The Mechanics of Inflation

Since the Great Financial Crisis in 2008 and the 'temporary' expansive monetary policy that followed, more and more economists now warn about inflation. Despite high monetary inflation during the time, prices did only rise slightly for consumption goods.

This encourages Keynesian economists to claim that more and more monetary and fiscal expansion is necessary, and they heavily demand it from the governments and central banks. The message is clear: 'inflation was not a problem in the past, and it will not be a problem now.'

The latest pick up in inflation because of the reopening of the western economies is recognized by central banks, but they assume that it will be just 'transitory'. As soon as the economy would typically run again, inflation, therefore, will normalize, so they say.

The biggest fear for sustainable higher inflation is, according to economists, the labor market. Their assumption is the trade-off between inflation and unemployment with steady inflation expectations, just as assumed in the model of the Phillips Curve. President Biden and secretary of finance Janet Yellen clarified in younger statements that this is precisely what the government wants to achieve. Yellen even said that a moderate increase in interest rates would be beneficial for the US economy.

Maybe this is a hint that the treasury department, on the one hand, and the Federal Reserve, on the other hand, are already assuming that the topic of INFLATION will probably stay for longer than they wish for.

However, if one looks at the mechanics of inflation, this assumption may not be as far-fetched as some may think it is. Inflation is constantly playing out in similar ways but on the one side but is always a little bit different on the other. Nevertheless, if one digs further into the topic of inflation, one can observe that all inflations follow a similar pattern. Today I want to write about this pattern, then look at the hyperinflation in Weimar Germany and the big inflationary period in the US after World War II and then try to think about what may be next today.

There are several dynamics and phases of inflation which always lead to a significant increase in broader consumer prices in the end. However, the magnitude and strength are always different because it depends on the reaction of central banks and governments on how to fight it. By looking back in history, one can see that sometimes they did a good job, sometimes they made a worse job. Whatever, the mechanics of inflation always work the same way.

The pity of inflation always starts with an expansion of the money supply, an increase in the quantity of money within the whole economy, the financial and the real one.

First of all, this leads to a decrease in the price of money, the rate of interest, and thus to a structural shift in production, away from producing consumption goods (goods of lower order) to produce more capital goods (goods of higher order). A portion of it always finds its way into financial markets.

A boom emerges, covering all the destructive consequences of monetary expansion, accompanied mainly by a fall in money velocity in the real economy and a rise in money velocity within financial markets. Profits of businesses go up, and so do their debt levels because they can use that 'paper gains' to leverage and engage in more capital-intensive projects. 

Most governments also expand, and the number of jobs within government bureaucracy as a whole and simultaneously the number of jobs business administration and thus non-productive jobs increases as well. With unproductive jobs, I mean jobs that are not necessarily needed to organize the production process and the production of goods. 

If one looks at inflations of the 20th Century, there were always some deflationary forces, such as productivity increases. Sometimes wages fall because of an increase in labor supply which also can be considered deflationary. 

Another aspect is that the currency does not devalue to the same amount as the quantity of money increases because investors often underestimate the problems. The enlargement in the quantity of money further leads to a rise in inequality, causing additional trouble. Nevertheless, as long as the economic boom continues, one neglects the possible consequences that come with it.

Those who expect those imbalances to be balanced out rather quickly and the price level is adjusting soon to the changes are wrong. This problem could remain unrecognized for a long time, especially in a globalized world where goods and services are exchanged between different currency areas. 

After a time when prices have remained relatively stable, the level of prices starts to rise gradually. During this phase, some economists always claim (although they should know better) that this shows that the expansion in the quantity of money does not necessarily lead to increases in the price level. This is their excuse to keep the inflation of the money supply going. 

The proponents of this kind of monetary policy overlook that the inevitable further increase in the price level is further strengthened at a certain point. However, the rise in the asset market is usually more significant than the increase in the price level, which is further mostly higher than the increase in wage rates. 

During this period, the velocity of money in asset markets is accelerating: The rise in asset prices causes more and more people to start to speculate because they assume that prices can only go up.

Now one can observe that the rise in the number of goods produced cannot keep up with the increase of the quantity of money, which is also accelerating. As the number of workers in unproductive sectors of the economy increases further, the problem worsens.

At a certain point, investors detect that their previous assumptions regarding their view on the economic strength of the currency area have been wrong. They start to move capital out of the area to invest it in other economies, and the currency's value goes down. Therefore prices for imported goods is increasing and thus puts pressure on prices in general. 

