|A symptom of the almost universal misunderstanding of inflation is the belief that people are unable to pay the inflated prices or at least are unhappy about paying them. They aren’t.
(I’m not talking now about that minor part of the price rises that are due to lessened production; that is a completely different matter—and is not inflation. The great bulk of today’s price rises are due to the government flooding the market with phony dollars—which is exactly what inflation is.)
As a first approximation, the general price level is determined by the ratio of the money supply to the volume of goods offered for sale—including services under “goods.” For simplicity, take services to be included under “goods.”)
(It’s a first approximation because the actual causal factor is people’s expectations about the future ratio, but the main thing shaping those expectations is the current ratio.)
Changes in the denominator of that ratio—i.e., changes in the quantity of goods offered for sale—are determined by factual conditions, such as the state of technology and whether or not there’s a war . . . or a pandemic. But things are fundamentally different in regard to changes in the numerator—i.e., changes in the quantity of fiat money. That’s based on the subjective, politically motivated rulings of government officials.
Incidentally, changes in the gold supply are in the category of objective phenomena, not politically dictated ones. So, in a gold-based system, changes in the gold supply cannot be taken as inflation or deflation.
Inflation is a government-created phenomenon by definition—i.e., by its fundamental difference from any objective, economically-governed occurrence.
For ease of communication with the public, I use the phrase “price inflation” to talk about the upward change in the general price level and “monetary inflation” to refer to inflation by a proper definition.
Then the point can be formulated as: monetary inflation causes price inflation.
That causal identification remains true despite the fact that a decline in production also causes price inflation. Here, “causes” means: “is one causal factor in creating.”
One causal factor can counteract another. And that has been the story, I believe, for the last 20 years: technology’s expansion of production has kept pace with the government’s expansion of the fiat money. The result has been: little price inflation—but with several other bad consequences, including a lower rate of progress.
Recently, however, the harm done by trillions showered down as “Covid relief” plus the decline in output due to shutdowns have overwhelmed technology’s advance.
Despite the shutdown’s interruption of production, the main cause of price inflation today is government’s monetary expansion. The money supply has maybe doubled (it’s nearly impossible to find any exact data), and the decline in production has been bad but not that bad. Remember, the U.S. government sent out thousands in the mail to virtually everyone. Plus there’s the Fed’s expansion through the banking system—which has been required to keep interest rates near zero for years and years.
So, if you are willing to grant that this price inflation is essentially due to monetary inflation, I can go on to make good on my opening point: high prices are high because people are happy to pay them.
Yes, of course, they would prefer to pay less, but the price at which any good is actually sold is the price someone is happy to pay. Yes, happy: the buyer is gaining a value. At the higher price, he would prefer to have the good rather than keep his dollars. That’s why anyone buys anything. In his judgment, paying the price will increase his well-being. It will make him better off. He’s glad to pay it.
The customer’s desire to pay is what pushes prices up.
It is claimed that sometimes costs push prices up. But that is wrong in two ways: 1) a cost is a price, so it can be pushed up only by the demand of the buyers—i.e., demand of the businesses who want to pay that cost, 2) the people who are paid the higher costs get more money per unit, so they can bid up prices for the final products.
For instance, there’s a labor shortage, so wages and salaries are going up. But they don’t go up unless the employer knows that he can pay more—i.e., he must expect to get more sales revenue, due to price inflation.
And when wages go up, the employees receiving the extra funds spend them mostly on consumer goods. So in most cases, the employers will indeed be able to sell at higher prices and get higher sales revenue. The whole change in prices is an adjustment of prices throughout the economy to the monetary expansion. It is not a change in the average person’s (short-term) well-being.
Psychologically, it seems like one is worse off when price inflation hits, because one has not adjusted to, say, $5-per-gallon gasoline. But the main reason gas is at that level is that people are bidding it up that high with the newly printed dollars they have been given by the government.
