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posted: Novemer 26, 2022
tl;dr: Policy recommendations for creating inflation that have been proven to work in the real world...
Inflation: Economists can’t agree what exactly it is, what causes it, or how to measure it. They can’t predict it. But every economist claims they know how to control it.
For the purposes of this post, I’ll use the popular definition: inflation is an increase in consumer prices, as measured by the Consumer Price Index (CPI). Asset price inflation is also a very real concept, but many people, especially homeowners and investors, welcome it, as it grows the theoretical value of their investment portfolios. The challenges that younger people face in acquiring these assets for themselves are usually brushed aside: on balance, people like asset price inflation. There’s also monetary inflation, i.e. increases in the money supply, but that definition of inflation is hopelessly outdated in 2022: only Austrian School economists, monetarists such as Milton Friedman, gold bugs, and Bitcoiners spend much time worrying about it. Consumer price inflation is the inflation that almost everyone hates, although the official policy of the Federal Reserve is to ensure that we have 2% of it per year over the long run.
At times in the 2010s, the Federal Reserve was actually concerned that there wasn’t enough inflation because they were failing to hit their 2% target. Let’s invent a set of policies to cause inflation. What would they look like?
Create lots of money
Entire books have been written about the U.S.’s fiat monetary system and how money is created and destroyed. The Federal Reserve certainly plays a role, but so do smaller banks and everyone who participates in the economy. There are different kinds of money, some of which can be more easily and rapidly spent than other kinds (think of cash in your pocket versus cash in a brokerage account for which you lack an ATM card). My preferred measure for the money supply is M2. As you can see from the graph it has grown a lot over the decades, and especially at the onset of the COVID-19 endemic, although it has come down slightly as the Federal Reserve has tried to fight inflation.
M2 money supply. Source: St. Louis Federal Reserve Bank
If the newly created money sits in a bank, or someone’s brokerage account, or on the balance sheet of a pension fund, or under a consumer’s mattress, it doesn’t cause inflation (again, defining inflation as “consumer price inflation”). But if that money starts to get withdrawn and circulated into the economy by consumers, without any corresponding increase in supply, it will be inflationary. The inflation can be masked by deflationary factors, especially newly created supply as poorer nations industrialize. But all other factors being equal, the newly created money will be inflationary when it finally enters the consumer economy. Money that is created above-and-beyond the growth in the total supply of goods and services represents potential inflation, similar to “potential energy” in the world of physics. Just as potential energy can become kinetic energy, monetary inflation will become price inflation when people start to use it.
Do helicopter drops of money while preventing people from working
The onset of the COVID-19 endemic caused a supply shock, which was compounded by government-imposed lockdowns and shutdowns of certain “non-essential” businesses. To counter some of the ill effects on people, the U.S. government gave money directly to many citizens and also to businesses in the form of Paycheck Protection Program loans, many of which were ultimately forgiven. This is about as close as we’ve come to implementing Milton Friedman’s idea of helicopter money. The end result was demand stimulation during a severe supply shock: we gave people money to spend and prevented or inhibited them from producing goods and services on which to spend the money. We had more money chasing fewer goods.
Shut down retail stores
Even with the PPP loans, many small businesses closed for good during the pandemic. Others were closed for lengthy periods of time due to government lockdowns. The main beneficiaries were online retailers and big box stores that sold groceries and drugs, which were deemed essential. These favored retailers were allowed to sell a broad range of products while facing less competition, which gave them greater pricing power.
Create an energy crisis
A factor in the inflationary 1970s was the oil shocks of 1973 and 1979. Energy is a component of the price of every good and service, so when it increases in price, it affects all prices. Fertilizer is energy intensive, and rising fertilizer prices deliver a double whammy on food prices: the higher fertilizer price has to be passed along; and if some poorer farmers can’t afford fertilizer, they go without and their yields decrease, which decreases the food supply.
For years the U.S. and other governments have been discouraging the production and use of fossil fuels and shuttering nuclear power plants, while stimulating less-reliable wind and solar. This became a global crisis when war erupted in Ukraine, and the U.S. and its allies responded with sanctions meant to punish Russia, a major supplier of oil, natural gas, and even uranium. Most of Russia’s energy still is making its way to market, but at higher prices because of shortages and increased logistical costs to dodge the sanctions.
Deglobalize
The primary impetus for globalization is to reduce costs by sourcing from global low-cost suppliers. China, especially, was a beneficiary of this strategy. However, the COVID-19 endemic demonstrated the downside of fragile global supply chains, and companies are responding by moving production closer to end markets. This onshoring and near-shoring activity will reverse some of the cost benefits of globalization.
Fight a war
Wars are always inflationary. Wars cost lots of money, and governments often create new paper money to keep funding and fighting the war. Some of the money gets spent on ammunition, bombs, and other resources designed to destroy themselves, buildings, infrastructure, and people, all of which removes productive resources from the economy and decreases supply. The production of war materials diverts resources from producing goods that people would prefer to buy: recall America’s automobile factories building tanks instead of cars during World War II. The excess money and supply shortages drive up prices if the free market economy is allowed to function. Knowing this, governments in a major war will often implement price controls and rationing of suddenly scarce consumer goods.
Taken as a whole, I think we’ve created nearly the perfect recipe for inflation. Some of these factors may abate, but others will persist for years. The inflation we’re experiencing began in June 2020, and I think it will last the entire decade or longer. We may not manufacture much any more in the United States, but we still know how to manufacture inflation.