Inflation: Misunderstood By So Many
Introduction
In this article, I present two levels of understanding of Inflation: one that requires no previous exposure to economic theory and another that serves as an introduction to the monetarist theories that bankers and Wall Street professionals invoke to justify their Inflation fighting recommendations.
First, I offer a review of the last couple of years of worsening Inflation numbers, explaining some of the basics truths about Inflation that every participant in the economy should know about.
It is in this section that I directly contest the explanation of Inflation that politicians and bankers have been pushing a lot lately, the one that blames our current Inflation on:
- The federal government spending too much on helping average folks
- Using money that The Fed provided via its “money printing”
After this review of recent history, I then take the reader into the world of economic theory, where I uncover the key analytical errors Milton Friedman made in his attempts to model Inflation’s causes and effects in his mind.
There Are Two Very Different Types Of Inflation
The first thing people need to understand about widespread price increases is that they are nearly always driven by one of two economic developments:
- Disruptions in the supply chain
- An increase in demand due to incomes inflation
It’s especially important that we understand the difference between these two types of Inflation because they have two entirely different impacts on the populations that experience them.
Supply constriction inflation is the bad kind of inflation. When the quantities of ‘stuff’ that suppliers are bringing to market drop, prices will rise until some people are priced out of the market.
That’s how The Marketplace rations scarce goods & services: according to one’s disposable income. It’s why the poorest members of society always suffer the most from Inflation that is driven by reductions in supply.
Demand-driven inflation is something quite different. Unrecognized by most observers is the fact that — in real terms — demand-driven inflation is actually quite harmless in that it doesn’t involve any reduction in the amount of stuff that is being brought to market and purchased by consumers.
The key to understanding demand-induced Inflation is recognizing that it only occurs when buyers have seen their disposable incomes inflated…enough for them to be able to afford the same stuff at a higher price that they used to buy at a lower price.
We know this must be true because — if their incomes had not been inflated sufficiently for them to be able to afford the higher prices — the higher prices would not hold. Product would remain on the shelves unpurchased and prices would be forced back down.
The ultimate harmlessness of demand-driven inflation is something financial elites don’t want you to know about. They want you to think it is very harmful to you, because they like using it as an excuse to throw the economy into a recession whenever it starts to reach full-employment levels.
With this cursory introduction to the basics, let us now go ahead and review the past few years to see how the Fed’s “money printing” did — or did not — contribute to America’s recent Inflation problems…
2020 Inflation: 1.3% (CPI)
The narrative politicians have been repeating a lot these days blames our recent Inflation problems on the Federal Reserve creating trillions of dollars in 2020 that government spending shoveled into the economy.
What are the actual facts?
In April 2020, the Fed did indeed inject a massive amount of newly created money into the economy in response to the huge spike in unemployment caused by COVID lockdowns. But knowing that simple fact tells us nothing.
It’s crucial we understand that there are two main paths by which the Fed’s created money enters into the economy. The first path we’ll look at is via government spending.
When the Fed prints money to purchase Treasury bonds, those dollars are eventually injected into the economy when the federal government spends them.
This did indeed happen in the Spring of 2020 when the Treasury distributed income subsidies to households across the board, either by check or direct deposit.
Now this distribution of Fed-created money would have led to significant price inflation IF the economy had been humming along at full-employment levels at the time when the checks were received.
If that had been the situation, then the government’s extra spending on income subsidies would have inflated the disposable incomes of all households & significant demand-driven price inflation would have been the result.
But because the distribution was received at a time when a significant drop in consumer spending had occurred — due to the huge spike in unemployment — the money handout had little impact on consumer prices.
Many of those who had lost their jobs simply used their government checks to pay their rent. Others who hadn’t lost their jobs, who were reasonably well off, mostly saved the money they didn’t need to pay off debts because they were facing an uncertain future.
Thus, the Fed’s freshly created money did not bid up consumer prices that year in any significant way. In all of 2020, the rate of price inflation as measured by the CPI was only 1.3%.
The increase in government spending that occurred in 2020 did not increase total spending in the economy but simply kept total spending from dropping to catastrophic levels.
2021 Inflation: 7.1% (CPI)
2021 was quite a different story. As unemployment levels began to drop, consumer spending began to rebound. That was when we started to hear about “supply chain” issues.
The most important of these was world oil production not keeping up with demand. Inflation caused by supply chain disruptions is, of course, the bad kind of inflation which has nothing to do with incomes supposedly being inflated by Fed money printing.
So did the Fed’s 2020 money printing have nothing to do with the robust increase in inflation that occurred in 2021? Actually it did, but not for the reasons that Wall Street professionals want you to believe.
