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Where Does Inflation Come From? (Hint: It's Not Oil)

Published 05/18/2018, 12:00 AM
Updated 07/09/2023, 06:31 AM

Inflation’s source has seemingly confused many for decades and continues to do so. Yet, there have been simple explanations available since Aristophanes wrote “The Frog” in the 5th century BC. The explanation for inflation was restated by Nicole Oresme in 1350, by Copernicus in 1517 and later named Gresham’s Law in 1860. Gresham’s law is a monetary principle stating that “bad money drives out good”.

There are relatively modern examples of hyper-inflation:

1) Inflation caused the Weimar Republic to collapse in 1933 paving the way for Adolph Hitler.

2) Venezuela is currently experiencing hyper-inflation. What will follow here?

Our own history now provides an understanding to the simple relationships causing inflation. Inflation does not come as a result of higher oil/commodity prices nor does it arise from higher wages, an increase in money supply or economic expansion. The simple explanation arises from understanding Free Markets in which every individual freely exercising daily value-based economic choices to advance individual and family standards of living. Julian Simon wrote about this in his The Ultimate Resource, 1981.

Joseph Schumpeter called it Creative Destruction, a “gale of creative destruction” describes the “process of industrial mutation that incessantly revolutionizes the economic structure from within, incessantly destroying the old one, incessantly creating a new one”. Capitalism, Socialism and Democracy”, 1942.

In vibrant and Free Markets, consumers drive a process of faster-better-cheaper which advance standards of living through individual decisions which consistently seek the highest value for incomes.

Such a process is inherently deflationary making the cost of living cheaper which leaves room for expanding quality-of-life purchases. For producers to remain profitable, they must relentlessly drive innovation in product offerings to meet shifting consumer demands. The only companies which survive are those which deliver consumer value and lower costs enough to remain profitable. Those who do not, quickly fail to survive.

The success of Amazon (NASDAQ:AMZN) in the development of the Internet retail marketplace is simply an extension of the 1893 Sears, Roebuck & Company catalogue. Amazon lowers the costs to consumers by cutting out the costs of middle-men in the supply chain and letting consumers make value-based buying decisions without having to incur travel and time expense to visit numerous retailers.

The savings in being able to make better value-based spending decisions from home and have items delivered at much lower cost than incurred when having to travel to multiple retail sites to accomplish the same end adds considerably to individual standard of living and improves the value received for one’s income. The Internet is inherently deflationary. Then, why do we still have inflation?

The basic source of inflation can be understood as an increase in currency without an increase in productive assets. In short, a larger rise in currency than a rise in Real Private GDP. A rise in the amount of currency without the same increase in society’s output lowers the value of the currency for each unit of output. Currency is a ‘experiential asset’. Currency’s value is established as it is used in the exchange of labor for goods.

Inflation does not occur with the expansion of bank lending, i.e. expansion of M2. Bank lending which operates through a fractional-lending system developed over hundreds of years creates currency when lending occurs and creates fixed obligations. If the borrower is successful, over time it pays back the debt, converting debt to equity using profits. The net impact is to permanently add the currency created through the initial lending process to the financial system. Companies that prove unsuccessful, default on their debt. Banks and other lenders are forced to write-off these losses and the currency created earlier in the cycle is taken out of the system.

Adding confusion to the M2 impact is that government can expand M2 during recessions in an effort to stimulate economic activity. Over a full business cycle, currency has grown faster than Real Private GDP producing inflation, i.e. more money than output. Inflation has ebbed and flowed with economic activity with a lag of a few years making it difficult to identify causation.

Inflation’s time lag is one of confusing elements in connecting short-term shifts in various indicators to identify the ultimate source. Inflation has been persistent. It seemingly arises out even with the obvious deflationary impact of economic activity of Creative Destruction clearly visible. It is relatively easy to get lost in the mass of economic details presented daily. Why does inflation persist?

3 charts of our economic history answer the inflation conundrum. Chart: US Real GDP, Real Private GDP, Real Government Exp&Inv, M2 and Core Inflation from 1947 shows the history of inflation vs. multiple economic measures economists have struggled to comprehend. Inflation has a history of correlation with GDP, with commodity prices and M2 (Money Supply). Commodity prices are a component of all inflation measures. With this history, it was natural to think inflation causality arose from shifts in GDP, M2 and commodity prices. The belief in ‘Supply/Demand’ correlation with prices has long been a basic economic concept. The history from 2009 tells a far different story.

US Real GDP

Economic history since 2009 shows strong M2 growth (due to the Fed’s attempt to drive inflation higher) and strong WTI pricing (due to the widespread belief the world was running out of oil) in the face of falling inflation which peaked July 2008 at 4% and declined to what is seen today as between 1.5-2%. On the M2 chart, an INDIGO DASHED ARROW is juxtaposed to a RED DASHED ARROW to show the lack of correlation to Fed policy.

