What is Inflation?

In a discussion of today’s U.S. economy, a serious writer must include inflation. Yes, I am going to talking about inflation. Probably, I am going to talk about it a lot. I guess that makes me a nut, right? I mean only scaremongers and right wing fanatics talk about inflation. Besides, since the early 90’s we have had almost no inflation, I mean only about 2 to 3% a year, which the Fed (the Federal Reserve Board) thinks is close to the right range.

But here is the killer, if you loaned the government $10,000 for a 10-year bond, at a 2.5% inflation rate, you would get back $7,810 of purchasing power. A loss of 22%, guaranteed! If I told you that I was going to give you an investment in which the principle would loose 22% guaranteed, would you like that? (At best, after taxes, the interest paid on the bond would bring the total to maybe $9000. You would still have a loss.)

In addition, any plan to retire ten years later would have to take into account the rate of inflation. None of that sounds as if a “low” inflation rate is a minor deal. And we are talking here about the potential of a higher rate of price inflation in the future, maybe the near future.

Well, what is inflation? That is the question. There are two competing definitions. Actually, if you look practically anywhere on the web, in “official” government materials, or at the writings of mainstream economists, you will find that inflation is defined as “a general raising of prices”. That is, the prices of just about everything in the economy are going up.

Is this definition really helpful? Does it mean something?

Well, maybe you want to know what causes inflation. (Some would argue that a definition should include causes.) This is an area of controversy. We have a difference of opinion. You will quickly find that the sides are drawn this way.

On the side of an answer that is wide ranging and offers little in the way of a means to reduce the threat of inflation. The best statement of this side that I have found so far is:
http://www.wisegeek.com/what-causes-inflation.htm. You will note that all sorts of actors in the economy can be at fault including producers, raw material suppliers, and others, many others. It just depends. I always wanted to know how one, or even a combination of these different actors could cause price inflation that went on for years. Any one of these explanations has some plausibility if you hold your frame of reference to a year or two. But how do you get commodity price increases that cause consumer prices go on from 1990 to 2007? I do not think it will work. I think that the people who use these answers do not actually look at the nuts and bolts. I think they are willing to settle for plausible. I do not like that because we are talking about people’s lives and goals here. Inflation eats away at what a person and their family are depending upon over the course of their lives, even 2%.

Really, think about this. We have all heard that the price of something is the result of supply and demand. When you think about all of the items in the economy, what you really have is that each buyer is allocating his money among the things that they have decided to buy at that time. If something costs more than it did, a person will have to make do with hoping something else will be less expensive, the amount they purchase of that item reduced, or taken off the list completely. If prices continue to go up, more stuff must be scrubbed from the list, unless more money is found. What we generally understand about supply and demand, reasonably, I think, is that the supply consists of the products we want to buy and the demand consists of what we want, our choices. More people want something and its price will tend to go up until there is more of it, and so on. In general, especially in a mostly capitalist economy, that is a good way of thinking about prices. But, in considering price inflation, we have to think more concretely.

At root, supply and demand consists of the products (goods or services) vs. the actual currency, dollars offered for the item. It is a purely mathematical/mechanical thing. At a specific time a certain amount of a product is available and a certain number of dollars is offered and the price is the dollars divided by the number of products. If in the next time period the number of dollars offered is higher per item of product, the price goes up. If the price continues to go up, the number dollars per product is continuing to go up. If this is true generally throughout the economy, then there has to be an increase of in the number of dollars overall. It can’t work any other way. If you look at the U.S. money supply over the years, you will find a constantly increasing supply of money. You will be surprised at the size of the steady increase. (This would be the dollars in the U.S. There is still more money being pumped overseas. Nor do the money supply figures include money that has been created and then invested, say in residential real estate, or in a business.)

That is the other definition of inflation: an increase in the money supply, which can and usually does, lead to an increase in consumer prices (which, for want of a better term, I call “price inflation”). Thus, we have had significant inflation for most of the last 60 years.
So the question is, where do all of those dollars come from? That will have to be the subject of another post. Sorry. The answer is long, complicated, and tedious.

Having just devoted “serious” time and space to talking about inflation, some may say, “But isn’t today’s problem the threat of deflation?” or “But they say that prices dropped this year, and probably will next year, too!”

Prices may have dropped in 2009. Government reports should not be accepted just because they are from the government. The government is not omniscient. What is always important is for you to keep an eye on the things that you and your family need and want. Did those prices go up, down, stay the same? Your personal situation is what counts for you.

More to the point here is that we can do little to change what is happening today, or even in the next several months. My concern is for 2010 and the next few years. Given that inflation is the increase in the money supply, Obama’s plans do make me concerned about what is going to happen. His spending and deficits will tend to put a lot of money into our economy. New money is inflation.

To anticipate my technical discussion of the government’s manipulation of the money supply, the U.S. money supply is increased by means of increasing bank credit, bank loans. Since the recent crisis began, banks have cut down their lending to near zero. That means that the primary money pump has not been working, and consequently, less new money (there is another way new money is introduced, but that is not as large as bank credit manipulation). I will talk about the banks and credit as time goes on.

We are also seeing import prices going up across the board. The value of the dollar has been falling. There are many dollars overseas, and the amount is continuing to increase. It takes only a slight increase in the portion of those dollars to begin coming back to lower the value of the dollar. That is happening. So the prices of imports have been rising. The dollars coming back are also competing for our domestic production, and will be a source for higher prices of our own goods. There are upward pressures on prices today. I think we will see more and more upward pressure as time goes on. Forewarned is forearmed.