Is Inflation About to Become a Problem Again?
Those of us of a certain age remember when inflation was a problem. For example, during the post-Vietnam War period, inflation was a vexing political issue that found few solutions. The value of money was falling, which is another way to say that prices were rising. It took more money to buy the same amount of goods and services.
President Gerald Ford, while physically more graceful than our current President, nevertheless stumbled badly with the WIN button, or Whip Inflation Now campaign. It suggested inflation was primarily an attitude that could be changed with public service slogans. It was sort of the equivalent of urging people to wear masks to stop the Wuhan virus and was about as effective.
By the time we rolled into the early 1980s, inflation was double-digit, running upwards of 12% per year, and required the towering Paul Volker as FED chairman, and the political guts of President Ronald Reagan to break the trend. Interest rates soared, the prime rate got to 20% and we suffered a serious recession.
It was the high point in monetarism, an economic theory that suggested that if the quantity of money grew faster than real output, the value of money would fall. Its most prestigious spokesman at the time was Nobel Prize-winning economist, Milton Friedman. He did not invent the concept but he embellished it.
Friedman is often quoted as saying, “inflation is always and everywhere a monetary phenomenon.”
That unfortunately is a shortened version of what he really said, which was “Inflation is always and everywhere a monetary phenomenon in the sense that it can be produced only by a more rapid increase in the quantity of money than in output.”
Notice the full quote gives the quantity of goods produced or output, a prominent place in the equation while the shortened version incorrectly repeated, suggests that it is ONLY the supply of money that is a factor. The supply of goods forthcoming is important to hold prices down, as is competition.
The short-hand equation is MV=PQ. Money supply times velocity of turnover of each monetary unit equals the price level times the quantity of goods (real GDP).
One does not have to believe in a pure mechanical reading of this equation to appreciate its essential truth, that is, the quantity of money, its rate of turnover and the supply of goods are important variables in the inflation phenomena.
If the quantity of goods is rising and the velocity of turnover is falling, a given increase in the quantity of money will not create price inflation. Money velocity or how often a dollar turns over has been collapsing over recent years. That and the rise of huge new producers like China are likely the reasons inflation has been “quiet” of late.
But if people believe inflation is coming, they will spend their money before prices go up and the velocity of turnover can rise. You can see velocity is subject to perception and expectations.
Besides the quantity of goods available, competition is important in holding down prices. Competition could be defined as a system whereby economic producers are free to enter markets and produce goods, and consumers are free to choose less expensive goods. You need both a rising quantity of goods and the choice to buy cheaper through competition.
It was further believed that government debt and deficits directly led to the increase in money growth, as the government was either borrowing, and crowding out the capital markets, or it was printing, which is classic currency debasement.
Inflation does indeed have something to do with the quantity of money. If held relatively stable, in a capitalist economy, there is the tendency for prices to fall. This makes perfect sense. You have an economy that produces things at a rapid rate, with rising productivity (more things produced given available inputs of labor and capital), prices will fall.
Think of what we have seen with widescreen TVs over the past decade, and apply that to almost everything produced.
This is so-called disinflation or deflation.
A good historic example is that of the United States. As our economy matured and began to outstrip Britain and our other European rivals, and money was anchored to the discipline of the gold standard, prices generally fell from the post-Civil War era all the way to the great monetary disruption caused by World War I. The purchasing power of money actually rose. A dollar saved today would buy more in the future, and not less.
Since then, we have had either crawling or galloping inflation. These terms are unfortunately vague in their usage. Crawling inflation could be described as a persistent “slow erosion” in purchasing power. Galloping inflation is when depreciation is rapid. Crawling inflation is annoying, but can be dealt with. Galloping inflation is beyond disturbing, it can upend whole societies.
Older people can see currency depreciation over time. For those without this perspective, we suggest you visit a handy website, US Inflation Calculator. You will soon discover that something as moderate at say 3% inflation can cut purchasing power in half in just 24 years. Inflation at 5%, can cut purchasing power in half in less than 15 years. It is like compound interest, only in reverse.
