Intro
I have not heard one argument from the Inflationists that isn't tainted by concepts blinding them to the pragmatic reality of how inflation actually works.
(5400 words)
The Nominal Game We Play
The reason a wage price spiral is not a cause of runaway inflation is because wages are not a cause of rising prices; they are a price, and all prices are an effect of the money supply, which expands the balance sheets of consumers and businesses (depending on how it's distributed). This is not something that has to line up perfectly on a chart because there can be lags shaped by things like velocity and confidence, particularly when influenced by pre and post globalization effects, among other variables, but without a broad increase in the money supply, where does the money come from to pay for general rising prices? If you say “wages,” you are engaging in a self-referential loop that requires funding to fuel it. The flawed thinking goes like this: “prices go up, which pressures wages up, which pressures prices up in a self-fueling spiral....” But this assumes an infinite balance sheet when in reality rising prices cause consumer and business discretionary income to shrink because it’s not simultaneous and it's unevenly distributed.
Let’s assume the money supply stays constant and the federal government forces a 10% increase in all wages so it happens simultaneously to all businesses. This would cause a 10% loss to all businesses via increased payroll, so let’s also assume every business decides to raise their prices by 10% to offset it. Let’s further assume everyone spends the 10% increase in wages proportionally across every business so they all initially lose 10% in higher expenses but it’s replaced with 10% of higher revenue. What is the result? Wages and prices go up but there’s no real economic gain. All that happens is the level of debt remains constant while the nominal wages and prices to repay it increases. This is the process of inflating away debt.
There is not a self-fueling inflationary mechanism here unless the forced simultaneous wage increases happen consistently every year, and there’s a boatload of assumptions I made to illustrate how unfounded fearing a wage/price spiral actually is. In reality, the money doesn’t get spent evenly, so some businesses receive a disproportionate amount of the benefit while others receive less or none. Also, not every business can raise their prices without hurting their revenue in lost volume. A business would likely respond to forced higher wages by cutting hours and making the remaining employees work harder, which is another reason why a wage/price spiral cannot fuel itself without continual funding. The same reason high prices cure high prices, inflation cures inflation, except during hyperinflations which typically involve an ever increasing flow of money to broad consumers from a noneconomic actor like the government. Free market competition prevents runaway inflation. You will only find sustained inflation in sectors or countries where monopolies exist, or government intervention overrides free market mechanisms broadly.
Here’s another flawed concept: inflation expectations cause rising prices. There isn’t a single merchant on the planet who will take my inflation expectations as payment for their goods and services. They insist on money, which is a prerequisite for inflation expectations, so if the monetary expansion stops, inflation expectations will follow, and demand will weaken, ending the inflation as discretionary income and profit margins get squeezed and cause a slowdown or recession. A caveat to this is how idiosyncratic it can be. A growing business could see all of its input prices go up and yet its free cash flow still increases because its market share is growing. Likewise, an individual who gets a raise that exceeds their increases in expenses is not affected by inflation in real-time. Naturally, the percentage change in wage growth for those making less money doesn’t increase the absolute dollar amount of their discretionary income nearly as much as those making higher income, so the economic effect from the same percentage increase in wage growth varies dramatically across the income spectrum for the universal goods and services everyone consumes, which makes inflation a very regressive tax that hurts the poor the most. A statistic that would express this is showing the percent of disposable income consumed by each category of CPI across each of the income quintiles. If that statistic existed there would be far less conceptualizing about inflation.
If you think prices can sustainably rise without being fueled by the expansion of the money supply into the hands of broad consumers, prove it to me by drawing a flow chart of 5 consumers and 5 businesses as pyramids with the largest base layer as income, a smaller middle layer as expenses, and the smallest top layer as discretionary spending. What is causing prices to rise? Is it a supply side phenomenon or is the money supply increasing? If it’s a supply side problem, the middle expense layers of the pyramids expand (overall) but the bottom income layer doesn’t, so the top discretionary spending layer must shrink. This is what happens when energy costs, interest rates, or commodity prices, rise, which forces a reallocation of budgets away from discretionary items towards mandatory spending on staples and utilities.