Let’s follow the money…
The way the Fed normally injects new money into the economy is through it’s purchases of financial assets held by banks. It deposits dollars it keystrokes into existence into the accounts of banks or other asset holding institutions in exchange for the financial assets it purchases. This newly created money is then lent by banks into the economy in the form of loans.
Who is it that banks lend to? They are, of course, always eager to lend to rich people who are seen as good credit risks. What do rich people borrow money for? According to economist Michael Hudson, 80 percent of all bank loans are real estate mortgages.
It turns out that many rich borrowers are speculators who like to leverage their investments in asset bubbles, like the bubble we’ve seen in the real estate market. The basic strategy of these speculators has been to buy residential & other properties and then sell them in a matter of weeks or months at a healthy profit.
Who were they selling to? Increasingly — as the surge in prices accelerated — it was to other speculators who planned to ‘flip’ the properties they bought, themselves.
In 2021, it was the real estate bubble that soaked up the largest share of the money that the Fed was creating for banks to lend. Speculators were delighted to be able to borrow money at historically low interest rates for their property purchases.
Real estate prices skyrocketed because speculators were often buying from & selling to each other. They didn’t worry about the high prices they were paying because they expected to turn around and sell at an even higher price soon enough. Real estate agents made a killing.
The net result of this speculative bubble in the real estate market has been to 1) price many working class families out of home ownership altogether, and 2) constantly squeeze the disposable incomes of those who rent their dwellings.
The Inflation this created in real estate prices showed up in the CPI’s “housing services” category of household costs. A 10% increase in the rent you’re paying will affect your household’s overall purchasing power a hell of a lot more than a 10% increase in your internet bill.
So when the Fed-fueled spike in rent/housing costs combined with the sharp increase in oil prices in 2021 (a supply shock, not incomes inflation), the result was a significantly higher Inflation rate in 2021 (7.1%) that had little to do with the federal government spending Fed-created dollars.
Inflation In 2022
Unfortunately, most of our current Inflation problems are still due to constrictions of supply and the real estate bubble, which means we are still suffering from a good deal of bad Inflation.
A new supply shock hit us in late February when NATO politicians decided they wanted to try to hurt Russia by refusing to buy cheap Russian oil and gas. This has forced NATO countries to pay more for the oil and gas that their economies cannot do without by turning to other sources of supply.
In other words, a political decision was made to reduce the supply of oil and gas that they shall consider “available” for purchase.
This of course has caused the world price of oil & natural gas to skyrocket and that in turn drove up the prices of everything that depends on those energy sources, e.g., transportation & manufactured products like fertilizer (thereby driving up food prices).
But still, we are hearing one politician after another blame Congress’ 2021 stimulus spending — the “American Rescue Plan” — for the Inflation we’ve seen thus far in 2022.
For the sake of argument, let’s go ahead and assume that the 2021 stimulus package did contribute to the 9.1% calculated Inflation rate (CPI) for June.
Can anyone say how much?
It turns out that Federal Reserve Board researchers made an attempt to do just that. In July they published the results of a study they had carried out, using available data, to estimate how much of the current inflation could be said to be due to the stimulus package. The number they came up with was 2.5%.
What this means is — according to Fed estimates — 2.5% of the 9.1% CPI Inflation rate for June was due to increased government spending. While my sense is that this 2.5% estimate is high, I’ll nevertheless accept it for the sake of argument because it doesn’t really matter if the number is 2.5% or 0.5%.
This number is quite tolerable because — if the Inflation really was due to incomes inflation (due to government generosity)—the price increases would have been fully compensated for by an adequate increase in buyers’ disposable incomes.
So when you hear someone blame the current Inflation on “excessive demand” due to government spending, all they’re really saying is that there’s no good reason for anyone to be upset about the higher prices, because the government has already compensated them for it…
Flawed Academic Assumptions About Inflation
One reason academic economists do not emphasize the different impacts that the two different kinds of Inflation have on purchasing power is because they were trained at the university to accept certain orthodox Inflation theories that are actually quite flawed.
Neoclassical theory in particular has long been tainted by its reliance on a theoretical conceptualization of Inflation that was propagated long ago by Irving Fisher early in the 20th Century, which he based on the foundational assumptions of The Quantity Theory of Money.
Fisher postulated that the macro economy can be said to have a certain “Price Level” (the price of “everything” at a given moment in time) that corresponds with that economy’s Money Supply at that same moment in time. So far, so good.
But the Quantity Theory of Money was applied to this observation by Monetarists in a way that simplistically assumed that if the quantity of money in circulation were increased, the result would be an increase in the prices of everything in the economy at the same rate.