And consider: $5 per gallon is 5 times the price it was in 2002 (in Austin, TX). But the gold price today is 6 times higher than it was then. So, if you paid in gold, you would be getting more gas for your money today than in 2002. And much more than in 1962 (gold being 45 times higher). The gold-price of gas continues to fall.
The essential problem with monetary inflation is not rising prices. One essential problem is the forced sacrifice of some to others: those who don’t get or don’t spend the new money until later are sacrificed to those who get and spend it first. The other essential problem is inflation’s distortion of production. Inflation wrecks the plans of borrowers and lenders, especially the plans of those who borrowed to finance businesses.
The Austrian economists are right: inflation creates malinvestment. Inflation works by faking the cost of capital. By fooling people into thinking more factors of production are available than actually are, lots of never-to-be-profitable projects get undertaken, and there will have to be an eventual liquidation of the malinvestment. (This can be a rolling re-adjustment or a sudden crash.)
A fascinating issue here is the decisive role of inflation-expectations. The so-called “velocity of money” is actually the influence of anticipated inflation.
If the rate of monetary inflation were (impossibly) known with certainty for 100 years in advance, all market prices would reflect the anticipated effects and the adjustment would occur smoothly and painlessly. But then the monetary expansion would not have the effect the statists “planners” want it to have. To achieve its “stimulus” effect, the inflation has to surprise people, including bankers, financiers, traders—everyone. To “stimulate,” the government has to trick people, fool them, defraud them.
For example, if you’re a lender, you expect the money you lend to be worth a certain amount when it’s repaid. Your inflation-expectations guide your decisions. For the government to stimulate the economy, to call forth extra loans and extra investment, it has to fool the lenders and investors into thinking they have more real funds (as opposed to paper funds) than they do. They have to trick the lenders and investors into thinking the real value of their future return will be more than it actually will be.
Suppose you have $100 to lend. If you anticipate a 2% rate of inflation, then if you expect an investment to earn a risk-discounted 6%, you subtract that 2% and figure the nominal 6% is only a 4% real return. How does the government get you to lend more?
By sending you $1,000 in the mail. Now, if you don’t realize that the money is being depreciated by that act, then you are willing to invest, say, $100 out of that $1,000 if you can get a nominal 6% return. Well, maybe not 6% this time, because those high-return projects are already funded and also because you are not the only one with extra savings, thanks to the government’s check-mailing program. So you lend another $100 at 5.5%, let’s say. That’s still okay with you, as long as you expect the value of the money to depreciate only 2%.
But due to the check-mailing program, the value of the money depreciates more. Maybe 4%, maybe 8%. Suddenly you find that both of your loans have lost you money. If the cost of living has gone up 8% (as it has recently), your first $100 got you a 2% loss, and your second got you a 2.5% loss.
At that point, if they are concrete-bound, lenders subtract 8% from the nominal amount of dollars they will be repaid, and that means fewer loans, and that in turn means the bust cycle begins.
(I say, “concrete-bound,” because they are just reacting to the past concrete rather than realizing that the government will inflate at a higher rate to trick them into maintaining the false boom. Savvy traders know that 8% is yesterday’s rate, and that to avoid a recession, it’s likely that the government will inflate at much more than 8%. How much more, they can only guess.)
One wealth-protection strategy is to put money that would be going into productive ventures into “hard” assets such as real estate and gold. In the early stages of the price inflation, the stock market is a good bet, but in the later stages, when the chaos hits and businesses can’t plan, only hard assets preserve real value.
But before you rush to buy gold or make any other investment decision, remember Ludwig von Mises’ dictum: in order to make a higher-than-average rate of profit, you must know something that the market does not. And I think “the market” here means: the major players in the market, those whose decisions control the most funds—the Warren Buffets, the Blackrock Capitals, the Citibanks, the big hedge funds.)
To return to where we began, I hope it is now clear how superficial and silly is the oft-heard complaint: “The price of things has gotten to where people can’t buy them.” Prices are that high because people are buying them at that price. That’s the price things have been bid up to.
Give people more paper dollars and they are going to spend them.