Inflation - Theory and History

For several weeks now we have heard a lot about inflation fears, inflation expectations & inflation in general. Therefore I decided to write about inflation this week.

After being more or less absent for more than a century, investors expect that inflation will return sometime within the next few years. Since day one of 2021 investors started to sell US treasuries, pushing inflation expectations to highs which we have not seen since 2008.

The article by Bloomberg journalists Vivien Lou Chen, Daniela Sirtori-Cortina and Edward Bolingbroke says that the anticipated annual inflation rate for the next half-decade exceeded 2.5% for the first time since 2008 -- aided by climbing oil prices.

We got used to the fact that allegedly the general price level has to rise over time. Economists and Central bankers claim that they have to make sure that prices do not fall, that we do not experience deflation.

According to proponents of moderate inflation there is a risk when the general price level stays constant or if prices fall, consumers will postpone their consumption decisions into the future and therefore start a dangerous downward spiral.

However, the phenomena of steadily rising prices is very young. With reference to data from Deutsche Bank it dates back about 100 years. Before that, the price level has been pretty stable although one can argue that for some time (before the industrial revolution took place) we also did not experience very much economic growth. Since the second half of the 18th Century on the world economy has started to grow like it has never before.

We can see that the phenomenon of steady, moderate inflation is very 'new'. Why it has become so? The answer to that may be found if we are looking at the more and more extreme measures of monetary policy by central banks.

The definition of inflation in the Oxford dictionary defines inflation as a general rise in the prices of services and goods in a particular country, resulting in a fall in the value of money; the rate at which this happens. That is the way we use the word 'inflation' nowadays. If we are talking about inflation, we mean a rise in general consumer prices.

However, we have to ask why prices rise in the first place? On the one hand, there is supply-side inflation, which means an increase in prices for factors of productions, like commodities or wages. Firms pass those rises in input costs to the consumer who experiences higher prices as a result. One argument by moderate inflationists is that inflation remained subdued for the previous 10 years because wages did not rise.

Another reason for rising prices is higher demand, if the quantity of supply stays constant. So, if demand for a certain good or service rises and producers cannot expand production as much as demand has risen, prices will rise.

It is needless to say that this two factors indeed play a role when it comes to price increases for certain goods or services. However, this cannot explain an increase in the general level of prices because a rise in prices of good A has to result in a price decrease in good B (if the money supply remains constant).

Therefore we cannot explain inflation solely by changes in supply and demand, at least if we want to know what caused the increase in the general price level. In fact, what we are calling inflation nowadays was called price-inflation back then.

The term inflation simply described an expansion in the supply of money. Price inflation is just the effect of an increase in the supply of money. If the newly created money is used to demand certain goods or services, those prices rise.

We do not even need a fiat money system like we have nowadays. Spain imported huge amounts of gold and silver from South America in the 16th century. Gold and silver were legal tender back then. But instead of being endlessly rich now, the Spanish people learned that one cannot dig prosperity.

Despite of huge amounts of precious metals, there was no increase in the production of goods and services. Therefore, the inevitable happened: Prices adjusted to the - now higher - amount of currency chasing those goods. Besides that, prices rose all across Europe.

Rising prices are simply the result of an expansion in the supply of money. Another example is Weimar Germany in the 20th Century where the German Reichsbank printed endless amounts of money to repay German war debt. The difference to the 16th Century was that it was not an increase in gold and silver, but simply an increase in paper.

I want to remind you what the four most dangerous words in the financial industry are: This Time Is Different. Some say so because inflation did not occur after the 2008 Great Financial Crisis although there have been economists and analysts who predicted it. Despite the big expansion in the money supply, there was no pick up in inflation. Quite the opposite actually:

The problem here is that it is impossible to measure (statistically) how prices would have developed if there was no expansion of the money supply. Therefore a profound theory of money is so important when we are talking about inflation or deflation. There has been plenty of inflation, not only since 2008 but since the current dollar-system replaced that of Bretton Woods. Especially if we look at the development of asset prices, price inflation of those is astonishing.

I want to make one thing clear at this point: An expansion of the money supply does not need to result in a higher level of prices. Why? Because the price level is also influenced by the amount of goods and services in circulation. These also have an impact on the price level.

Let us make a small thought experiment: If we are imagining a evenly rotating economy (I like to refer to the Misesian model instead of the Walrasian one) where every economic actor is constantly repeating his actions and its' preferences do not change.

If the money supply expands by 10 % in this economy but a new development in the production process leads to an increase in production by 10 %. The rise in demand (compared to an economy without an expansion in the quantity of money) because of the expansion in the quantity of money is accompanied by a rise in production, the general price level will stay exactly where it has been before.

Statistically, price inflation would be zero per cent in our model. Nevertheless it means that consumers are worse off after the increase in the quantity of money because if the money supply has stayed constant the increase in production would have lead to a 10 % decrease in prices. Consumers would have been able to buy more goods and services with their disposable income.

Further we know, that an expansion in the quantity of money does not affect all sectors of the economy equally, but some sectors more than others. The Spanish Scholastic already discovered this in the 15th, 16th Century.