If there’s an increase in the money supply, the bottom income layer expands, which allows the top two layers to expand as well because there’s more money available to spend. You cannot expand the expense layer in the middle without shrinking the discretionary layer at the top unless the income layer rises, but the income layer can’t rise universally for everyone unless the money supply increases broadly through wide scale borrowing or redistribution stimulus programs. Increases in prices caused by the supply side induce recessions that self-correct the supply imbalance because consumers and businesses don’t have the money to pay the higher prices, so demand wanes. If the productive output of an economy increases while the money supply remains the same, prices go down. This is a welcome deflation and the natural mechanism of the free market because it reduces the middle layer of expenses and therefore increases the discretionary layer without requiring the income layer to increase.
A runaway wage price spiral is impossible, but a slow moving one is the basis of our economy. In fact, a system of fractional reserve banking and deficit spending requires a wage price spiral; it’s the lubricant that allows the engine to run, so it’s peculiar to hear people worry about a wage price spiral when it’s the desirable outcome. Without a wage price spiral the whole system implodes. How else are people going to pay for the higher prices? Prices don’t come down; wages go up. Our system requires a continual expansion of the money supply to fund a continual wage price spiral to prevent it from collapsing. It’s surprising how many people didn’t take the time to figure out the difference between a rate of change and a price level of inflation. There are still people who believe prices have to come down for inflation to subside when it’s wages going up over time that makes it work. What usually deflates following, or alongside, an inflation, is asset prices, not consumer goods, although sometimes asset price deflation is so dramatic it deflates consumer prices as well - until the money supply reinflates everything again, which is the pattern we’ve been in for a hundred years.
If we had sound banking, and sound money, wages and prices wouldn’t have changed much from 100 years ago. The median house would still be a multiple or two of around $6,000 and the median salary would still be a multiple or two of around $2,000. Prices don’t rise over time because the economy grows. In fact, the scale and efficiency of free market competition causes prices to fall over time. Prices rise from the money supply increasing, diluting purchasing power, which then requires more dollars to buy the same stuff, so it’s not prices that are rising, it’s the purchasing power of the dollar going down. Central bank critics blame this on the Fed when most of the money supply is created by banks. It does not matter that banks are funding what should be viable economic activity; what matters is the supply of money per capita vs the productivity. In theory, the money supply could expand and prices could still go down if the overall productivity was increasing faster. In comparison to a system of hard money like gold, the money created by banks could not exist. It is future economic activity brought forward into the present by a printing press. This is why demographics play such a huge economic role and why the Boomers distort everything they touch.
This is the nominal game we play, and there’s no stopping it because in a debt-based system the value of the collateral supporting it can never deflate or it would destabilize the centralized creators of credit with contagious counterparty risk, which would force the Fed to bail them out. Some like to argue letting the system fail would be akin to the sharp quick depression of 1920, but in a globalized world we don’t have the base layer of manufacturing to lean on, so bailing out the system is not a choice, it's mandatory. Restructuring the debt is also not an option because it would be a massive deflation of the value of collateral. The only choice is the continual debasement of the currency through money supply expansion with the hope that increases in productivity from A.I. eventually outpaces it, or there will be a loss of faith in the currency, which is the ultimate expression and failure of the institutions comprising our system.
To illustrate the point, in 1913, an approximation of M2 was 29.7 billion, and the population was 97 million, which is $306 per capita. In 1959, the first year of officially tracked M2, we had 177 million people and an M2 of 298 billion, or $1,678 per person. In 2023, M2 was 21.1 trillion and the population was 339 million, which is $62,223 per capita, which is 203x the amount from 1913. M2 might be a flawed statistic but you get the point: if M2 was distributed evenly Jeff Bezos would have to sell the yacht. In a gold backed system, the money supply tends to naturally increase in proportion to population growth and improvements in technology as more people are available to mine the gold, and the equipment becomes more efficient. If the money supply per capita stayed relatively the same over the last century we would still have an imbalance of wealth but it wouldn’t be so extreme, and the evolution of technology would have been glacially slow, so there would have been pressure from foreign competitors who were increasing their money supply and reaping the benefits of faster technological improvements in the same way athletes got tempted into steroids to keep up with competition. The predicament we find ourselves in may have been the inevitable result no matter what choices were made along the way, but that doesn’t mean we can’t course correct voluntarily, or be forced to course correct by technology in the future.
