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Confused About the Source of Inflation?

Only if one chooses to ignore the obvious.

For many centuries our ancestors thought that the stars and planets circled around the Earth, because that is the apparent motion. Only relatively recently was it firmly established that the Earth was instead spinning.

Observations can be deceiving.

In response to everyday supply and demand, the price of financial assets, goods and services usually move up and down, a sign that the markets are functioning properly. But when there is an increase in the price of everything, it is safe to assume that inflation is the root cause. But this apparent increase in the price of everything is a deception, because it is in fact the dollar that is devaluing.

A subtle difference, but important to understand because just as there is supply and demand for assets, goods and services, there is also supply and demand for dollars, as dollars are needed to facilitate financial transactions.

Which implies that for the dollar to lose value, the supply of dollars must be increasing relative to the demand for dollars, or the demand is decreasing relative to the supply.

Consider the second case, and assume that the supply of dollars is constant, that inflation occurs if the demand for dollars decreases.

Whether it be domestic transactions or the sale of international oil, many goods and services are priced in dollars. Every time such a sale takes place, dollars, whether paper or electronic, are used to transfer wealth. Throughout the world such transactions are occurring continuously, thus we can imagine that for every 24-hour period, V amount of dollars are used to exchange wealth.

V (dollars-used / time-period) is referred to as the “velocity of money.”

V, to some degree, is proportional to the “demand” for dollars. That as V increases, more dollars will be required to exchange wealth.

There are other forms of demand for dollars, an example being how many are simply being stuffed in mattresses, but V is a significant one.

Under what circumstances would V decrease, causing dollars to lose value?

One possibility is that an economy has become inefficient, that there are less people performing productive work, or working at all, the results being less wealth transferred.

Another possibility is that there is a shortage of goods and services available for purchase, also resulting in less transactions, less wealth being transferred. For those lucky few that have read my book, recall that:

If the aggregate supply of goods and services decreases and if all the other forces are strangely constant, then the value of the dollar will decrease, inflation happens.

Aha! So when the politicians and Nobel-prize winning economists blame our high rate of inflation on our present supply shortages, are they correct?

Only if you conveniently (and politically) choose the ignore the other half of the equation, namely that the supply of dollars, which as can be seen the graph below, has increased by about 50% since the beginning of Covid.

Consider what happens if the supply of dollars increases during a period of no economic growth, i.e., no increase in the amount of goods and services produced, of wealth being transferred. Everyone has more dollars, all trying to buy the same, fixed amount of stuff.

If the aggregate demand for goods and services increases and if all other forces are strangely constant, then the value of the dollar will decrease, inflation happens.

In the first case, inflation happens if there is a shortage of goods and services, while in the second case inflation happens if there is an excessive supply of dollars.

Why is it so hard to comprehend that our present situation is a combination of both of these cases? Why are so many ignoring the supply side of the equation, choosing to blame our high rate of inflation exclusively on the shortage of goods and services?

I will tell you why. Because reducing the supply of dollars will prove to be very difficult to implement, there will be political pressure not to do so, at least not aggressively.

Just as it excessively expanded the money supply, only the Federal Reserve can reduce it. To do so, it has two tools at its disposal.

The first is to increase the overnight lending rate. During the remainder of this year, as announced, there will be seven increases, resulting in less loans, and per the fractional reserve banking system, a reduction in the money supply.

Moving in the right direction, but to reduce inflation to a healthy level (1-2%), this by itself may prove to be neither be fast nor significant enough.

A more dramatic action would be to reverse Quantitative Easing, the method by which the Federal Reserve dramatically increased the money supply. To do so the Federal Reserve will have to sell off some of its debt holdings before they mature, thus taking dollars out of the system, also reducing the supply of dollars.

The political problem is that federal deficit spending requires the Federal Reserve to buy more Treasury debt, which in turn increases the money supply. By reducing its debt holdings, the Federal Reserve will curtail future deficit spending.

And there lies the problem, as deficit spending is very popular among politicians. There will be tremendous political pressure on the Federal Reserve to continue buying debt, meaning that the money supply will continue to increase, that high inflation may continue even if the supply shortage problem is solved.

Inflation is a government creation, the result of failing to adjust the supply of dollars in response to the demand for dollars, to keep them in balance. Just as our supply shortage problem was created by the government, the result of paying people not to work.

Inflation is a market distortion, making our economy less efficient, reducing the overall wealth, to the detriment of most.

Finally, the often-ignored truth is that high inflation, especially the recent spike in the price of homes and stocks, is a social injustice. In 2019, the home ownership rate among white non-Hispanic Americans was 73.3%, compared to 42.1% among Black Americans. Inflation rewards those that own a house with a 30-year fixed mortgage, while punishing those that rent.

Ditto for those that were wealthy enough to own stocks before the run-up in stock prices.

The Covid emergency is over, it is time to make our economy efficient again, as we will need to accumulate wealth for future challenges.

It is past time for the Federal Reserve to take immediate and aggressive action to reduce the rate of inflation, and for our federal government to become more fiscally responsible.


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