The problem with Fisher’s conceptualization of The Price Level is that it encouraged economists to imagine price Inflation — caused by money supply Inflation — as some kind of mysterious “effect” which spreads out evenly like a mist over the entire economy, causing all prices to increase by the same percentage.
It’s an assumption that simply ignores available empirical evidence to the contrary. The graph below, published by Forbes magazine, provides stark evidence to us that different income groups experience different rates of Inflation.
The reason rich people have been experiencing higher rates of Inflation than everyone else is because Congress decided in the early 1980’s to reduce the top marginal income tax rates (including capital gains tax rates) that rich people are required to pay.
The result: the disposable incomes of all rich Americans increased significantly. Rich people, of course, did what rich people always do when they acquire a big windfall of disposable dollars: they threw them at the asset and luxury markets, inflating their prices considerably.
At the same time that rich people were seeing their disposable incomes increase dramatically, the out-sourcing of good-paying jobs and the weakening of labor unions generally put downward market pressure on the incomes of common wage earners.
As these graphs illustrate, the Rich and the Non-Rich have experienced significantly different rates of Inflation as Congress has continued to pass more and more tax cuts for rich people over the decades.
In light of these empirical facts, we are confronted with a supremely important economic reality:
It is indeed quite possible for one income group to experience disinflation, or even deflation, at the same time another income group is experiencing double-digit Inflation
So the assumption that Inflation is something that affects everybody about the same — depriving everyone in society of purchasing power at a somewhat equal rate — is simply wrong.
Therefore, the first thing we should be asking whenever we hear someone bring up the topic of Inflation is, “Which income group’s Inflation rate are you concerned about?”
The Right Way To Calculate Inflation Rates
Given the historical evidence — that Inflation rates vary across income groups — it would make sense for economists to abandon the approach to measuring Inflation they’ve relied on for decades.
The CPI, PCE, & GDP Deflator indexes all seek to provide an “average” rate of price increases (supposedly affecting all of the economy’s participants ) over a period of time.
The problem with these price indexes is that they are used to estimate the “real” purchasing power of an individual household’s income or an individual firm’s earnings by “adjusting them” for the impact of money-supply Inflation.
But that’s a problem, because the impact of money-supply Inflation is going to affect different income groups at different rates. So using an average of the different Inflation rates that different groups experience to ‘correct’ for Inflation is irrational.
This is why I have proposed that the Bureau of Labor Statistics should compile and publish a spectrum of Inflation rates derived from market baskets that are configured to reflect the spending habits of income earners in various income brackets (with asset prices prominently featured in the market baskets of the highest income earners, properly weighted).
With the data that such a report would provide, both academic economists and policy makers would be forced to explain which income group’s price Inflation they are concerned about and why.
Is it not interesting that rich people really don’t mind Inflation when it is their own incomes that are being inflated? Only the Inflation that wage-earners experience (CPI) seems to bother them. Why? Could it be the fact that — generally speaking — the incomes of common wage-earners are a “cost” to the wealthiest members of society?
With this new understanding of Inflation fundamentals, we can see now why most of the “money printing” the Fed has carried out since the 2008 financial crisis did not produce a big jump in Inflation as measured by the CPI.
The Inflation that monetarists predicted would occur did occur (in the stock, art, and real estate markets); it just didn’t occur within the income groups that are represented in the CPI.
Are Creditors The Big Losers To Inflation?
In most economics textbooks you’ll find a listing of those participants in the economy who are said to be Winners or Losers as a consequence of Inflation. Near the top of their lists of losers are creditors.
Creditors are said to be losers to Inflation because they lend out dollars that have a certain amount of purchasing power on the day they’re borrowed, but when the loan is paid back years later, the dollars the bank receives will supposedly not buy as much as they used to, due to Inflation.
It turns out that this notion is completely false.
The first flaw in this account is failing to notice that the kind of Inflation they are blaming for the supposed loss of purchasing power is not supply-constraint Inflation, but is rather demand-driven Inflation, originating from monetary Inflation, which is experienced by consumers as disposable income Inflation.
Therefore, if a banker is concerned that monetary Inflation will reduce the purchasing power of the dollars she receives in the future, then what she is actually saying is she expects that the income of her bank and all other banks will be inflated over the course of the loan and that it is with those Inflation dollars that banks in general will bid up the prices of the ‘stuff’ banks typically buy (income streams & real property).
Which is to say that even though banks will face higher prices, they will already have been compensated for that development by the inflated incomes they all experienced. That’s what monetary Inflation does.
