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Post 10 – Inflation
“By a continuing process of inflation, government can confiscate, secretly and unobserved, an important part of the wealth of their citizens.” —John Maynard Keynes
“It is a way to take people’s wealth from them without having to openly raise taxes. Inflation is the most universal tax of all.” —Thomas Sowell
Prices are the exchange rates between money and goods and services. If rates of money growth exceed growth rates in the production of goods and services, prices will rise.
Inflation refers to a persistent increase in prices. Inflation is caused by too rapid growth in the money supply. Since the Federal Reserve controls the money supply, inflation is caused by the Federal Reserve.
When I was in graduate school in economics, this connection between inflation and too rapid growth in the new money was so theoretically and empirically well-documented by Milton Friedman and others that any student forgetting this relationship would have failed. Astoundingly, the current Federal Reserve leaders, to our detriment, are incorrectly focusing on interest rates rather than on money growth. There are economists who are trying to call attention to this. One is Professor Steve Hanke of Johns Hopkins University, and you can see him discuss these issues at
Inflation Just Got Lower, What’s Next? Economist Steve Hanke’s 2023 Forecast – YouTube
Inflation is different than increases in prices due to a key input, such as energy, becoming more expensive. Once prices adjust to the more costly input, price increases stop.
Prices do not stop rising during an inflation. For an analogy, consider water going into a bathtub that is full (economy at full rate of production) at the same rate that water drains from it. The bathtub will remain full of water. However, if you increase the rate of water (money) inflow, then water will overflow the tub and cause damage (inflation).
Unless other policies interfere, if the economy is not at maximum production (bathtub is not yet full), an increase in money (water) growth will induce real production to expand until it cannot increase any faster (until the tub is full). At that point any higher growth rate in the money supply will translate into a higher inflation rate (overflow). An inflation rate will persist as long as the accompanying rate of growth in the money supply persists.
When I was a professor at the University of Houston during the late 1970s and 1980’s, I co-authored an article in the Journal of Finance demonstrating that a quarterly increase in the money supply (M2) will influence the dollar volume of national output each quarter for about two years. This impact over time results from the new money circulating through the economy. Assessing the lagged effects are tricky because future variations in the money supply will also be influencing the economy during the impact periods of earlier changes.
Here is the source of current inflation. In the year ending January 1, 2020, the M2 money supply had grown at a 6.69% annual rate. The Biden administration, which came into office at that time, increased government spending by 67% in one year, some due to sending people money during the Covid lockdown. This spending was financed by borrowings through issues of government securities. The Federal Reserve chose to buy a heavy portion of these securities, injecting new money into the economy, rather than allowing interest rates to increase with the borrowing. I said as such in the Wall Street Journal, May 30, 2023 issue.
The Federal Reserve increased the money supply in the first five months of 2020 at a rapid rate. Its growth rate for the year ending May 2020, only five months later, had increased to 22%, and for each of the next ten months money grew from a year earlier at greater than a 20% pace. The “tub” was overflowing.
Here is a broader view. The two-year average growth rates in the M2 money supply ended January 1 for 2018, 2019, and 2020, respectively, are 5.59%, 3.18%, and 5.18%. The two-year averages for the consumer price index ending the same periods are 2.13%, 2.37%, and 1.87%.
For the two-years ended 2021, 2022, and 2023, the money supply growth rate was 19.52%, 16.27%, and 4.66%, respectively. The slowing for the two-years ended January 1, 2023 was due to reductions in the money supply in late 2022. Declines in the money supply are continuing as I write (mid-2023), The two-year inflation index for the same periods are 1.26%, 4.96%, and 7.87%, respectively. Note the lag in the impact of the rapid money growth on the inflation rate.
Due to lagged impacts, the inflation rate will likely decline to the 3-5% range for 2023. Since prices are not perfectly flexible downward, when money growth is abruptly decreased the real output growth in the economy will likely decline, also. The abrupt slowing in the two-year averages of money growth, from the high teens in 2021 and 2022 to 4.66% for the two-years ending January 1, 2023, along with the declines in the money supply during 2023, raise the prospect not just of slower economic growth but of a recession.
The government requires us to hold our retirement funds in liquid assets, such as cash, short term securities, bonds, or stocks. This is why inflation so easily damages our retirement funds. Unless our rate of earnings on financial investments exceeded the inflation rates in recent periods (if yours did not, don’t feel alone), our retirement funds have decreased in purchasing power during that time. For example, over the last two years, your rate of earnings on financial assets had to be 7.87% per year to maintain purchasing power.
Government finances its debt with new money (don’t you wish you could??) and you and I pay in loss of purchasing power of our retirement funds. The same is true for our wages, interest earnings, and dividend income, if any of these apply.
“Inflation is taxation without legislation” —Milton Friedman
“Inflation destroys saving…” —Kevin Brady
The Pew Research Center found in 2022 that adults under the age of 30 are about as likely to only have a positive view of socialism (28%) as they are to have a positive view of only capitalism
(24%). There are fundamental economic differences worth remembering.
The Market
How does capitalism, or a market economy, work? It is driven by the choices of consumers.
An important aspect to remember about a market economy is that exchanges are voluntary. Both the sellers and the buyers are better off, or they would not have entered the exchange.
Suppose you don’t want to buy a car this year. Can the car companies make you buy one? No. Even big firms are only big because we choose to buy their products.
In a market economy, consumer choices and movements in prices and profits guide the production and use of scarce resources to their most valuable uses. Firms’ profit motive induces them to respond to consumer desires. If demand goes up for a product, for a time prices and profits may rise because it takes some time for supply to respond. These increases induce existing suppliers to increase their output and other companies to enter that market and supply the desired product, and when they do prices and profits decrease. (In inflationary periods, this decrease in price may appear as a price rising more slowly than others.)
