Inflation Myths

Myths about Inflation and the Reality

Inflation is defined as a continual increase in the general price level. It is imprecisely measured by indicators like the CPI (consumer price index, a weighted index of prices of typical commodities for sale in the state currency units).

Does Government Net Spending Cause Inflation?

If you think “yes,” then you have succumbed to the Quantity Theory of Money (QTM) myth.

Note that the QTM identity is an equation that expresses an identity, so it is not wrong. The rate of circulation of currency $MV$ is equal identically to quantity of goods produced $Q$ that get sold at the “price level” $P$, so $MV=QP$.

The myth is that raising $M$ causes a rise in $P$. This Austrian School and Neoclassical story is obviously false. Most firms will try to raise $Q$ before their particular $P$, so in aggregate we hardly ever get pressure on the general price level at the macroeconomic level from just a rise in the money stock $M$.

Also, a rise in money stock gets roughly 20% saved, so not spent, so is not adding anything to price pressure. Even if everyone spent all their income, why would the price $P$ necessarily go up if firms can meet the demand (again, by raising $Q$ by hiring more labour or bringing online idle machine capacity)?

It is only when either (a) firms cannot easily raise $Q$ that they feel a pressure to mark-up their prices (due to various effects, not the least of which is wanting to retain customers), or (b) the firm is a monopolist desiring to price gouge or an oligopoly cartel is acting as price fixer. In case (b) government regulations preventing such unfair monopolistic practises are fully warranted, or a break-up of the monopolies, even capitalists would agree with this.

((Or as arch sociopath billionaire investor Peter Thiel said, “capitalism is for losers.” Or I think it was actually “competition is for losers.” But that’s more or less the same thing.))

Even then this has to happen wholesale throughout the entire economy to get general price level inflation, and that is rare. Only wars, famine, and plagues tend to cause a general supply shortage, or, the perennial problem, the supply of raw energy (oil mainly) which explains most, if not all, of the inflations of the 1970’s and early 80’s, and quite a significant fraction of the post-COVID inflation. If I get around to it we will later do some empirical work to validate this hypothesis against the alternate that the post-COVID inflation was caused by profligate government spending.

The reality is that never in all recorded history have government deficits caused hyperinflations. The causality has always been the reverse:

The cause of all hyperinflations, everywhere, have been supply shock events, like war, war reparations, pestilence, drought or famine and plagues.

The reason government deficits increase during hyper-inflation events is because people find real goods in scarce supply, so people are competing for purchasing power, and government welfare payments have an inflationary bias in such cases. The government is forced, involuntarily, to issue more currency to the poor. This puts pressure on prices. But the cause is the supply shock (cost-push), not the governments non-discretionary impact on demand-pull. There is a good analysis about this direction of causation for the case of Weimar Germany here.

However,

1. such inflation is indefinitely sustainable${}^\ast$
2. The fix to stop the inflation is to eliminate the source of the supply shock.

${}^\ast$ unless the government is promising redemption in gold bullion for it’s tax credit, or for water, or pizza,… which the government cannot promise forever to deliver, so generally governments no longer promise such redemption, and instead will tick off your tax payment instead as the redemption.

So the currency inflation is a natural reaction event. The supply shock source is what needs to be corrected, not the monetary inflation.

Once supply chains and goods supplies are restored, the hyperinflation always stops dead.

Remember, inflation is a continual increase in the price level. It is extremely hard for a government to keep inflation going, even if it wanted to, because if supply is good people don’t just take money issued by their government and go out and eat more or travel more. There are physiological limits to what people can do!

Since the mid 1990’s the Japanese government has desperately been trying to get inflation in yen prices above 2%. They keep failing! (Until COVID did it for them, not the way they wanted.)

Any MMT economist could show them how to get the inflation they want, but the point is that even governments that want more inflation find it difficult to get any. If you give people who already are eating enough and have shelter more money, they tend to save it, so in that case you cannot get any inflation just by raising the government deficit.

There might even be evidence to the contrary: that when governments spend more, provided it is functionally targeted to good investments in real resource supply, the prices drop, because the government is offsetting the need for bank credit, and providing for good productive jobs at the same time. It is another empirical project for Ōhanga-Pai to dig into this causal relationship.

The way Japan could get the inflation they want would be to fully employ all Japanese workers, and give them decent living wages. That will make skilled workers scarce for private firms, which increases the wage bids. That will give Japan the inflation they want, and in a very healthy progressive manner.

A few pithy examples

In quantitative sciences it can be useful, for limited purposes, to consider extremes,the extreme cases tell you what the asymptotics will be, so reveal tail ends of dynamics. You cannot use asymptotics for shorter run or highly constrained dynamics. But the inflation story is one where the asymptotics are good at revealing a few things about the relation between currency issue and prices.

Consider fruit prices and house prices.

If the central government handed me a million dollars next pay check — which they can because they can just whip out the computer keyboard at the central bank and type in the numbers, authorized by a nice vote in Congress I bribed them for (extreme case remember) — I would not be going out buying a million apples, I’d be buying avocados, but only a dozen, since my refrigerator can’t keep more than that fresh for long.

