As the nation experiences the worst inflation it has seen in 40 years, discussions on inflation have, naturally, become more common. From Janet Yellen and Jerome Powell to journalists and pundits to the people you meet around the water cooler, everyone has something to say about inflation - what causes it, what needs to be done about it, how long it will last, etc. In all of the discussion, there is a recurring misunderstanding that arises. The non-experts talk about the basic argument of “too many dollars chasing too few goods,” basic economics. Those who want to be more sophisticated about the issue talk about things like bottlenecks, supply chains, and wage-price spiral. While all of the sophisticated phenomena are real and are happening, they are largely irrelevant to the analysis of inflation. Talking about the sophisticated factors actually misunderstands the issue. Inflation is a macroscopic, equilibrium kind of phenomenon, while factors such as bottlenecks, supply chain issues, etc. are transitory, localized phenomena. The difference between inflation and transitory factors is the same as the difference between microscopic fluctuation and thermodynamic parameters in the study of matter.
Thermodynamics is the study of large-scale characteristics of matter in equilibrium. It does not care where each atom is at any moment in time. It does not care how a system makes its way to equilibrium. It just cares what the final state is. It answers questions like, “If I put a hot coal in a bucket of water, what will the final temperature be?” The subject concerns itself with studying the “intensive” parameters of a system. Those are the things about a system that are equal throughout. It does not bother with local fluctuations on an atomic scale. For example, the temperature of a bath of water in equilibrium is the same regardless of where the temperature is measured. The thermometer could be on the surface, at the bottom of the tub, or wherever and it will still measure 100 degrees (the ideal temperature for a bath). You could talk about microscopic fluctuations in temperature in particular parts of a system, but that departs from what the notion of temperature is trying to capture. In the same way, inflation is a term that describes a general, pervasive phenomenon in a country’s economy. It is a term that captures the overall reduction in buying power of the dollar (or whatever currency your country uses). Supply chain issues and wage-price spirals are internal mechanisms that work out as the economy relaxes to a new state of equilibrium after an external stimulus. While these factors do affect prices, they are not relevant to what an assessment of inflation is trying to capture: the change in what a dollar buys after the economy reaches a state of equilibrium.
Citizens might understand inflation only on an intuitive level, but it is the phenomenon that they really care about because it is an equilibrium condition. If the buying power of a dollar is going down because of inflation, it is not going back up. Inflation is a change in the status quo. It is not something that is going to go away unless there is another impulse on the system that pushes the system in a different direction. People care, but they are not overly concerned with a temporary price increase because of a transitory supply chain issue. They know that the price will go back to where it was after the issue gets sorted out. But if the price is going up for good, people care a lot. Citizens are concerned about inflation because of the phenomenon that it describes. Talking about inflation in terms of transitory factors either misunderstands inflation or is a subtle attempt to convince an audience that price changes are not inflation but are temporary.
To couch the issue in an analogy, consider a family spending a day at the beach. They set up their blanket and umbrella and all their sand toys in a spot where they can stay dry but still get to the water. Everything goes smoothly until a large wave crashes on the shore stopping mere inches from the family campsite. The father asks if the tide is coming in because they might have an urgent need to move their things back from the water. One kid starts talking about how there was a strong gust of wind that blew the wave up toward the shore. Another says that he thinks the waves look bigger than when they arrived. A third points out that the current wave is stopping several feet from the blanket. But the father does not care about all these factors. They do not say anything about whether or not the tide is coming in. The factor that matters is the average height of the water. If it is increasing, then the family needs to move. Inflation is like the average water level. If there was a random accidental occurrence that temporarily raised the prices of a few things, then the the tide is not rising, so to speak. The average citizen wants to know if prices are going up because the buying power of the dollar is going down.
Factors that Do NOT Cause Inflation
Supply Chain Disruptions
The citizenry wants to know about inflation, so the informer class is telling them about it. Unfortunately, whether out of ignorance or subtle deflection, a lot of the informer class talks about inflation in terms of the transitory factors that have little to do with real inflation. Supply chains are almost never a factor in inflation. A disruption in a supply chain is a transitory phenomenon. If the supply chain goes back to how it was before the disruption, then the price will go back to where it was. Milton Friedman1 describes prices as information mechanisms. An increase in price due to supply chain snafus is simply an indicator to the public that the goods which were previously simple to produce are now more difficult to produce. A price increase due to a supply chain problem does not represent inflation. Even if a supply chain is completely and permanently cut off and the price of the good is permanently higher, it is not an inflationary phenomenon because it reflects the difficulty of producing that particular good and not a change in the buying power of the dollar.
