What Actually Causes Inflation (and who gains from it) | Forbes

I made a post two weeks ago in which I explained that the popular view of inflation (wherein it is caused by money growth) depends critically on assumptions that do not hold in the real world. Money comes into existence when someone adds it to her portfolio of assets. This occurs either when she borrows money (which creates new cash from reserves) or sells securities to the Federal Reserve (which injects new cash into the system). Neither of these scenarios allows the central bank to increase the supply of money beyond demand, the story told by those in the money growth ==> inflation camp. Instead, inflation happens first. This then means that agents need more cash for transactions, leading them to borrow more or sell government securities to the Fed. Thus, the money growth accompanies inflation, but it does not cause it. The original post can be found here:

Money Growth Does Not Cause Inflation!

What I did not answer there (except for a brief example) was what economic processes were actually responsible for the initial rise in the price level. I’ll fill that void here.

Inflation Defined

Inflation is simply a rise in the average price of goods and services in the macroeconomy. Which particular goods and services depends on the measure we are examining. Consumer price inflation is the one usually in the news, and it takes a weighted average of various items purchased by the typical household (the list being determined by survey and then updated periodically). The average can rise while some prices have actually fallen, and how much it reflects your personal situation is a function of how closely the basket of goods and services in the index matches your buying patterns. But, the bottom line is that we say that inflation has occurred when the average price of those goods and services has increased.

This does not happen by magic. It takes someone, somewhere making a conscious choice to charge more for the good or service they sell. The initial increase does not have to be in something that is being directly measured by the consumer price index. No household in my neighborhood, for example, buys barrels of oil; and yet when they become more expensive that sends a ripple throughout all related products. In the end, consumer prices jump as well.

Of course, that someone, somewhere who raises their price must also be in a position to make it stick. I could march into the Chancellor’s office here at TCU and demand that my salary be doubled, but that probably won’t accomplish a whole lot (other than to give me a chance to update my vita while I am cleaning out my office). Other factors must come into play. Many circumstances can cause inflation. I will focus on four.

Causes of Inflation: Market Power

First, the economic agent could have market power. This means they have the ability to avoid (at least to some extent) competitive pressures. It is the latter that forces firms to please consumers. Adam Smith wrote in 1776 that we cannot trust the undertakers of business to look out for anyone but themselves, and so we must handcuff them. But not with markets, per se, with competition, and the two do not always go hand in hand. The OPEC oil cartel in the 1970s and 1980s is a classic example of marker power. Had there been other viable sources of what they sold, they could not have restricted supply and driven up prices as they did because the competition would not have allowed them to do so. We would have just bought oil (or a close substitute) from someone else. Up to late 1973, they lacked the political will to set strict quotas among the various exporters. But, once the motivation was provided by US involvement in the Yom Kippur War, they made a conscious decision to raise prices by cutting supply. And because they were able to avoid competition, it worked! Even though households do not buy barrels of oil, it caused terrible inflation. It drove up the prices of anything that used petroleum or petroleum-based products, it raised the price of gas and, therefore, anything that needed to be transported, and it caused inflation in other energy sources as users shifted to those products. Market power–not money growth–caused this inflation. The money supply only rose as a result of the fact that firms and consumers took out larger loans and sold assets for cash. The Federal Reserve acted as it should have done in these circumstances, accommodating this increased demand.

(Note that having market power does not give carte blanche to raising prices. Even monopolists can only charge so much before consumers stop buying their products. However, they have the incentive and ability to engage in periodic attempts to capture more income for themselves. I won’t go into the specifics of when and how they do so here, but this phenomenon is discussed in detail in Alfred Eichner’s classic study of the microeconomy, Megacorp and Oligopoly: Micro Foundations of Macro Dynamics, Cambridge U Press, 1976. Thought it’s a little dated, the basic lessons still apply.)

The impact of the inflation of the 1970s and 1980s was hardly even, and this is always the case. Remember that when you pay more for something, the person on the other side of the register is also getting more. It depends on individual buying patterns and particularly where you earn your salary. With the OPEC inflation, those in the oil industry, while facing the same rising prices at the gas pump, grocery store, etc., as everyone else, were actually better off than they had been before because their salaries and profits rose at a higher rate. This was especially true of those in the OPEC countries who controlled the oil supplies. The inflation process redistributed income towards them–that was the whole point, wasn’t it? This fact is exceedingly important to understand. Inflation never affects everyone equally. It shifts buying power from one group to another (even though the winners may still complain because they see themselves as hurt by the overall price increases–what they don’t understand is their role in causing the latter!). In fact, it is the very attempt to capture more income that is at the heart of the inflationary process under these circumstances. Money supply growth did not cause prices to rise, OPEC’s attempt to grab a larger income share did. No amount of controlling the money supply was going to eliminate the ultimate impact of rising oil prices: the redistribution of income towards those countries and the oil industry.