As economists we should be familiar with the Cantillon-Effect. Richard Cantillon, an english economist who was living in Paris, was describing this phenomenon in his posthumously published Essay on Economic Theory (p. 149-150):

'If the increase of hard money comes from gold and silver mines within the state, the owner of these mines, the entrepreneurs, the smelters, refiners, and all the other workers will increase their expenses in proportion to their profits.Their households will consume more meat, wine, or beer than before. They will become accustomed to wearing better clothes, having finer linens, and to having more ornate houses and other desirable goods. Consequently, they will give employment to several artisans who did not have that much work before and who, for the same reason, will increase their expenditures. All this increased expenditures on meat, wine, wool, etc., necessarily reduces the share of the other inhabitants in the state who do not participate at first in the wealth of the mines in question. The bargaining process of the market, with the demand for meat, wine, wool, etc., being stronger than usual, will not fail to increase their prices. These high prices will encourage farmers to employ more land to produce the following year, and these same farmers will profit from the increased prices and will increase their expenditure on their families like the others. Those who will suffer from these higher prices and increased consumption will be, first of all, the property owners, during the term of their leases, then their domestic servants and all the workmen or fixed wage earners who support their families on a salary.They all must diminish their expenditures in proportion to the new consumption, which will compel a large number of them to emigrate and to seek a living elsewhere. The property owners will dismiss many of them, and the rest will demand a wage increase in order to live as before. It is in this manner that a considerable increase of money from mines increases consumption and, by diminishing the number of inhabitants, greater expenditures result by those who remain.' 

Humanity profited from big gains in productivity in the last hundred years. Today, our society produces a multiple of those goods that were produced back then. This is another factor why inflation has remained moderate for the last 30 years.

The latest decade of high inflation were the 1970s when President Nixon closed to gold window and dollars were not redeemable in gold anymore. The US had to print lots of dollars during the late 60s and the 70s because on the one hand they had to finance the Vietnam war and on the other hand Nixons predecessor, Lyndon B. Johnson, had greatly increased social spending during his War on Poverty.

They had to close the gold window, because some countries (for example France under President Charles de Gaulle) demanded their gold reserves back because they did not trust that the US would stick to its' promise that the dollar is as good as gold. And rightfully so, as Nixon closed the gold window... temporary as he said...

During that times inflation was at 6.1 % already and pushed upward into double digit territory when the oil price shock sent energy prices through the roof. Suddenly, the Philips-Curve was not working anymore and apart from the model, where unemployment is supposed to fall if inflation is high, inflation AND unemployment stayed at high levels.

In the 2010s we did not observe much price inflation in consumption goods, although CPI-measurements were changed constantly and as a result I would say that one cannot compare CPI numbers from the 1970s with those in the 2010s. Probably inflation is higher than the CPI suggests, although the Fed and the ECB always refer to this as felt inflation. Nevertheless, monetary policy has prevented consumers from participating in the increased productivity of the last few decades through lower prices.

We see that inflation is a monetary phenomenon through and through, like Milton Friedman once said. At the beginning of every rise in the general level of prices, the money supply is expanded. The Cantillon Effect shows that price inflation happens in those sectors where the money flows into.

With reference to the real economy within our fiat money system, commercial banks play a big role in the supply of money. They can (and should) lend a multiple of the amount of base money because of the fractional reserve system. The higher the base money supply, the higher the possible amount of credit for the real economy.

However, banks are holding back since the GFC in 2008, the higher amount of base money stayed within the financial economy and led to price inflation in financial assets. Without a doubt, prices of stocks, bonds or real estate would be much lower today if central banks had not injected massive amounts of liquidity into the markets. 

The average Jane and Joe are those who suffer because it is much harder for them to build up wealth because of this expansionary monetary policy. Wages did not pick up as much as asset prices but at least live expenses did not so too.

However, this may change as central banks try to intervene with more and more extreme measures. While after 2008 broad money was not expanded, since 2020 it has been. People got free money via stimulus checks which - because of lockdowns - was not spent but saved widely. As soon as the economy fully reopens this money may flow directly into the economy and drive up prices. Another role which may accelerate that is that supply may shrink because of a possible rise in business bankruptcies.

Should we accept deflation instead which would benefit low income workers? Economists mostly refer to the deflationary spiral that I have mentioned here in the beginning. But does a moderate decrease in pries lead to a postponement of investment and consumption into the future? 

If we are looking at the tech-sector, you will notice that this theory does not hold there. Prices in the tech-sector did not only fall, but investment and demand increased heavily. Therefore I would argue that we should not fight deflation as it benefits the weakest actors within society. 

Although, probably it is about something else and inflation is welcomed because it allows heavily indebted governments, firms and households to pay down the debt at the expense of savers as their savings get devalued while debtors enjoy a decrease in their debt burden.

On the other hand, deflation would also lead to a drawdown in asset prices and (possible) indeed cause another financial crisis. However, this would result in a transformation of the economy in a more robust and vibrant one. It would be the cure, not the disease because the unsustainable boom really is the disease. But who is looking forward to a hangover after a long night of drinking...

Have a great weekend! 

Fabian Wintersberger

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