There is no concept in economics today that is as poorly understood as inflation. Academic economists, investment professionals, media pundits, and politicians all wallow in confusion about what it is, what causes it, and what impact it has on the economy. Unfortunately, this confusion frequently results in poor policy prescriptions used in an attempt to fight it.
Inflation is a decline in the value of the currency. That’s it. Historically, the value of the currency was measured relative to gold and/or silver. Up until 1971, the US dollar was pegged at $35 to one ounce of gold. Gold has certain monetary characteristics that that make it stable in value, which is why it has been used for centuries to define money. When a currency’s value is stable, there is little to no inflation.
There is no such thing as an acceptable amount of inflation. Inflation is anti-investment. Hence, it is anti-growth. Its impact on the economy can be profound. Instead of investing in risky future income streams that are returned in deflated dollars, assuming the investment is successful, investors find shelter in hard assets such as real estate, art, or precious metals that tend to fare well when inflation is rearing its ugly head.
Inflation is not an increase in some definition of the “money supply” as frequently cited by adherents of the Austrian School of economics, or best measured using government contrived statistics such as the Consumer Price Index.
The Federal Reserve is not causing massive inflation by allegedly printing an endless supply of dollars. Fact is, quality money is plentiful wherever it is needed to facilitate exchange. Money supply is production-determined and is not magically controlled by central bank mandarins. That statement may cause some heads to explode, but think about it. The U.S. dollar, although floating in value, is abundantly available outside the U.S. wherever production is taking place, even in hostile countries such as Iran and Venezuela. This is so because the market believes the dollar is still the most desirable currency in the world. The Fed has zero ability to influence this activity. If money printing was a sufficient condition to ensure prosperity, then Zimbabwe would be one of the most economically-successful nations in the world.
The Fed also has no ability to influence inflation via interest rate machinations by fiddling with the federal funds rate or by “tapering” its purchases of U.S. Treasury securities and mortgage-backed securities (MBS).
Interest rates are market-determined. Yes, as a large participant in the market the Fed has some influence on rates, particularly on the short-end. But in a global market as massive as the one for U.S. Treasury securities, the Fed can’t outmuscle the will of the individuals and institutions that comprise the market.
Many conservatives blame government spending for rising prices. They point to the Biden Administration’s blowout COVID “relief” spending as a primary culprit and believe that the “Build Back Better” legislation, if eventually passed, will make it even worse.
The line of thinking here goes something like this. Government spending creates “excess demand” relative to supply, so prices rise as a result. But this violates Say’s Law (and common sense) that demand is a consequence of supply. We must first produce before we can consume. Government can only spend insofar as it first extracts resources from the private sector. So when government spends, there is merely a shifting of demand from one set of pockets to another. There is no so-called excess demand created. Excess demand is one of many common economic fallacies.
Prices for goods and services rise and fall all the time in a market economy. Prices are information, the vital signals that a dynamic market economy uses to allocate resources such as raw materials, labor, and capital.
For example, an increase in the price of a good informs producers of that good that it is something valued by consumers. This signal alerts producers to ramp up production to meet demand. To reach a point where supply and demand are satisfied, the price will rise. This process is too frequently defined as inflation, but it is simply the market adjusting to a change in the quantity demanded (of that good).
Given the great damage done to global trading relationships by the liberty-usurping COVID-19 lockdowns and other related mandates, is there really any wonder why prices for so many goods have risen? But again, this is not inflation. It is merely the economy trying to adjust after experiencing trauma created by nail-biting politicians and bureaucrats the world over.
It is critical to point out that in a growing economy, prices fall. Investment born of savings results in productivity-driven advances that allows businesses to produce more with less, relentlessly driving down the price of goods and services in the process.
In a competitive marketplace, companies look to expand market share by lowering prices. How many businesses can you name that have prospered by exerting some perceived “pricing power” to consistently raise prices to consumers? Actually, the opposite is closer to the truth. Businesses succeed by investing capital that will allow them to profitably produce at lower and lower prices, thus expanding the market they serve.
Presently, a reasonable argument can be made that there is some real inflation coursing through the economy as a result of dollar depreciation in recent years. The price of gold has risen from $1,200 in late 2018 to the $1,800-$1,900 range that it has remained at over roughly the past year. The price level of the economy is still adjusting higher to account for this devaluation but it a gradual process.
If the Biden Administration wants to fight inflation and make the dollar even more desirable, it has all the power to do so. It can re-link the dollar to gold. Despite conventional wisdom, the U.S. Treasury is responsible for the value of the dollar, not the Fed. When the Nixon Administration officially decoupled the dollar from gold in 1971 (as part of the Nixon shock), it was not Fed Chairman Arthur Burns that pulled the trigger. It was Treasury Secretary John Connally. Biden can instruct his Treasury Secretary Janet Yellen to commit to keeping the value of the dollar stable relative to the price of gold. If the market believes the commitment is real, it will comply. As RealClearMarkets editor John Tamny frequently states, presidents tend to get the dollar they want.
Unfortunately, Biden and his economic handlers have no idea that they have this power. Alas, it appears Biden instead wants to make the situation worse by suggesting 1970’s-era price controls on a variety of goods, including petroleum and meats.
John Maynard Keynes once said, “There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose.”
Or properly define.