Imagine a country sells cheap lumber to a pencil manufacturer which allows them to sell a pencil for 10 cents. Imagine this relationship exists for decades. Unfortunately, this country is small and practices poor forest conservation. They eventually end up cutting down all their trees and exhaust their supply of lumber. The pencil manufacturer has no other option than to buy its lumber from another supplier at double the cost which pushes the price of a pencil up to 15 cents. This is not inflation. This is the market telling the consumer that lumber is now more difficult to produce and that the products which relied on the cheap lumber will have a greater cost to bring to market going forward. The cost of products that do not rely on the cheap lumber source remain unchanged, assuming their materials are still available at the same price. Changes in price relative to other products represents changes in supply and demand. Market factors have changed, and the prices send the signals to the consumers about those market factors. Inflation is when the price of everything goes up because the buying power of the dollar has gone down.
Wage-Price Spirals
Similarly, wage-price spiral is not an inflation-producing phenomenon. It is a mechanism that allows the market to adjust to internal forces. A wage-price spiral will stop when the market has relaxed to its new equilibrium state. Trying to stop a wage-price spiral to prevent inflation is like trying to hold up a tent after the tent pole has broken. The canvas falls to the ground as a response to the tent pole breaking. The only reasonable way to keep the canvass from falling is to replace the tent pole. If companies are paying more for labor and prices are increasing because the laborers have more dollars to spend, that means that the companies are able to collect dollars more easily. When more dollars are introduced to the system, the information goes out into the market that dollars are easier to get, and as all of the parts of the market adjust to the impulse of added dollars the wages and prices go up. Asking for a raise does not cause the inflation. The wage-price spiral is a market response to added dollars which will stop when the market has finished adjusting.
Consider a theoretical illustration. An island nation pays each of its inhabitants 70 coins per week to harvest food for the island’s consumption. Each person then buys a box of food each day for 10 coins from the island’s government. After a week, the island authorities have all of the money that they started with, and the people have provided for their own subsistence. Imagine that the island decides to pay each of its inhabitants 140 coins per week instead for their work. The amount of food produced has not changed. The number of people offering to buy it has not changed. The only thing that changes is the number of coins available to purchase the food. Naturally, the price of the food goes up to 20 coins a box. Nothing in the situation has materially changed. The authorities have simply decided to double the supply of money in the system. The value of one coin has been cut in half, but the islanders are unconcerned. The coins are just a unit of money. Saying that they are worth half and paying twice as many makes no difference. Openly and honestly doubling the money supply in this way inflates the currency but causes no wage-price spiral.
Upon doubling the money supply, the island authorities have enough coins to pay all of the islanders and buy all of the food on the island at the same time. The government has a windfall at its disposal and concedes
If the island government instead decided to double the money supply but keep the new money for themselves, things would play out differently. The money supply would increase, but the information would take time to leak out into the full system. The result would be phenomena like the wage-price spiral. Imagine that the government does not spend all the money at once but slowly make additional purchases with money that should not have been in the system. The market will respond to the added money by increasing prices because demand has increased. There is a new very wealthy buyer in the market. After a period of time, the laborers realize that they can no longer afford as much food as before, and some of them become disgruntled and demand a higher wage. Rather than lose laborers, the government concedes a wage increase to those who ask. The available money to purchase food increases more, and the food price consequently increases. The people who did not ask for a wage increase become more motivated to combat the increasing prices by asking for raises as well. Eventually, the system will settle out into the state where everyone is paid 140 coins and food costs 20 coins per box. But because the money supply increased covertly, the market had to adjust to the new conditions and some people had to suffer while others benefited during the adjustment process. Although it did cause temporary problems for society, the wage-price spiral did not cause the inflation. The introduction of more money into the system caused the reduction in value of the money. The phenomenon of the wage-price spiral was an outcome of the system adjusting to the new conditions of an increased money supply. If the money had been announced and paid to all of the laborers up front, the only adjustment would be the market prices and the wage-price spiral, along with all the pain and confusion, would have been avoided. When the ones managing the mechanics of the system, e.g. the money supply, are also participants in the system, there is a strong potential for problems and abuse.
The island example is extremely simple and tries to illustrate the process rather than represent a realistic system. There are innumerable complicating elaborations in a real economic system, but the driving force (additional money supply) and end result (higher wages and higher prices) are the same. When the government introduces more money into the system, the market responds to the change by increasing prices and wages to finally reach the new equilibrium. The only entity that can legally add money to the system is the federal government. Consequently, the only party responsible for inflation is the federal government, not people asking for raises in the face of rising prices.
