Why inflation is a monetary phenomenon

Throughout the latter half of 2021 and into 2022, the United States has been experiencing its highest inflation since the early 80s.

Predictably, the spin has been avoiding the actual problem. President Joe Biden has called it a supply chain problem, which is partially true. Senator Elizabeth Warren has fallen back to the “corporate greed” playbook, which is patently false.

Such misdiagnosis leads to coming up with solutions that don’t fix the problem, but make it worse.

First, let’s address Warren’s “corporate greed” assertion. It makes two false assumptions commonly made by populists and socialists. First, that businesses set prices arbitrarily, and by extension, consumers will buy goods at the same rate no matter what the prices are, thus leading to higher profits. Secondly, it assumes businesses don’t compete for consumers, which they obviously do.

Firms compete on a variety of factors — convenience, quality, price or some combination of the three. The competition between firms keeps prices as low as possible low, especially in high-volume, low-margin industries. If Walmart or your local grocery store, for example, is raising prices, it’s because it would lose money without raising them. They operate on razor-thin margins. Thus, there has to be another explanation besides “corporate greed.”

Ultimately, it’s not supply chains. It’s not “greed” — at least of the corporate variety. It ignores the Milton Friedman axiom that “inflation is always and everywhere a monetary phenomenon.”

The monetary piece — from February 2020 through December 2021, the M2 money supply grew 42.5 percent — much faster than the money supply has ever grown over any period of time in recent U.S. history. Predictably, a sustained rise in prices has followed.

Why? The concept of scarcity tells us there is a fixed number of goods and services at any given point in time. More dollars in circulation chasing that fixed number of goods drives up the price. The increased amount of dollars in circulation will increase demand because those dollars will either be invested or spent.

When invested, they bid up the prices of assets — such as stocks, bonds and real estate. When spent on consumption, they bid up the prices of good and services.

Why? Buyers compete against other buyers. Sellers do not have to work hard to find buyers and can sell to the highest bidder. If the prices don’t rise, shortages will occur and those holding the item will be able to re-sell it on the secondary market — effectively causing the price to increase. On a microeconomic level for a single good, we see this frequently — look at the secondary market for tickets to major sporting events, or real estate in a buyer’s market. Eventually, the primary sellers adjust to this new reality and prices increase.

The second issue is that process is also happening in the markets for capital goods, driving up the costs of production, eventually leading to higher prices for the end consumer.

The first question you may ask is, “won’t the increased demand lead to increased supply?” As Friedrich Hayek had frequently said, prices are signals and the higher prices would eventually lead to an increase in supply. However, that supply will always lag the increase in demand caused by the increase in the money supply.

The other problem is, the increase in supply might not actually reflect market conditions, because producers are responding to higher prices not caused by increased demand due to market forces, but caused by increased demand due to an increase in the money supply. Essentially, demand that likely would’ve happened over a period of time is now pushed to now due to the increased amount of dollars in circulation, often leading to misplaced production and surpluses in the future.

The second thing that could cause inflation is a decrease in supply — the “cost-push inflation.” In this explanation, an increase in the cost of producing goods, such as an a rise in the cost of raw materials, fuel, labor or increased business taxes. That pushes the supply curve for those goods to the left, and thus pushes up the price.

Cost-push inflation would be moderated and often focused on the specific industries hit hardest by rising costs. That would be coupled by the fact that consumers’ incomes are not increasing and thus the higher prices for specific items would eat up a larger percentage of a family’s budget. Thus, those higher prices would be offset by fewer goods being sold. If such cost-related price hikes happen across the economy — as can happen with a sudden, sharp rise in wages, taxes or energy costs — the result would be stagflation, a recession coupled with inflation, as the U.S. experienced in the 1970s. This is a real concern currently because of the supply-chain crisis and the tight labor market forcing up costs and prices for specific goods.

But even so, the actual effect of inflation would be moderated by less demand. Where higher costs lead to sustained inflation is how the Fed reacts. Often, any recession is met with a significant loosening of monetary policy — lowering interest rates and thus boosting the money supply to try to boost demand. However, when the recession is caused by a supply crisis and higher costs, as happened in the 1970s, expanding the money supply creates a feedback loop. More dollars boosts demand for items already in short supply, forcing the prices up even higher and leaving wage-earners in a cycle where they can’t keep up with the rising prices.

Inflation is not “corporate greed.” Short-term inflation caused by supply-side problems frequently resolves itself. Sustained inflation is always and forever a monetary phenomenon, and ignoring the monetary policies to pursue fiscal solutions will ultimately lead to a loop of unintended consequences.

Andrew Smith is an economics instructor at New Palestine (IN) High School and Vincennes University. He is the Vice Chair of the Libertarian Party of Hancock County, Indiana.