It is true that the dollars they spend in the markets they participate in as banks will not buy what they used to, but the only reason that is true is because most of the customers for those desirable assets have all experienced incomes Inflation.
Important: contrary to the claims of Inflation hawks, it is not the dollars themselves that experience a loss of purchasing power due to some kind of mysterious “inflation effect”; it is only the dollars that are spent in certain markets whose customers have been experiencing inflated incomes that lose purchasing power in those markets.
Consider the example of rich people who have experienced robust monetary Inflation over the past few decades. If they spend some of their Inflation dollars on stocks, they will indeed be able to buy fewer stocks with those dollars than they used to.
However, if they were to spend those same dollars on their electricity bills, the loss of purchasing power of those dollars in this market would be minuscule in comparison, because most electricity consumers have not seen their incomes inflated as have rich people, so the price of electricity has not been bid up to the same degree that financial assets and luxury items have been.
So no “debasement” of every unit of a currency in circulation due to Inflation ever occurs. A dollar “loses purchasing power” due to incomes inflation only with respect to those specific markets which serve customers who have had their disposable incomes inflated.
This is why two different income groups can experience different rates of Inflation even though both are exchanging the same dollars. What matters is 1) which markets the dollars are being spent in, and 2) what has happened to the disposable incomes of the majority of buyers who frequent those markets.
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The other group that is most often mentioned as one of the big Losers to Inflation are fixed-income recipients. The concern is that pensioners and others on fixed incomes have no means to “keep up with Inflation.” Indeed, how can they if their incomes are fixed and non-negotiable?
The good news is that this is one problem that is incredibly easy to fix. All the government needs to do to fix this problem is keystroke into existence any extra dollars pensioners might need in order to maintain their rankings within the hierarchy of all disposable incomes.
This simple fix — at virtually no real cost — is all that needs to be done to ensure that fixed income households will suffer no loss of purchasing power due to overall demand-driven price Inflation.
How To Control Inflation
The crucial difference between demand-driven Inflation and supply constriction Inflation is something that all the participants of an economy should understand.
Inflation driven by incomes Inflation is actually extremely rare in American history. The episodes of sharply higher CPI Inflation that the United States has experienced in the modern era have nearly always been triggered by supply constrictions.
Unfortunately, central bankers have used the fear of demand-driven Inflation as an excuse to throw the economy into periodic recessions — economic catastrophes that feature high levels of unemployment and massive suffering on a large scale.
If voters understood that there’s nothing for them to fear from incomes Inflation, they‘d likely put political pressure on their politicians to stop the Fed from using its traditional sledgehammer approach to fighting Inflation and require that it use intelligently designed credit controls instead.
Currently, when the Fed acts to abate Inflation, it raises all interest rates across the board until aggregate demand has slumped to the point where jobs are being destroyed in a big way. It’s the approach to fighting Inflation that Monetarists have long recommended.
Such a simple-minded, destructive approach is completely unnecessary. With intelligently designed credit controls, the Fed can narrowly target only those industries/markets that are responsible for pumping excessive amounts of the Fed’s created money into the economy.
It’s not hard to identify which industries are experiencing ‘excessive’ price inflation. Simply note which sectors have been experiencing both 1) increased bank borrowing and 2) increasing price levels at the retail level. Prime example: the real estate market.
If the Fed were to create a pool of ‘loanable funds’ of limited size that it will allow banks to lend from (to customers in targeted industries/markets) it will then be able to ‘discover a price’ (interest rate) for those funds.
In this way, it will be able to establish an absolute quantitative limit on how much money is pumped into specific sectors of the economy.
In the real estate market, allowances could be made for first-time home buyers and single dwelling owners by arbitrarily setting an affordable rate for them. All others — a group that includes all of the economy’s leverage-reliant speculators — will face much steeper rates for the available funds.
By narrowly targeting specific industries/markets for reduced lending, nearly any asset bubble can be deflated in a somewhat controlled manner without jeopardizing the health of the rest of the economy.
If loans for major appliances and automobiles can continue to be offered at affordable interest rates, demand in those industries would remain robust.
Conclusion
Price Inflation is an economic phenomenon that has been misunderstood by theorists and policy makers for generations. Simplistic assumptions and sweeping generalizations are primarily to blame.
My hope is that the unique insights into Inflation presented in this article will ultimately lead to wiser economic policy decisions in the future…
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The analysis in this article which refers to economic theory was originally presented in the article “Why Rich People Should Insist On A Full-Employment Economy”, which explains why free market economies should be managed in a way that optimizes the economic well-being of the Working Class…
