Summary: inflation is probably not what you think it is.
This essay sketches out in simple terms the nature of inflation and its relevance to today’s geopolitical situation. This is just a sketch, nothing technical. A hundred pages could not adequately explain these things.
As Milton Friedman said, inflation is always and everywhere a monetary phenomenon. Rising commodity prices are not inflation, or even inflationary. More important is what happens next, after commodity prices start rising. Rising commodity (or import) prices strain the social fabric and distort the economy. The poor suffer most, since food and energy can comprise 1/4 or even 1/3 of their spending (everyone has their own CPI; the national CPI is an average). Many industries suffer from rising raw material costs, as raising prices usually depresses unit sales. All cry for relief from the Central Bank, our monetary wizards.
The central bank can ease their pain, accomodating rising prices by increasing the money supply. This allows wages to rise, easing the pressure from rising costs. This relief is, however not free. The ”cost” or “price” is allowing rising prices to ripple throughout the economy. This is inflation. Wages are the key factor, the channel between rising commodity prices and inflation. People cannot spend what they do not have, so rising prices in one sector force down other sectors.
Inflation is bad, and tight money prevents inflation. So all is fine, under the guidance of a wise central bank. But — what if commodity prices continue rising? Then the situation becomes more interesting.
For example, rapid global growth may increase consumption faster than capital investments can increase the supply of commodities. As food and energy consume more of people’s budgets, expenditures on other things must drop. Discretionary purchases go first, and so the economy slows as those business reduce spending (capex, headcount, hours, wage rates — it all adds up). Eventually some people cannot make their monthly loan payments (credit cards, auto loans, mortgages, etc). Now the financial sector suffers form rising defaults. This is deflation, caused by rising commodity prices and too-tight monetary policy.
To recap this greatly simplified explanation:
- Rising sector prices plus tight money can create deflation.
- Rising sector prices plus easy money can create inflation.
Price pressures can come from sources other than commodity prices. A devaluation of the currency increases the cost of imported goods. Fortunately, the US imports relatively few goods or the severe fall in the value of the US dollar would might already have forced an unpleasant choice on the Federal Reserve’s governors.
Which is worse for a high-debt economy like ours, inflation or deflation? To grossly oversimplify… The 1970’s had the “great inflation”, a bad decade for America in many ways. The 1930’s had deflation, and saw the Great Depression. That is an easy choice!
Fed Chairman Bernanake is an expert on the Great Depression, and well understands the danger of deflation to the United States. He — that is, the government — has powerful tools to fight inflation and deflation. However, success is not necessarily easy, painless, or guaranteed. There are other factors influencing the outcome, making it difficult for the Fed to induce inflation to offset rising commodity prices.
- Globalization acts to cap wages in industries exposed to foreign competition (e.g., manufacturing, software engineering, call centers).
- High rates of immigration caps wages for affected workers (low skilled workers, computer programmers, engineers).
- The net result might be that wages fail to rise with inflation. That could be painful for America.
Worse, these things are far more complex than painted by this little analysis. To mention just one of the many other relevant factors: the US is addicted to borrowing from foreigners; going cold turkey would be painful. Worse, we need to convince our foreign creditors to continuously “roll over” our loans, since we cannot repay them. This means keeping interest rates sufficiently high and the US dollar sufficiently strong.
The next chapters will discuss the causes of inflation today, and what it might mean for the world.
Please share your comments by posting below (brief and relevant, please), or email me at fabmaximus at hotmail dot com (note the spam-protected spelling).
For more information about this subject
- Is the US Government deliberately underestimating inflation? (8 November 2007)
- What you probably do not know about China’s food crisis (21 April 2008)
- Higher food prices, riots, shortages – what is going on? (29 April 2008)
- A giant breaks his chains and again walks the earth: inflation (10 June 2008)
Originally published at Fabius Maximus and reproduced here with the author’s permission.