One of the main benefits of an incrementally expanding money supply as the cause of incrementally rising prices and wages is best demonstrated with housing. When someone takes out a 30-year loan for $300k at 6%, they end up paying $347k in interest. If the house is $360k at the time of purchase and it appreciates at 4.59% (which is what Google just told me was the average from 1992-2023), after 30 years the house will gain $495k in value and be worth $855k. The average inflation rate was 2.48% during that time. The average annual wage growth since 1992 was 5.15% (according to Google citing SSA). So this Slowflation creates $150k in nominal purchasing power (not counting any refinancing at lower rates over time), which comes from the dilution of the currency causing house prices to rise more than the total interest cost, which is a transfer of wealth from those who hold the currency but don’t own a house, and it’s yet another contributor to the wealth imbalance as those who don’t own assets fall further and further behind.
Slowflation benefits bankers in nominal terms (but since the money is created out of thin air, the interest received is a net gain even though the purchasing power of the principal they loaned gets diluted over time); it benefits homeowners in real terms (since their house and wages appreciate more than the interest and inflation (overall)); it benefits the government in nominal terms because the debt issued 30 years ago is diluted by rising tax revenue); and it benefits businesses in real terms as they raise prices and become more valuable as assets. The people it hurts are those who don’t own assets, savers in cash, and owners of debt (unless you create it out of thin air like a bank, or if the price of the debt rises like a treasury bond bull market for 40 years so the total return offsets the loss in purchasing power when the principal is repaid).
One of the more misleading charts is the 99% loss of purchasing power of the dollar over the last 100 years because it doesn’t show the rise in wages that offset it. Chat GPT says inflation since 1913 has averaged 3.1% but real wage growth was still 2% until 1979 and then just below 1% ever since. While money sitting under a mattress decays over time, money earned to pay living expenses has outpaced inflation, so the question is: why haven’t real wages for the lower half kept up with the upper half as seen here, and the answer is globalization. If you owned assets AND got real wage growth during this time you’ve done quite well as “number go up.” This outperformance of higher wage earners in real terms is more evidence of the insidious effects of globalization and the wealth imbalance it causes.
One of the better arguments for a trend change from structural disinflation to structural inflation is the shift from monetary to fiscal dominance. And while I agree this shift is happening and will continue to happen, I don’t agree that it has to cause consumer prices to accelerate any faster than they have in the previous century of Slowflation. Fiscal dominance does not necessarily mean a runaway train of inflation - it means the effect of the responses to deflationary collapses will be more dominated by fiscal policies than monetary policies, but that doesn’t change the order of operations requiring a deflationary collapse first, which then causes an inflationary response that will now likely be dominated by fiscal effects, but typical deficit spending doesn’t cause “general rising prices” in the same way it causes rising prices in specific sectors.
If we follow the money, government spending flows to the military, transfer payments, healthcare, retirees, infrastructure, etc., which creates artificial demand for the businesses in those sectors and ends up on the balance sheet of banks, but banks aren’t short on capital, so this increase in lending capacity still requires creditworthy borrowers with collateral and viable loans. Neither the Fed nor the Treasury can print creditworthy borrows. To use the pyramid analogy, deficit spending is not a broad based increase in the income layer of the overall population because it’s narrowly distributed to select recipients and businesses. If the government passed a UBI policy, or the Fed started pinning the curve, then I would agree it would be a structural change (which is likely coming if AI takes too long), but that is a really high bar to pass Congress and would only happen as a response to a deflationary collapse.
If you believe deficit spending causes broad consumer prices to rise, prove it to me with a flow chart showing where the money comes from, and who receives it, then explain how the price of milk and beef and cars will rise if 80% (?) of the population doesn’t receive the money to increase the demand for those products. Prices can only rise if there is an imbalance of supply and demand, so if supply remains constant then where does the sudden increase in demand come from? Some of the inflationists have the right understanding; they’re just saying it wrong. Deflation is the problem; inflation is what they do to prevent the problem from occurring. Some of the deflationists have the order of operations right but they underestimate the response: the only certainty in life is the Fed will be diluting the purchasing power of existing bond principal to pay for future government obligations.