As a very quick aside, it’s worth pointing out that just because the market created a particular price, wage, profit rate, or income does not mean that it is somehow objectively “fair.” These numbers only quantify our existing social values. There are, of course, more purely economic forces at work, too. Gold is more valuable than silver because there is less of it. But can we truly justify the wages and incomes earned by African Americans in the 1950s as economically reasonable, simply a function of their productivity? The fact of the matter is that a free-market system in a racist society reflects and reinforces racist values. Markets are people, and the preferences of those people, for good or bad, end up in the prices we see. My point here is that there may be times when we would, as a nation, actually prefer to alter the outcomes created by competitive pressures. Desegregation interfered with the market mechanism and the forces of competition, as did movements aimed at creating safer workplaces. Furthermore, paying African Americans more and reducing the chances of on-the-job injuries caused inflation (because they raised costs) and redistributed income. Was this justifiable or not? Unfortunately, these are not simple questions.

Causes of Inflation: Demand Pull

Another means by which inflation can take place is a rise in demand relative to supply. Say there is an increase in the demand for housing during an economic expansion. Bottlenecks may arise in certain building supplies like lumber. Contractors bid up these prices in an attempt to secure the materials they need; these price increases then ripple through the economy. Firms and consumers again desire a larger money supply to be able to operate, which the Fed presumably accommodates. The producers of lumber and bricks may also experience a rise in their incomes as part of this process–and why shouldn’t they? This is how a market system is supposed to work. Those selling goods and services in highest demand should see their profits and wages rise, even though by definition this will almost certainly cause inflation. This attracts others to sell these same goods and services, while some consumers go in search of substitutes. This is the greatest strength of a market system, it’s flexibility in the face of unanticipated changes.

Causes of Inflation: Asset Market Boom

Third and very relevant today, inflation can be injected from the asset market. The connection between the prices of goods and services and those of financial assets is tenuous. Sometimes there is practically none at all. Witness the 1990s, with a massive increase in stock prices but very little movement in the consumer price index. However, lines of causation can exist, particularly though commodities futures. I have already written about this at length in the context of gas prices:

Why You Are Paying So Much For Gas

The gist of the above is this. When speculative money bids up the price of a commodity future, this creates an incentive for those actually selling the commodity to withhold supply today in favor of the future (when prices will presumably be higher). The rising spot price then convinces the speculator that her bet had been correct, and she increases her position. This may drive futures prices even higher, and so on. Thus, a goods price is driven up by the price of a financial asset. The winners here are 1) those whose portfolios include those assets (of course, they can only realize their gain by selling) and 2)the producers of the commodities in question. Those producers often bear the brunt of the blame for these inflations, but they are not actually the source. As usual with inflation, it leads to a rise in the money supply as agents take out loans and sell government securities. The way to stop this inflation is not via blocking monetary growth, however, but to control the link between the asset market and the commodity price.

Causes of Inflation: Supply Shock

Last is a supply shock. If a storm rages through the Gulf of Mexico, taking out oil derricks and refineries along the way, this may well raise the price of oil and gas. As it should, for this creates incentives to build more derricks and refineries and for consumers to find alternate energy sources. Again, this is what capitalism is supposed to do. In terms of who wins with this sort of inflation, it’s obviously more complex since it depends on whose derricks were destroyed and who gets to build new ones. In any event, this, too, can lead to a rise in the money supply and there is no logical reason for the Fed to block this.

Conclusions

This is not an all inclusive list, but I would think that it covers the vast majority of what we have experienced since the end of WWII (today, we are most threatened by the link between financial markets and commodities). The bottom line is that there are a number of processes that can create inflation, none of which starts with, “the money supply increases.” Someone make a conscious decision to raise a price or wage, and they must be able to make this stick. Because every higher price you pay means someone is getting more income, inflation causes a redistribution of income. Sometimes it does so in a manner that we would endorse and sometimes not. But in any event, it causes a rise in the demand for money that the Fed will almost certainly accommodate–and rightfully so, for refusing to do so almost always serves to punish those already in the weakest position.

I’m afraid this more realistic perspective does not offer a nice, simple rule as in the money growth ==> inflation camp. That said, neither do they since that’s not how the world really works! In reality, monetary policy does not cause inflation, and it is not well placed to stop it. What it does do is very strongly and directly affect interest rates. But prices are determined elsewhere in the system.

SOURCE:  http://www.forbes.com/sites/johntharvey/2011/05/30/what-actually-causes-inflation/

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