Today our ruling elite buys into a different theory, that of Modern Monetary Theory. This theory posits that the quantity of money in circulation has virtually nothing to do with purchasing power. Jerome Powell, Chairman of the Federal Reserve in early March echoed this idea when he stated, “When you and I studied economics a million years ago, M2 and monetary aggregates seemed to have a relationship to economic growth,” but, “right now … M2 … does not really have important implications. It is something we have to unlearn I guess.”
There is so much to unpack in this statement that it could take a book to do it. Suffice it to say, the usefulness of a theory has nothing to do with its age, it has to do with its validity. When a FED Chair dismisses Milton Friedman and says we must unlearn what most economists think is true, that is a head-turner.
But of late, politicians have learned that debt and deficits, don’t hurt interest rates nor cause inflation. We have indeed invented a free lunch. There is no cost, they say, for their policies.
Much of the previous stimulus policies, did not lead to an increase in the money supply. The FED created “reserves” for the banks, and by paying banks a return on these reserves, and requiring banks to boost capital, much of the newly created money remained locked in the banking system or flowed into financial assets, which have been inflating like crazy.
Now, the money supply is growing. M2, a broad measure of money, has jumped about 25% from the same time last year. That is the fastest growth since WW II.
But the FED and the Democrats say not to worry. Their printing money policies will not lead to inflation because the supply of goods will be rising. Really, the supply of goods will be rising by more than 25%?
Skeptical markets are beginning to rebel against these policies. Key interest rates such as the yield on the US 10-year Treasury have more than doubled, and other countries such as Brazil and India are seeing sharp increases in rates as well. The more Powell says such nonsensical things, the more rates have risen.
Key commodity prices are rising. Ask anyone familiar with the cost of building materials, metals, energy, and a host of other products, and they will tell you that Lockdown policies have disrupted supply chains and the supply of goods is not rising, but prices indeed are. The same can be seen at the gas pump and in transportation costs.
In personal purchases, we have noticed a sharp rise in the price of swimming pool chlorine, furniture costs, ammunition, autos, and many food prices. It becomes an issue of whether you believe what you see with your own eyes versus what the government is telling you with its indices.
Now the government that lied about WMD, Russian collusion, and the health of Joe Biden, wouldn’t try to lie to you, would they?
And then there are prices of many things not in the “consumer index”, such as the price of stocks and real estate. Just because they not in the index does not mean they are not important. Indeed, we may spend more on real estate and investments than we spend on cheap clothes made in Asia. Yet these important items are not calculated in the index.
At this point, we don’t know if these flickering signs of inflation will intensify or subside. But the setup does not look very good from a common-sense perspective.
We have a government, through the totality of its policies, that has increased the quantity of money drastically while imposing Lockdown policies that shut down production. It now wants to impose heavy taxation, more regulation, a racial spoils system that punishes merit, and even more spending. It and its big business allies, seem bent on cartelizing the economy, which reduces competition.
It is a government more interested in wealth redistribution than wealth creation.
That seems like a formula for more money to be chasing less production, a good working definition of inflation.
If both the supply of money continues to rise and is accompanied by either stability in or a rising trend in velocity of money turnover, inflation could become a serious problem again.
If that is the case, you will know who to blame.
The risk is that unlike 1980, we are far more indebted today, at all levels of government, corporate, or household levels. Rising interest rates could cause another debt-driven financial crisis.
So, our government, led primarily, but not exclusively by Democrats, is putting the nation on a knife-edge. If interest rates and inflation continue to rise, we could experience first bad inflation, and then as interest rates spike to painful levels, another deflationary bust.
The policies being pursued certainly do not argue for stability.
Socialism has consequences.
Neland D. Nobel retired after 45 years in financial services, portfolio management, and financial planning.
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