Because politicians fear the consequences of the expansion of the money supply is put on halt, they continue to increase the quantity of money. Historically the magnitude of the increase is different, and thus this influences the unfolding of the inevitable consequence.

Finally, businesses and workers anticipate the accelerating price increases: firms begin to charge higher prices, and they have to repeat this step as workers also more often demand higher wages. This wage-price spiral is fueling inflation further, and more businesses fail and exit the market because the demand for some goods falls, and they do not make a profit anymore. 

The crisis starts in asset markets because the end of the boom leads to a fall in asset prices (equities, bonds, and real estate). More and more money is exiting the financial economy and flowing back into the real economy, which leads to an increase in money velocity. 

Rising velocity then leads to a further pick up in price inflation. However, the strength of the effect differs because lots of other external factors are influencing it, for example, how the public is reacting. As a result, one cannot forecast how fast money velocity returns to levels before the boom. 

This is why the inflationary period in the United States after World War II is much different than the hyperinflation in Weimar Germany. What is certain is that the economy needs to reach a new, sustainable level which depends on how all those imbalances play out and how the people in charge of monetary policy react. However, how hard the side effects will differ from example to example.

Before I discuss the current state of affairs, I want to recap the inflation in Weimar Germany and the inflationary period of the United States after World War II and show that the mechanics I described above work for both. 

The tragedy of the great hyperinflation in Weimar Germany of 1923 started in 1914, at the beginning of World War I. The German Reich had just abandoned the gold standard and started to inflate the money supply to pay for the war instead of the public making sacrifices due to higher taxation. 

Inflation, however, remained pretty much stable during the war, despite the significant increases in the money supply. While the supply of money increased ninefold, prices only doubled. Apart from the war, the population's lives continued to be relatively unaffected by the expansion of the money supply.

After the war ended, all participants went through an inflationary period, which was necessary to correct the emerging imbalances. Nevertheless, in the spring of 1920, this should change...

German prices were 17 times higher than before the war, but now as all other countries went through a recession, Germany continued to expand the money supply.

Then, the tragedy ran its course: The expansionary monetary policy from the Reichsbank led to an economic boom. Especially industrial business profited big from this monetary policy: exports went up, masses of tourists visited Berlin, which was considered one of the most beautiful metropoles back then. All of this led to big increases in wealth for some new-rich who lived in beautiful (newly built) houses. Those who had access to the newly created money got it quickly, and nobody was really interested in using it to produce real value. 

Those who had no access to money were not that lucky: Although unemployment remained low and wages were increasing, others struggled. 

Easy money kept businesses alive who would have gone bankrupt otherwise; the number of insolvencies collapsed. Speculation became ubiquitous, and everyone participated. As a result, stock prices were four times higher in November of 1921 compared to February 1920. The 'Berliner Boerse' (stock exchange) was buzzing, financial companies couldn't keep up with their paperwork. More and more mergers and acquisitions demanded more and more unproductive work. Those who were at least necessary for the German economy enjoyed the most gain in their wealth.

Even during this period, prices remained relatively stable because the currency remained strong: The German Mark had become the most valuable currency of the world, despite the enormous increase in the quantity of German Mark. However, the seed has been sown: While finance minister Matthias Erzberger has followed our more restrictive approach, all caution was dropped after he had to resign due to a court ruling in 1920.

The nationalistic right-wing parties, especially one of their leaders, German economist Karl Helfferich, and their financiers, the German industry (a big winner of inflationary policies), should be primarily accountable for the events that followed. 

In December of 1921, stock prices fell 25 % and moved sideways afterward while prices in the real economy spiked. Simultaneously the printing press ran hot, and German government debt exploded. The only way to repay the debt was by printing even more.

Interestingly, the German budget was the most balanced one since 1914. Until the summer of 1922, prices had tenfold, and businessmen started to quote prices in gold or other considered stable values like the US dollar. In the following 11 months, prices should increase further by a hundredfold. 

In the end, prices quadrupled every week: Usually, the price of a Schnitzel had increased by 20 % between ordering and paying the bill. Unlike some claims, reparation payments hardly had a share in the economic collapse: Until 1923, the German government had paid roughly 5 % of its annual economic output.  

The difference between the hyperinflation in Weimar Germany and the tremendous inflationary period in the US mainly differed in its backstory and in the intensity of the unfold that followed. Nevertheless, the roots can be traced back to another war, World War II, although it never reached such extreme levels as Germany, even though debt levels were pretty much the same (about a quarter of yearly GDP).