To think inflation is the problem is like saying alcohol is the problem for the alcoholic when it’s the underlying condition of pain causing them to drink. This is not just semantics. If inflation was the problem you’d want to be long the dollar and short everything else because the Fed would be forced to keep increasing overnight rates ever higher attempting to contain it. Since deflation is the problem, you want to be long assets that benefit from Slowflation as nominal prices continually increase over time from monetary and fiscal policies forced to prevent a deflationary collapse, which occurs at times along the volatile way.
The 1970s inflation was largely caused by simultaneous demand for credit by a freak demographic boom all hitting their peak borrowing years at once over an entire decade (amplified by oil, of course). The 1940s inflation had elements of a locked down economy, and a simultaneous release of consumers when soldiers returned, all hitting a restrained supply chain since so many manufacturers switched to producing munitions, so a sudden increase in demand hit a reduced supply. (Among other factors in both decades, of course.) To whatever weak extent companies are reshoring due to subsidies, that is a supply side force because it’s not increasing the money supply. And Treasury deficit spending financed by the private market isn’t inflation; it’s just redistributing money and crowding out private investment that could have happened elsewhere. Foreign buying of treasuries is outside money like the Fed, which is additive, but you’d have to follow the money to determine who is receiving it to figure out which consumer prices are likely to sustainably rise from it, not to mention where it came from, which is our trade deficits. In other words, unless there’s a fiscal program that broadly distributes the money, it’s not possible for demand to outpace supply and cause a general rising of consumer prices, so there is no chance of a resurgence in inflation like we saw during Covid. When the Fed inevitably starts cutting rates it is very unlikely to cause enough borrowing to spur inflation like the 70s’ freak demographic boom - largely due to the loss of secure incomes in the lower half caused by globalization. There is a huge difference between general rising prices and the rising prices of specific sectors caused by government interference in the free market. And there is a huge difference between rising prices caused by the supply side vs rising prices caused by an increase in the money supply. The former causes a temporary economic boom while the latter causes a recession, so a new word should be coined to express the difference because the effect on assets prices is dramatically different.
My experience of the Covid inflation will force the “supply shock only” theorists to soften their views. When I bought my business in 2018, if I call the numbers I bought into 1x, I expected the changes I implemented to increase both the top and bottom lines by 50% in 2019, which is exactly what happened. I thought maybe another 25% increase would happen in 2020, but that would max out this business without getting into a world of headaches I had no intention of getting into. But then Covid hit in 2020 and both the top and bottom lines increased 3.5x and stayed there for two years. I was not affected by a supply problem at all, not even a little bit. My suppliers all raised their prices by 50-100%, which forced me to raise my prices the same, but that was in response to the insane demand, not a supply shortage. In July 2022, when everyone started the summer of endless vacations, my numbers reverted all the way back down to 2019 (a 70% drop). I am neither that good nor that bad at running this business, and while there is some degree of consumer preference changes for sure, nearly all of what happened was caused by the one-off stimulus money. I agree a supply shock was the cause of some degree of the price hikes for a lot of global companies, but if the inflation wasn’t driven by money, then how did the top and bottom lines for so many companies increase so much? I would argue 75% of the CPI increases were caused by the distributed money and 25% was a supply shock. This is a better explanation why it’s taking so long for the last mile as the money works its way through the system, which has been extended by the Inflation Amplification Act.
To put inflation in the most concrete terms possible, put yourself at a sales counter of our newly established business. In front of you is our cash drawer, a credit card terminal, and a computer with financing options. On the other side of the counter are 5 customers representing each of the 5 income quintiles. The person in the lowest 20% income bracket is not a factor in determining our cash flow. In fact, in the business of their life they are losing money since their income is being subsidized by transfer payments from us. Most of the people in the 20-40% bracket feel like they’re in the bottom bracket and don’t have much discretionary income. The top 80-100% bracket also doesn’t matter because there’s not enough of them to move the needle broadly and they don’t have to change their consumption even as the world ends in an apocalypse. It’s the 40-80% and most specifically the 60-80% bracket that will move the needle on economic numbers the most. This is the group with the highest number of people with the most discretionary income to spend.
