen burgers.

During times of inflation, it is the job of the Federal Reserve to adjust monetary policy to lower inflation while attempting to maintain high employment, a goal that is usually mutually exclusive.  Among the tools the Federal Reserve can use to accomplish this is raising the Federal Reserve Rate (the rate the Fed charges banks to borrow money).  Raising the Fed Rate triggers an increase in several interest rates—including home and car loans—resulting in fewer loans being made and effectively lowering the amount of cash circulating in our economy.  Accordingly, the Fed has increased the Fed rate twice in the last few months and predicts that inflation will begin to drop slowly over the next year.

The Federal Reserve always confidently predicts a return to normalcy.  And after every one of its policy failures, it tells us that it has learned from past mistakes and it is better equipped to handle future crises.  The Fed told us it had learned from the mistakes of the Great Depression, from the stagflationary period of the 1974-82, from the collapse of the tech market in 2000, and from the housing collapse of 2008.  This string of failures makes the Fed absolutely positive it can prevent the recession that normally follows periods of high inflation.  Personally, I plan to keep my kitchen pantry well stocked.

The government can do several things to decrease inflation:  It can spend less money, it can stop giving subsidies, and it can raise taxes as these are actions that will decrease the amount of money in the economy.  Forgiving student loans, extending unemployment benefits, increasing welfare programs, and giving cost of living adjustments to those on Social Security are all actions that will raise inflation.  I’m not saying that those aren’t good ideas, but they absolutely will raise inflation.

And what about all those other looney ideas about the cause of inflation that I listed in the first paragraph?  Crazy statements (like those from attention-seeking politicians) tell us nothing about our economy….but they do convey a great deal about the motivations of the speakers (and even more about their low opinion of their listeners’ intelligence).