What is Inflation, Anyway?

I was probably about 12 the first time I remember hearing the term “inflation.” From what I can recall (since that was a quarter century ago) I believe I placed it into the same category as the “heat waves” which caused the deaths of elderly folks without air conditioning: Bad, but not something I could control or really understand.

Thankfully, I’ve learned a bit since then.

From Investor Words we have the following definition: “The overall general upward price movement of goods and services in an economy, usually as measured by the Consumer Price Index and the Producer Price Index.” I’d have to go with technical but off-base.

Let’s try one from Your Dictionary:

  1. an increase in the amount of money and credit in relation to the supply of goods and services
  2. an increase in the general price level, resulting from this, specif., an excessive or persistent increase, causing a decline in purchasing power

Ahh, much better. You see, the real cause of inflation is the currency/credit supply, not the price levels. Price levels are a secondary effect.  Of course, since very few of us actually keep our eyes on how much currency/credit is available, we generally think in terms of price levels, as in “Based on inflation, a pound of beef now costs 3 times what it did in 19XX.” At the same time, price levels are affected by much more than inflation. Despite the fact that we trade within a market which is far from free, the once robust market (unwilling to go gently into that good night) still has an influence via the laws of supply and demand.

That said, inflation may be safely laid at the feet of government (assuming that government is in charge of printing currency). Milton Friedman must receive the credit for this understanding of how inflation works (as this was not always the case):

Against the conventional wisdom, Mr. Friedman argued that “inflation is always and everywhere a monetary phenomenon.” Inflation had nothing to do with aggressive unions, greedy businesses or even oil cartels — the bad guys who took the blame in the confusing 1970’s. Prices shot up everywhere because the federal government made the supply of money grow faster than the real economy created value. Based on the historical record, he argued, the effects of monetary policy were fairly predictable.

Given this, and the fact that our duly elected Senators are being called upon to raise the debt ceiling to $12.1 trillion within the next few weeks or the world will end default will occur, let me ask another question.

What have we not learned in the last 25 years? Massive increases in the money supply are inevitably followed by a massive uptick in inflation. For any of our elected officials to simply talk about inflation as though it falls into the category with death and taxes (as one of a few things which are certain) is wrong. The only thing which is certain about inflation is that it, like taxes, is something under the control of government. By the time inflation is felt, it is true that government can do little to mitigate its impact on the economy at that time, but government can change the policies which caused the problem in the first place, allowing the inflation to decrease over time.

Of course, instead of submitting ourselves to the inflation hyperinflation, we could just default on outstanding Treasury-bond backed loans, thereby torching the money supply. Unfortunately, that choice would result in massive disruption of the economy if not create the environment for a shooting war with, oh, China?

At present, assuming we don’t go the default route, we are floating somewhere above the waterfall, within earshot of the cataract yet unable to move the boat to shore. Let’s hope, for a change, that we can all swim once we hit bottom.