In the 2nd chart, Inflation vs. WTI, WTI’s massive rise occurred during this fall in inflation. Marked on this chart in BLACK DASHED ARROWS are some of the instances when significant inflation shifts occurred without comparable shifts in WTI. Fed’s frustration has been quite public in its effort to manipulate inflation higher.

Chairperson Bernanke promoted the image of ‘Helicopter Ben’ as being highly capable at controlling inflation. The Fed for all its actions and bluster had very little impact on inflation. Likewise, the oil price rise during the ‘Panic of Peak Oil’ had no discernable impact on inflation. Somewhat hidden in this data of the US Real GDP, Real Private GDP, Real Govt Exp&Inv, M2 & Core Inflation is the actual reason for falling inflation during this period.

The 3rd chart is the US Real GDP vs. Total Govt Expenditure & Investment from 2000 and provides greater detail which explains the underlying source of inflation. What jumps out is the period of ‘Sequestration-2009-2014 which reduced Govt Exp&Inv spending by an annual rate of ~-2%. This is the period which correlates with the decline in inflation from 4% to less than 2%. If one revisits past episodes of inflation, one will find a strong and lagging correlation with Govt Exp&Inv. When government enters into discretionary spending, for social programs, military, highway/bridge/rail projects and space programs, inflation has been the result. The more the spending the greater the inflation.

When a major spending binge began in the mid-1960s with the Vietnam War, the ‘Man on the Moon’ program and the ‘Great Society’, inflation soared. The period known as ‘The Great Inflation’ was the result, but it still remains a puzzle to many. Even today, OPEC’s oil price rises mid-1970s are blamed when these price increases were only in response to then rampant US based global inflation. It took Chairperson Volcker’s raising Fed Funds rates to 18%+ in the early 1980s to prevent a spiral into hyper-inflation. The Govt Exp&Inv spending beginning in the mid-1960s left no permanent improvement on US society with much of the ‘Great Society’ reversed in later decades as ineffective. What consumers were saddled with was an inflated currency.

US Real GDP Vs Total Govt

Inflation has a simple source. It arises when currency is created without added long-term improvement in Real Private GDP. Real Private GDP is defined as Real GDP minus Government Exp&inv. Government Exp&Inv is discretionary government spending for large social engineering programs, national infrastructure spending, spending on wars and etc. Transfer payments to Social Security and health and welfare programs tend not to be as inflationary. This is because transfer programs spending decisions are made by individuals trying to generally maximize the value obtained when these funds are spent.

Government Exp&Inv spending usually carries attached political agenda designed to benefit the profitably of favored supporters of the political party in office at the time. This type of spending is not as sensitive to the value received as it is expected to generate an immediate political effect. For the most part, Government Exp&Inv has produced little long-term benefit, but for roads and bridges.

These are temporary bulges in Real GDP which do not result in lasting improvements in long-term standards of living. History has many failed government social engineering programs. This spending occurs via taxation and issuance of Treasuries. The net/net is a long-term expansion of currency outstanding without improvement in long-term Real Private GDP. Military spending stands out the most inflationary of all even as it is a necessary expense for defense of the nation. Military spending results in the complete destruction of the capital deployed when equipment destroyed, ordinance detonated and sadly most of all lives lost.

The estimated annual cost for keeping a US soldier overseas is ~$1,000,000 currently. The cost of raising a child who becomes a soldier with military training is in the range of ~$500,000. If a college education is involved the expense is higher. It is this value to society which is lost when individuals in the military are permanently disabled or killed. Defense is a necessary cost of Democracy, but doing so is inflationary and most destructive of society’s capital. This is what the data tells us.

The Investment Implication:

Inflation is a direct consequence of government spending. It is not caused by commodity prices nor is it caused by M2(Money Supply) or economic expansion which is deflationary. Inflation cannot be controlled by the Federal Reserve. Commodity prices and interest rates shift in response to the market psychology response to perceived inflation and other perceived Supply/Demand issues.

Government spending is the same as ‘bad money driving out good’. Government is required for a vibrant and creative society to exist. Government is necessary for self-organization and defense from outside and internal threats to individual rights in a Democracy. Nonetheless, government spending is inherently inflationary. The best approach to limiting inflation is to be sensitive to the outcomes from government spending programs. There are lessons to be learned in our economic history. Government spending results in a lagged inflationary cost to society’s standard of living. Current increases in Govt Exp&Inv have not yet resulted in higher inflation. But, this needs to be closely monitored.

DISCLAIMER: The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.

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