According to austeritricians like Mr Atif Mian or any of the other New Keynesians and Neoclassicals, I’d be buying a thousand avocados probably, because I do not know how to manage my money, I need a neoliberal daddy to drip feed me. (Sure, see the sarcasm dripping off the page, but this is the extent of the neoliberal argument for austerity.)

If instead I go and buy a house I get one house. How is that real estate inflation pressure? It isn’t. If everyone gets a free million and goes buying a house, then yep, house prices go up, but avocado prices don’t. Relative value stories here.

However, in time the avocado prices should go up because the avocado growers notice selling 12 tonnes of avocado a year no longer buys them a house or mortgage payment, so the house prices should eventually cause a general increase in the price level. But there is a quicker way, which would be to make energy more scarce, since energy is a far more basic important input into all production, so unlike house prices, energy price shocks directly cause pretty general inflation events.

But even then it is difficult for government spending to keep the inflation going. Once the suppliers catch up with demand, is the government going to just pay ever more and more for electricity? No. The inflation event stops when the supply pressure eases, or when alternative supply is created (innovation and whatnot). No government ever decides to just issue more currency to bid up prices for no reason (except maybe for boondoggles, pork barrels, and military spending corruption, which I guess counts as unnecessary and yet does happen).

Previously under “What is Money?” I used the farmer and police officer story borrowed from wbmosler talks, that’s another one to keep in mind, it’s all about relative value.

When a government issues a bucket-load (really an oil tanker load) of money suddenly the supermarket shelves go bare? I don’t think so. Households do not have the storage capacity. Can other fictional commodities like purely financial assets like stocks and crypto boom in price? Sure, because nothing real backs them, but then it’s all ponzi, so you go into those fictional commodity markets at your own risk, not the general public risk. No amount of stocks issued by Google is going to collapse the environment.

Stock prices

The price of a stock is supposed to reflect the real output capacity and sales of a firm. Most stock prices however are driven up by ponzi financing, so it’s a gambling game — who can hold out the longest before the stock price adjusts downwards to reality?

Warren Mosler had a great regulatory rule for eliminating this gambling game. Just limit all stock prices to $\text{\$2}$ per share, and they can start at $\text{\$1}$ per share. If a firm wants to raise more capital they can issue more stock. This is after all the only public good use for a stock market. It is to gain investment capital for firms, it is not to generate fake income on a piece of paper for the investors.

Market forces are still then at play, since a firm will not find buyers of their stock if their firm is known to be in sales revenue trouble.

This is also the monopoly story all over again. The firm is the monopoly issuer of their IOU, their stocks. So they can either set the price or fix the quantity and let price float. The sensible option is to fix price and let quantity float.

The investors are protected when the gamble is eliminated. It is pure greed that stock prices are permitted to go up in price without limit based only on psychological ponzi mentality.

What is the QTM Myth?

The QTM uses a macroeconomic identity:

$$ M V = Q P $$

On the left we have money supply $M$ and velocity of money $V$. Here $V$ is just the rate at which money circulates (sales per $1 per year). You can take a single dollar and circulate it very fast, passing it from buyer to seller who becomes the next buyer, then to seller to buyer… rapidly enough that a single dollar bill can sustain an entire (small-ish) economic system. In practice people like to save on average 80% or thereabouts of their income, if they can, so to circulate money to drive commerce, a supply of currency that grows is more typical than making the velocity of circulation more rapid.

On the left-hand side of the above equation we have quantity of goods $Q$ and price level $P$. More exactly, $Q$ is the amount of output that gets sold each year. If the time period is a year, then $P$ is the average price level over the year (it does fluctuate).

It is an identity that $MV$ must equal $QP$. It follows from definitions of these four quantities.

The inflation myth is that by increasing money supply $M$ we will necessarily cause prices $P$ to rise, and that’s inflation, if it is done continuously.

So lamestream economists tell you this myth that if governments run a continual deficit (injecting money into the economy, thus increasing $M$) then we will always get inflation, a continual rise in $P$.

This is bogus. You can immediately see why. Or at least I hope you can see why. There are several reasons why this myth is false.

1. A fraction of $M$ can be leaked away in savings accounts, so increasing $M$ via government net spending does not cause increasing $P$. If these savings leakages increase over a time period then it directly lowers $V$, so might lower $P$.
2. Firms hate to raise their prices, they like customer loyalty, so they will always prefer to raise output $Q$ instead of raising prices $P$.
3. A growing population will having growing output, and demand for that output, so $M$ must increase in this case otherwise prices will decrease.

Firms only raise prices either, (a) when they find they cannot raise their output, or (b) when they have a monopoly, so have not competition, so can greedily just purely price gouge their customers. A monopolist, as a rough psychological rule, does not care about customer loyalty. Customers have nowhere else to go. This is of course a major source of inflationary pressure, and is the dominant source of post COVID-19 inflation — price gouging by monopolies, especially oil cartels.

People think food producers are also price gouging, but oil is the main input into food production, so not all food producers are price gouging, they are just passing through their energy usage costs to consumers. This is one big problem of unregulated capitalism. If left alone, firms pass off costs to consumers, and the poorest consumers are the ones who suffer the most. It is terribly unjust.

