Inflation

by Tim Nadreau, Ph.D.

Since the trough of the great recession to just before the COVID-19 shutdown, the inflation rate of the US dollar was stable, averaging about 1.8% per year. From December of 2020 to December of 2021, the inflation rate went up to 7.53%, the slope of the CPI tilting up to 3.2 times its historic rate (see Figure 1 below).

Monopolies?

It is difficult for me to envision a case in which a monopoly exists apart from government protections, many of which have unintended consequences. It is the unintended nature that masks the protectionism embedded in a policy. For example, suppose an environmental regulation is imposed causing a cement manufacturer’s costs to increase. For some reason, our cement manufacturer is refusing to fight the regulation. Why?

Any regulatory cost makes it difficult for new firms to enter the market. This government regulation acts as a protection for the cement manufacturer against potential competitors, and the firm is willing to give up part of its profits to “pay” for that protection, provided the regulatory burden doesn’t eat up more profits than the competitor would have. Although the regulation looks like an environmental policy that would damage cement manufacturers, by defending the policy, the firm appears to the public like a good steward of the environment. Win win! The unseen consequence is that this regulation prevented competition, and likely innovation, that would have lowered the price of cement.

You might argue that, if the monopoly is still making profits, there is still room for competition even after the regulation/protection is imposed. This is true enough. However, it must be remembered that start-ups don’t usually have the cash-flow, capital assets, or financial track record necessary to cover high fixed costs or to obtain financing, effectively barring their entry.

Just a short time ago, Robert Reich wrote a piece blaming corporations for inflation, claiming they are able to pass along their increasing “supply chain costs” on to the consumers more effectively than smaller firms. He argues that the increasing supply chain costs are real; firms should cover the increased costs with any profit margins they have so that the consumer remains unharmed. This would force a false price signal to be set in the market, as consumers would not be facing the true costs embedded in delivery of the good or service being purchased. His entire argument also ignores the basic concept of elasticity: the “incidence” of the additional supply chain costs will be borne by the more inelastic agent.

His main point is that larger corporations have more elastic supply curves than their smaller competitors. Although it is true that larger companies benefit from economies of scale, I hope he is not advocating that all firms in an industry must be equally sized or have the same marginal costs curves, as doing so would destroy the incentive to innovate and further reduce R&D funding.

A compelling argument against monopolies causing inflation comes from Larry Summers. He pointed out that, “The emerging claim that antitrust can combat inflation reflects ‘science denial.’” Antitrust is meant to break up monopolies, but what Summers is saying is that breaking up monopolies won’t curb inflation. The rational is quite simple: constants don’t cause change. If the monopoly could have increased prices yesterday, and did not, why then did they decide to increase the price today? This is worse than a post hoc fallacy—at least there, the cause of change in one variable is being (perhaps erroneously) attributed to the change in another variable. Following this argument, the continued, fixed presence of monopolies spontaneously resulted in inflation. Lest someone think there are more monopolies or that monopoly power has increased, Summers notes, “There is no basis whatsoever thinking that monopoly power has increased during the past year in which inflation has greatly accelerated.”

Borrowing?

Okay, so the culprit isn’t monopolies; economists across the spectrum agree with that assessment. Then what is? There is a big push that the cause of inflation is government borrowing. Rand Paul, and his father before him, argued that we were borrowing millions from China. Supposedly, that borrowing devalued the currency via the fractional reserve banking system. Picture it like this: I have $1 in my bank account; the bank lends that dollar out, but don’t show my account shrinking, meaning two people have a claim to the same dollar, and, voila, one dollar just became two. However, the bank is required to hold a certain number of deposits in reserve—they can only lend out a fraction of their depositors’ money—and thus, we have fractional reserve banking.

The fraction that must be held in reserve is called the “reserve requirement” and is set by the Federal Reserve’s Board of Governors. This reserve requirement means there is a limit to how much money can be created through double counting of deposits. Once we reach that limit, inflation stops—that is, until we inject more money into the system. At this point, borrowing no longer generates more “money,” just like me borrowing a hammer from you doesn’t create more hammers. This is precisely the point: borrowing cannot sustain inflation beyond what is allowed by the reserve requirement. What’s more (as can be seen by the first graph), inflation is not only being sustained, it is increasing! Jeffery Hummel discusses all of this in a lecture he gave at FEE entitled, Why Fractional Reserve Banking Is More Libertarian than the Gold Standard.

MMT by any other name…

If it’s not monopolies, and it isn’t the borrowing, what is causing this inflation? The quantity theory of money is still the best explanation for the type of inflation we are experiencing. True, supply chain disruptions are causing shortages of particular goods, contributing to the rising price of those goods, but this explains neither the increment of the price rises nor their persistence in the overall market basket of goods. The quantity theory of money says that real output price, times quantity of goods sold, is equal to the amount of money in the economy, multiplied by the rate at which those dollars are spent—money supply times velocity.

𝑀 × 𝑉 = 𝑃 × 𝑌

Where 𝑀 is the money supply, 𝑉 is the velocity of money, 𝑃 is the price level, and 𝑌 is nominal output. When the government shut down the economy and put shelter-in-place orders into effect, the velocity of money plummeted. What’s interesting is that this means a large part of consumer budgets are still spent in their local economies. Figure 2 shows the precipitous fall in velocity from 2020 onward.

Had it continued, it was likely going to cause output to collapse, but the government tried to rebalance the equation by creating money and increasing the monetary base.

Notice the sharp rise in the stock of money. Suddenly, the equation was balanced! But now all that money is in the economy, and the economy is starting to open back up, what do you think is going to happen to velocity? As consumers reengage with the market, velocity will increase again. Now the only variable that can move to make the economy re-equilibrate is price. And—what do you know—up it goes.

Someone might argue that the U.S. treasury “borrowed” that money into existence. They would be correct in a technical sense, but not in a practical one. During the great depression, the FED actually printed money and sent it with treasury officers out to banks to help both increase liquidity and stave off bank runs. Today, they do the same thing electronically. The U.S. treasury issues notes (IOUs), and the FED buys them by putting a bunch of money in the government coffers—just like printing money and putting it in a bank vault. This type of “borrowing” is not at all the same as when an individual buys a treasury note or U.S. Savings Bond, because this is newly created money the FED is putting into accounts, not recirculating money that already existed in the economy.

Our take is that inflation is here, it isn’t transitory. To bring inflation down quickly would require the government to pull money out of the economy as the velocity begins to rise. They can do this through increasing tax rates and paying back the FED, who then “destroys” the money, effectively eliminating the debit and credit sides of the ledger. This is the essence of MMT: Government wants to buy something, so they “create” the money and go buy what they want. Now inflation starts to go up, so they tax the money away from the citizens and “destroy” it. Even Greg Mankiw, who has an excellent overview of MMT HERE missed the most insidious part of this process. Government will effectively become the only buyer in the economy. They will have the ability to print and spend, but the citizens will have their money taken away through taxation—this is nothing more than socialism by a new name. If you thought supply chain issues were bad now, you better hang onto your hat.