An Increase in the Money Supply (Yes!, Sometimes)
One other factor that deserve some comment is the fact that increasing the money supply does not always cause inflation. When new actors enter an economy, the money supply needs to increase to accommodate them. Generally, when the economy grows, the money supply needs to increase to prevent deflation, which is an increase in the buying power of the dollar. (An increase in the buying power sounds like a good thing, but changing the value of a dollar significantly causes problems whether it is up or down.)
Return to the island example for an illustration. The island economy is functioning normally with the money value remaining constant when suddenly a textile company moves to the island and brings enough workers to double the population of the island. The newcomers want to be a part of the island’s economy and will need coins to participate. The island will also need to double the food supply to support the increased population. Fortunately, they can trade the textiles for food and double the food supply on the island. If there is no change in the money supply, then there are only enough coins to pay each person 35 per week. The price of the food boxes will have to drop to 5 coins because this is all the people can afford. The people have not become poorer. The value of the money has changed because of the growth of the economy and the population. Twice as many people have to use the available coins to participate in the economy. If the authorities did not want the psychological effects of paying people less and prices dropping, they could have doubled the money supply when the newcomers arrived on the island and everyone would have been paid the same and paid the same amount for their food. In this simplistic example, increasing the money supply does not cause inflation but is necessary to keep the value of the coins constant.
It is not necessarily required for a government to keep a constant money supply. Increasing the money supply does not always cause inflation. Inflation occurs when the increase in money supply is done not to accommodate growth but for irresponsible purposes, like increasing the buying power of the government at the expense of the citizens.
How Inflation Hurts
Most people understand inflation at a practical, visceral level. They used to go to the store and buy their necessities with their take-home pay from work. Now, the prices have increased, and they can buy less. They want the problem to stop and at the very least not get any worse. They know that the government has some sort of control over the economy, and they vote accordingly. This level of understanding is usually enough to hold the government somewhat accountable for its impact on the money supply, but it is useful to understand more deeply what who is responsible for inflation and the problems that it causes.
The first consequence to understand about the effects of inflation is that it is effectively the federal government stealing from the population. As stated above, the federal government is the only entity that can legally increase or decrease the money supply, and so it is the only entity that should be held responsible for inflation. When the government wants to spend more money than it has, it can become an irresistible temptation to increase the money supply to pay for increased spending. But this is not mere indulgence, as people often see it. Increasing the money supply effectively steals from everyone else who holds dollars. In the island example, if the government covertly doubles the amount of money and keeps the increase for itself, then it can buy things that it should not have been able to buy. If it pays all of the laborers their current wage, there should be no money left for purchases. But with the additional money, the government can then buy things that the laborers were going to buy. If the government paid all of the laborers and then announced that the money supply is now double, the price of food would double to accommodate the new monetary situation. The effect would be that the laborers would be able to afford only half the food that they used to afford and the government would have a purchasing power equal to the entire laborer population. Until the market reached its new equilibrium of prices and wages, the government would have an enhanced purchasing power that it had insidiously extracted from the population. The real world government works the same way. By increasing the money supply it gives itself purchasing power that belonged to the rest of the dollar holders. In this way, inflation is a tax increase that no one voted for and no one wrote legislation to pass.
Another characteristic about inflation is that it hurts people who have saved money. In the readjustment process that takes place after a change in the monetary supply, laborers end up getting a pay increase. The increased money supply gets spread out around the economy, and everyone seems to have their fair share. In the case where the money supply doubles, the fair thing to do would be to give everyone a dollar for each dollar that they have. But in reality, the adjustment is not fair. Wages increase, but nobody is getting more money for what they have stored in the bank. If a person has diligently saved money over the years and accrued a substantial savings account, they suffer disproportionately because the increased money supply simply decreases the value of the money that they have saved. Inflation is the easiest way to rob a bank! You don’t have to set foot inside. If someone had all the dollars in the world stored in a bank vault and the federal government doubled the money supply, the value in the bank would drop in half without having to touch the dollars in the vault or even the bank itself. Inflation causes several injustices, but one of the worst is how it abuses and punishes prudent, responsible behavior, i.e. money that is saved in the bank never gets adjusted for inflation.