Competition enhances consumer choices. Competition also keeps prices from being “too high” in relation to costs. For example, I cannot successfully charge $500 for repairing a fence if someone else will do the same job for $200. No company, big or small, is immune to competition. Only when firms use the government to limit competition can firms charge prices that more persistently generate abnormally high profits.
Property rights are important in a market economy. The freedom to innovate and reap its benefits have allowed ordinary people to make extraordinary economic contributions. This is a key reason why “Rising Above the Gathering Storm”, a report commissioned by all three of the U.S. national academies, says maintenance of our market economy is essential to maintaining America’s competitiveness in the world.
Socialism
Under socialism, government planners control the key parts of the economy, for example, health care. Individuals with government power determine much of what is produced and who gets it. They have the power to limit goods for consumers and, instead, produce goods desired by the government leaders, such as in North Korea. They can use funds to support their friends, often under the guise of subsidizing “key” industries.
Even if government officials are trying to provide for consumers, these individuals cannot possibly know enough to match the efficiency and productivity of a market economy. Market prices and profit rates fluctuate daily in response to millions of decisions by consumers and producers, and these fluctuations guide resource use.
Producers and consumers respond to price incentives. Many prices under socialism are government-imposed. If price is set above a market price, production exceeds consumption of the good. If price is below what a market would indicate, then consumers want more of the product than producers are willing and able to provide. Shortages of important goods are common in socialist countries. In the U.S. today, government controls how much doctors can charge Medicare patients. Since these prices are below market, it is difficult to find a doctor who will accept a new Medicare patient. Sometimes government planners will impose not only prices, but what to produce and how much.
Socialism requires big government. Government acquires resources very differently from people in the marketplace. It uses coercion.
Suppose you don’t feel like paying taxes this year. Does anyone make you? You bet. Suppose you don’t want to support what government spends money on. Does anyone make you? You bet. The federal government makes you. And they have guns, and prisons, and agents that can confiscate your income and everything you have if you don’t go along with the agenda. Just ask Willie Nelson. Thirty years ago, the IRS decided the tax shelters his accountants had set for him over many years were illegal. They were not judged illegal right away, but after years, and with the associated levied penalties, what the IRS said he owed was huge, and the IRS confiscated basically everything he had.
Your freedom is reduced when the size of government increases. Government takes more of your income and determines who gets it. The government limits your freedom by imposing costly regulations, sometimes to achieve agendas that could not get passed by Congress. Government has the power to punish those who do not abide by their decrees.
Freedom
Freedom requires freedom of choice in economic matters. To the extent your economic freedom is impaired, so is personal freedom.
The U.S. still has a viable marketplace where mutually beneficial exchanges occur, but it is under threat from a growing government. In the welfare state that our federal government has primarily become since the 1970’s, the government transfers funds it takes from one group (taxpayers) to another. One group is hurt. One group benefits. Those in power in the government determine who is in which group.
People sometimes talk about the federal government as if it was some kind of care-taking nanny. This is not true. The government is run by people with self-interest, and those in charge of big programs and budgets are the most powerful and the most compensated. Greater numbers of our populace respond to government provided incentives to be more financially dependent upon government. Hence, there is a tendency for government to perpetually grow, even in our country, which was founded by people opposed to big government and its inherent power.
Since people don’t like additional taxes, those in power in government fund their increased spending through borrowing. The government’s debt securities are bought by others, including foreigners, because they know government has the power to confiscate resources from its populace. The government can do this either through new taxation or by robbing the purchasing power of the public’s income and retirement funds through inflation caused by printing new money to honor its debt obligations.
The growth of our government has been accompanied by unprecedented increases in government debt, which is now $31.5 trillion and, due to interest charges, rising every second. The reported debt includes federal government securities held by the public and intragovernmental holdings. When unfunded promises by the federal government are added, such as for Social Security, the debt rises to $151 trillion, or the equivalent of $986,000 for each taxpayer. Even in the face of that debt, there is tremendous resistance to cutting spending by those in government.
You might have 1000 comments, but they will typically start with “yes, but.” It is the “yes” part that we need to remember.
The “but” portion refers to the good things you perceive only government can provide. But market-based solutions can solve most of the problems. I invite you to read Dr. Thomas Saving’s book, Live Free and Prosper, in which he describes how many of today’s problems can be solved without giving up our freedoms. Dr. Saving is one of the world’s great economists, and the book is a gem.
Live Free and Prosper: Restoring America by Increasing Freedom: Saving, Thomas R.: 9781519230904: Amazon.com: Books
You might not be concerned about socialism’s threat to freedom because our rights are delineated in the U.S. Constitution. However, these rights are only realized when people in government use the power of government to ensure them. Otherwise, socialism is the road to serfdom. History shows that power corrupts, and that socialism is typically just a path to tyranny.
When I go to a store, I see an array of products. I do not go to sleep at night wondering if the products are going to be there the next day. Yet, they are. Why?
What makes our economy work?
I have always been fascinated with economics, enough to get a Ph.D. in that field. I have supported my family by applying economic principles. In the “publish or perish” academic world, I published articles in peer-reviewed journals. As an expert witness in large commercial lawsuits, I faced examination by lawyers who were provided questions by opposing economists.
In this section of the website, I will explain some basic economic principles that will help you understand our economy and the reasons certain things are happening in this world that we share. I will address some economic topics of great interest to us all.
In the picture I am with Dr. Tom Saving, a friend and a great economist.