Now a genuine inflationary impulse happens like the Covid stimulus. First of all, businesses don’t control their prices; they are set by demand relative to the supply in context of the competition. A functioning business does not want to raise its prices; in fact, it’s scared to raise its prices because it could lose customers and hurt its top and bottom lines from less volume. When inflation causes all its expenses to go up, a business is forced to raise its prices and look for efficiencies anyway it can. The idea of pricing power is also exaggerated because it too has limitations. If Coke and Pepsi raise their prices too much they will discover their loyal customers will choose to get their diabetes from the local generic brand.
Once the intensity of the inflationary demand subsidies, the hangover begins. The business has higher expenses, the employees have higher expenses, the customers have higher expenses, and wages haven’t kept up for enough of the population because they’re unevenly distributed. So the business has to get lean, eliminate unnecessary spending, and figure out how to reduce payroll by giving the most critical employees a raise, but also more duties so hours can be cut overall to keep the expense the same (if necessary). This is why a wage/price spiral is so impossible. It’s not how it works at all. The thought process of a business owner morphs into: how can I maintain (or even increase) productivity with the same payroll?
If you apply this dynamic to every business on the planet, some businesses (like mega cap tech) are growing their markets because they have products and services continually in need and expanding throughout the globe, so they aren’t as impacted, but the vast majority of small businesses feel an economic contraction much more intensely, so their ability to raise prices to offset their expenses is limited, which is why it’s not a self-fueling phenomenon unless the flow of money to the broad consumer base that is causing the supply/demand imbalance is perpetual. Imagine being behind the sales counter of every business in existence. Follow the money of deficit spending. How many dollars are reaching the customers standing before you and which income quintile do they belong to, and what sector is the business in? Imagine an extended oil price shock, or a weaker dollar causing commodity prices to rise, or any supply side shock like higher interest rates or higher prices from “deglobalization.” Our prices are going to rise but the consumer's discretionary income is shrinking, so they have less to spend. Now compare the supply side causes with stimulus checks sent directly into the hands of our customers, bidding up our prices. The supply side causes a contraction; the demand side causes an expansion, then a contraction. This is at the crux of the difference between cyclical and structural forces.
A structural force is grounded in the incentives of the participants, making it perpetually self-sustaining unless something changes to alter the incentives. Structural disinflationary forces are caused by: downward pressure of free market competition eroding profit margins; improvements in output from the efficiency of technology; cost savings from CEOs seeking the lowest cost labor and expenses in the world; the saturation of debt devouring consumer discretionary income; and the demographics of the baby boomers entering their non productive years.
The argument that we entered a new inflationary regime rests on forces like remote work, higher energy costs, fiscal dominance, and deglobalization, but remote work is likely disinflationary, if not deflationary because it will cause serious write-downs of commercial office real estate debt on bank balance sheets with unknown consequences. Remote work is like globalization for digital services, and, really, it’s just changing office locations - it doesn’t add or subtract economic activity. When workers don’t want to come to the office, it opens the potential workforce to the entire world. I recently needed some web work done, so I put an ad on Upwork and received so many replies I had to shut it down. My choices were Dan from Denver for $150/hr, or Monika from Mumbai for $35/hr. One thing you discover about the Monikas from Mumbai is they don’t always represent their fluency in English accurately. And I’m sure some US jobs require a cultural knowledge that can only be acquired through decades of living here, but there is an enormous amount of work the Monikas from Mumbai can do if our workforce doesn’t want it. She did a fantastic job. The point is there’s no economic gain or inflationary impulse if you relocate workers from a downtown office to their houses.
I won’t spend much time on energy because it would be a supply side issue, not an inflation problem, so by definition that’s cyclical as the market will seek a high enough price to self-correct the imbalance, which will drive up prices without an increase in money to pay for it, so it will cause a recession. I agree with Doomberg that Peak Oil is a myth. According to Worldometers the globe has 47 years of proven reserves at current consumption. And if a supply shortage one day becomes an issue, we already have existing technology to solve the problem, even if all the budding new approaches fail: we can convert to natural gas; we can build modern nuclear plants and make our own hydrogen or ammonia; and/or upgrade the grid to power sodium/lithium or lithium/iron batteries, among dozens of other possibilities. The necessity of data centers incentivizes the creation of cheap, efficient energy. I won’t be surprised if A.I. solves fusion or aliens come out of the closet with advanced energy technology.