One more injury that inflation inflicts upon society is that it injures the poor more heavily than the rich. Various factors lead to this injustice. One is the case of the fixed income individual. If someone has earned a pension or received a stipend for subsistence for whatever reason and that income agreement does not have an adjustment for inflation built into it, the person has no recourse in the face of inflation. Even the 2% inflation that the government aims to maintain will slowly dwindle bank accounts and the value of the fixed income. Wealthy people usually do not rely upon a fixed income revenue stream. Even if they do not work, they rely upon an income dependent upon the stock market which adjusts itself to inflation. Stock values will increase in an economy that is experiencing inflation. The increase will appear to be growth, but it is simply an adjustment to the changing monetary situation. But the stockholder has at least not lost value. The income from the stock grows with inflation. Similarly, one way to avoid inflation is to buy capital assets that will increase in value with inflation. For example, a person with disposable income might buy a plot of land for $100,000. With 10% annual inflation, the value of the dollar will decrease, but the value of the land will not change (ignoring other simultaneous factors for simplicity). After a year, the land will be worth $110,000. The value of the dollar decreased, but the land owner avoided the cost of inflation by putting his money into an asset that will grow with inflation. Some people will buy gold. Others will buy homes or land or cryptocurrency. But it is only the people with disposable income who can put it into things that will avoid inflation. The people who simply saved their money or who rely on a fixed income suffer the full brunt of inflation while the rich asset owners suffer only a modest loss.
Current State of Inflation in the US
Inflation is a tricky variable to measure, which is one reason that it is so easy to misunderstand and misrepresent. Much like the father trying to assess the height of the water at the beach, there is no immediately available quantity from which to take a reading. He has to watch the waves, form an average in his mind of where the waves crest on the beach, account for the distribution of wave heights (you don’t want to average over three waves and have two of them be particularly large), and try to get some sort of estimate about how far away the average wave height was when they arrived. Experts have all kinds of complicated metrics that the use to estimate inflation: Consumer Price Index (CPI), Personal Consumption Expenditures (PCE), chained CPI, core inflation, etc. All of these tools are meant to get at the elusive value of the dollar which cannot be measured directly. But keeping a consistent metric over the years and comparing measurements over time will give a sense of inflation at least relative to other moments in history.
There are many websites that provide historical inflation data, but here is the one I usually use. The monthly data from January 1914 until April 2022 appear in the figure below. The historical data helps to give context to that state of inflation today compared to other periods of time. It shows how bad things are now and how bad they can get. Some key points in the historical data are,
Shockingly high inflation ~20% during and after World War I (1914-1918)
The wide trough of deflation over the early 1930s (the Great Depression)2
Sharp spikes of inflation during and after World War II (1939-1945)
The infamous stagflation years in the mid to late 1970s
The current 40-year high of ~8.5%
Inflation today is over 8%, a number not seen since Ronald Regan’s administration wrung inflation out of the economy in the early 1980s. The negative dip in 2009 is apparent after the housing market crash of 2008. Things had been rather tame for the following 12 years but have been on an upward spike since the beginning of 2021. Below is a figure that zooms in to the timeframe from 1980 until present. I added a red line that shows a linear fit to the data from 1982 to 2021. The inflation rate was on a downward slope during that time span which shows that the country was experiencing a gradual improvement of the inflation condition for US citizens. Then the current spike began, and the era of 40 years of improvement ended. Inflation can cause societal upheaval and unrest and is not good for the physical or psychological health of a country.
Inflation is an important problem that will be a strong factor in the elections coming this fall. It is an issue that will undoubtedly receive significant attention in the media and around the water cooler or kitchen table. Explanations involving supply chains and temporary shortages should be taken with a grain of salt because they do not address the essence of inflation. Rising prices are, of course, a concern, but temporary rises have real solutions. Work out the supply chain issue and prices will return to their former state. Increase supply of a commodity with rising price, and the price will fall. If supply chain issues will take years to solve, then prices could remain elevated for an extended period. This could be seen as a sort of pseudo-inflation, but the real concern of inflation is the permanent change to the value of a dollar caused by an inappropriate change in the money supply. And always remember where the blame belongs for inflation. It rests squarely on the shoulders of the federal government and all of the politicians who choose to spend money that they do not have. Remember who it hurts as well: certainly the rest of society but especially those with limited income and those who responsibly save their money. Milton Friedman, a Nobel Laureate in Economics, taught the pertinent lesson sixty years ago in his analysis of the Great Depression. In his book “Capitalism and Freedom,” he said,
The Great Depression in the United States, far from being a sign of the inherent instability of the private enterprise system, is a testament to how much harm can be done by mistakes on the part of a few men when they wield vast power over the monetary system of a country.
Much of the analysis in this essay was derived from Milton Friedman’s discussions on inflation in his books “Free to Choose” and “Capitalism and Freedom”.
For an insightful analysis of the monetary system factors and events in the years around the Great Depression, see “Free to Choose” by Milton Friedman. Chapter 3, The Anatomy of Crisis, contains the relevant commentary.
Here's a good video from the man himself, Milton Friedman,
https://www.youtube.com/watch?v=GJ4TTNeSUdQ