Comment on 3. obviously a population cannot grow forever. First because the carrying capacity of the land gets pushed up against. But well before that, people do not like having lots of kids if they do not have to, like Japan and New Zealand, we have an inverted demographic situation, meaning relatively fewer young people are generating the output for themselves and the retirees. Our population however is for now still slowly growing, just less fast than in the past.Hence for price stability in NZ we need a growing net money supply, so the NZ government must run deficits (net fiscal injections).

Or, if we are lucky to happen to see continual drops in our import prices, we can probably live for a while with a low NZ government deficit, but this is not up to discretion of our government. The NZ government deficit will automatically be lower, all other things equal, if our import prices are dropping.

Also, Q is Quantity Sold

Not all output produced by firms is sold, a lot is held as stock. So when either $M$ or $V$ goes up, prices $P$ can remain constant for a short time as firms deplete their stocks. Firms love to do this, since all stocks eventually depreciate. A firm keeps non-perishable goods in stock only while they think they can later sell them. But while they are saving output to stock, this lowers the effective $Q$ in the QTM equation without effecting prices.

Nominal versus Real Inflation

If and when government currency injections (aka. fiscal deficits) put pressure on prices, it is only because firms have maxed out their output capacity, so the firms are forced to raise their prices to suppress demand. (They’d be a bit stupid not to, and in any case it’s a social psychology effect, they always do raise their prices if they cannot hire more labour or machinery.)

But what counts in all this, for economic justice, is not how much stuff $1 can purchase.

What always matters is how much stuff your whole income can purchase, not what just $1 can purchase.

The decline in $1 dollar’s purchasing power is called nominal inflation. It is never a serious problem if the lowest real wage is rising faster.

The decline of your entire annual income purchasing power is called real inflation, and it is the serious problem.

Got it?

Nominal inflation shown by the CPI index and other metrics, is not a cause for concern.

What is of deep concern is whether your real wage is declining, not the number on your paycheck.

Nominal inflation can go on forever until the end of time with no serious economic justice impact. Real inflation by contrast cannot be sustained indefinitely, it hurts the poorest the most through no fault of their own, and is unsustainable, if we do not want to see people dying in our streets.

Nominal inflation (CPI inflation) is only a psychological, hence political, problem, it is not an economic problem. Real inflation is the serious economic justice problem.

It is possible to have nominal inflation and real deflation — a decline in how much stuff $1 can buy, but an increase in what your total wage can buy. In fact, this is the norm. How? Because machine automation, hence unit worker productivity, pretty much historically always increases. (It’s thanks to engineering inventiveness and science.)

The great social unrest from the COVID-19 pandemic inflation era is the decline in the real wage, not the nominal rise in prices.

Governments can do a lot to fix this, by adopting a Job Guarantee scheme, which boosts the lowest wage to a decent living real wage, by fiat — government just says: “This is the Job Guarantee wage, take it or leave it.” The Job Guarantee cannot cause any inflation because the private sector bid for unemployed labour is already zero. At worst there is a one-time upwards adjustment in prices when the JG is introduced, if it is introduced at a wage rate higher than the existing unemployment benefit.

Caveats

Telling the inflation story correctly is pretty important in social discourse. Too many people get it wrong, spreading misinformation and ignorance, and this can hurt our democracy and economic justice desires.

I would say the most important thing to learn about inflation is the stark difference between nominal and real inflation. If you understand the difference (which is not hard) you’ll have a superior understanding than most people who rant hysterically about the “evils of inflation.” Inflation is not evil, provided the lowest real wage is rising. And sometimes moderate inflation is necessary to keep the lowest real wage rising.

Why?

Full employment ensures the real wage is the highest possible, all other things being equal. Provided the full employment is in non-bullsh$\ast$t jobs. Full employment (in non-bullsh$\ast$t jobs) tends to imply moderate inflation, because there is always some residual job seeking friction, even with an MMT style Job Guarantee policy running well. That’s why inflation per se is not inherently evil.

Although, to be honest, I would say the Job Guarantee is not quite running well enough if there is residual inflation. But in any case, moderate inflation is healthy because it directly reduces the purchasing power of hoarded wealth, and it is the hoarders who are not playing fair in a monetary system.

By “hoarders” I do not mean “savers.” Families saving for planned future big purchases are not hoarders, they have every right to be permitted to save, and not get too big an inflaton hit. To help savers banks offer term deposits at roughly the going inflation rate, so savers, in most nations today, are not really running many risks.

But to the banks there is little difference between a saver and a hoarder, I mean they don’t really know the difference. So the term deposit mechanism does unfortunately also benefit hoarders. This is why we cannot generally rely upon the circuit theory of money (endogenous money) for a fair and just economic system. There generally has to be a monopoly net issuer of currency to make up for the leak in currency circulation due to both savers and hoarders. And that net issuing institution is government. And their net currency add is called “the deficit”. It’s a good thing overall that it increases with the increase in the population size, and that is completely natural.

A growing population is expected to need a growing money supply.
— Warren Mosler.