Why we don’t incentivize EV hybrids as an interim solution to slow down oil use and grant more time to develop the tech is beyond me. This does not mean we won’t cause our own energy crisis from political incompetence, but that is a political argument, not an energy scarcity one. The abundance and efficiency of energy will go UP over time, dramatically. I expect the next 150 years will have an even greater, cleaner, and cheaper energy impact than the last 150 years, but humans do all the wrong things first until they finally get it right. (Again, I’m not talking about the price of oil spiking if we sabotage ourselves. I’m talking about energy scarcity or abundance and whether we need to worry about the future existence of our civilization.) We already discussed fiscal dominance as a reactionary function and limited in scope unless the money is broadly distributed. We’ll explore the illusion of deglobalization next week.
The Fallacy of Real Yields and Universal Inflation
There’s a huge difference between a universal system of standardized measurement like the Metric System, or the US Customary System, and a relative system seeking an average statistic to calculate things like CPI, which varies immensely per individual. Since there is no universal measurement of inflation, there is no universal real yield. It’s a meaningless number akin to the weather channel saying the global temperature is 48 degrees (Farenheit). It depends entirely on where an individual lives, and in the case of CPI, what they spend their money on, what they own, how much income they earn, and their net worth.
The way to calculate a meaningful real yield would be a spreadsheet where an individual can enter their income and how much they spend per CPI category to derive an individualized CPI, which would have to be compared to their local prices over time. Unlike a house, rising auto prices have a much different effect since they lose value for everyone, but the percentage loss against incomes and its psychological effect vary immensely. Increases in services depend how much you spend on them. Once you input your income, assets, and spending in the proper CPI categories, you can calculate an exact inflation rate against any rise in your income. If you own a house it’s likely keeping up with overall shelter percentage increases but it will of course vary by region and locality and the value of your home. If your wage increase is higher than your personal inflation rate then you’re not being affected by the real-time inflation, even as the purchasing power of the dollar is going down. Technically, the real yield on your excess savings can’t be determined until the money is spent. In the future, when every dollar can be embedded with the ability to track CPI and asset returns across time, it will be possible to calculate the real yield of each dollar from the time it was acquired until the time it was spent, which is the only accurate way to do it.
If you have money in treasuries collecting 5% in an investment account that you’ll never spend in your lifetime, it’s more appropriate to measure the real yield in terms of alternative investments. Even though it’s apples to oranges, that money could be invested in the S&P, or if you think a market cap weighted stock index to bonds is an unfair comparison, you could use low beta dividend etfs, or more duration, or credit risk, or asset diversification strategies etc... When making a real yield calculation across long periods of time, comparing the yield against alternative investments is just as relevant as CPI to determine the loss of purchasing power. But the final real yield isn’t complete until it’s compared with the price increases in the categories of how the money is spent. Otherwise, it’s just an average global temperature, which may be all we have, but it’s wildly inaccurate.
SUMMARY
Rising prices caused by an increase in the money supply into the hands of broad consumers creates a temporary economic boom that lifts the top and bottom lines of businesses and their equity prices, but much like a drug, it is not self-sustaining and only lasts as long as the money is flowing. Rising prices caused by any other reason shrinks margins and disposable income, which results in the lower equity prices of a recession to reflect the self-correction of the supply imbalance through demand destruction. Sustained inflation can’t exist unless a monopoly like the government overrides free market competition, but even then it’s important to follow the money to determine if it’s a general rise in prices or it’s contained to narrow industries and therefore a relative rise in specific prices like education or health care. The Fed inflates asset bubbles; the Treasury inflates consumer prices wherever the money flows. These two forces, combined with fractional reserve banking, inflated an Everything Bubble via a 203x increase in M2 per capita over the last century. Since the Fed and Treasury have chosen to prevent the deflationary pressure of globalization upon our economy with liquidity (as seen in their balance sheets), but most of our treasuries are privately owned, inevitably there comes a point when the interest to service the debt consumes the entire budget so the Fed will have to outright monetize the debt and pin the curve. A productivity miracle from artificial intelligence can save the day, but will it arrive in time? The mystery and suspense is like living in a movie.
Next week in The Surprising Superiority of Modern Monetary Theory, we’ll find out if a long-term sound money advocate has changed his mind.