During the war, inflation remained relatively stable, like in the German Reich. After the war, inflationary policies were stopped (a good approach), a short period of inflation followed where imbalances diminished, and inflation remained stable until 1950.

Until 1962, expansive and restrictive monetary policies took a turn, and because of that, inflation was not a problem. After the start of the Korean War, prices spiked but due to a change in behavior of market participants who expected another implementation of price-controls and not because of a change in monetary policy. However, the Fed had to fight the rise in interest rates, which led to a period of yield curve control to keep rates stable.,

When John F. Kennedy won the presidential elections, a mood of economic optimism set in, taxes were lowered, and economic subsidies were installed. After Kennedy's death, Lyndon B. Johnson continued on the path. The Fed began to expand the money supply, and the economy experienced an upswing. As a result, inflation remained low. 

However, Lyndon B. Johnson's policies changed the structure of the economy. While the total number of workers (27 million) did not change, the number of those working in productive sectors decreased by 13 %. Simultaneously, wages in those sectors rose slower than inflation. 

Interestingly, many businesses suffered, which leads to the question: Who profited from the expansion in the quantity of money. Like in Weimar Germany, it was workers in unproductive parts of the economy, government bureaucrats, and speculators. From Jens Parsson's 'Dying of Money':

'Legions of Americans - investors, conglomerators, brokers, advisers, lawyers, accountants, analysts, clerks, programmers, bureaucrats, and so forth - served the business of making money with money and creating absolutely nothing even as a byproduct'

If nobody is working in productive sectors of the economy, a fall in economic output, while the money supply remains stable or increases, will follow. 

One can see: Although the mechanics of inflation were equal in both examples, the difference between the German hyperinflation and the inflationary period in the US after World War II is significant. When inflation spiked in the 1970s because of the spike in oil prices, it quickly went north 10 %. Why? Because the Fed did a much better job than the German Reichsbank, inflation in the US accelerated much slower and by far less dramatic than in Germany in the 1920s. 

Now, let us move to the present and evaluate the current inflationary environment. The recent spike in the total quantity of money is more similar to Weimar Germany than to the inflationary period in the US after WWII. Since the pandemic's start, the narrow money supply M1 has quadrupled, while back in the days, it quadrupled from 1960 to 1986. Simultaneously one can observe that the imbalances became larger since the dot-com bubble popped because everyone feared the consequences of a more restrictive monetary policy.

While the reaction of the Fed has similarities to those of the Reichsbank in Weimar Germany, many ask why the inflation is not there yet (at least in the US CPI numbers)? If we look at money velocity, we can assume that, with all its interventions, the Fed has succeeded in keeping the money in asset markets for 40 years now. For example, if we put US market cap relative to M2 money supply, one can observe that money velocity in asset markets has not fallen but has increased. 

During the last decade, inflation was pretty stable in the US but has accelerated since July 2020. In May, core inflation has risen .7 % month over month. Year over year inflation has been the strongest since 2008. If one only assumes month-over-month inflation of .5 % this year, prices would increase by 6 %. 

Supply chain bottlenecks push prices up while simultaneously fewer and fewer workers actively produce real goods and services. Lots of money is spent on education which has no real use in the real economy, but those people want to buy real goods and services. 

Additionally, the current political environment leads to the conclusion that global trade is either on halt or on a step back. To keep living standards constant, which means the ability to buy the same amount of goods and services, the US needs increased production. This only works over an allocation of workers to the production of those and thus probably to higher wages in those sectors, further leading to higher prices.   

One sees that the seed for the coming higher inflation has been sown for 20 years now, probably much more than after World War II. Still, one has to be cautious to conclude that the future scenario will be like the one in Weimar Germany. 

On the one hand, it depends how the Fed is reacting to the coming rise in inflation: If the Fed is following the actions of the German Reichsbank and continues to grow the money supply exponentially, then an alike outcome is a probability. But as Mark Twain already said: It is difficult to make predictions, particularly about the future! However, I would instead think that a result like the Stagflation of the 1970s is more likely, and therefore I'd bet on high inflation, but not hyperinflation.,

Have a great weekend!
Fabian Wintersberger

Disclaimer: This is a personal blog. Any views or opinions represented in this blog are personal and belong solely to the blog owner and do not represent those of people, institutions, or organizations that the owner may or may not be associated with in professional or personal capacity.