Inflation Matters

Key idea 1

Inflation is a rise in prices usually triggered by an expansion of the money supply.

We’ve just defined inflation. To summarize: it’s a continual rise in the prices of goods or services, or an ongoing decrease in the purchasing power of money.

How can we visualize this? Many introductory economics textbooks would explain it using an example similar to the following.

Imagine there are five bakers and five brewers, each selling a loaf of bread and a pint of beer daily. Both items cost one gold coin each. Initially, there are ten gold coins in total. One day, another ten gold coins are discovered and evenly distributed among the ten individuals. Despite the unchanged number of bread loaves and beer pints (five each), the discovery of additional money prompts people to perceive they have more wealth. Consequently, they begin competing by offering higher bids to secure additional bread and beer. This heightened demand causes the prices of both bread and beer to rise. Now, each loaf costs two gold coins, as does each pint, instead of the original one gold coin.

In reality, inflation progresses more gradually and through a more intricate process than the simplified example. However, as illustrated, inflation is closely linked to the money supply, which refers to the total amount of money circulating within an economy. When the money supply increases, prices tend to rise as individuals compete by offering higher bids to purchase a limited quantity of goods.

In the bread and beer example, the increase in the money supply occurred when a stash of gold coins was discovered. In reality, increases in the money supply are generally caused by two primary factors: central banks printing new currency and private banks issuing loans to individuals or businesses.

An extreme and well-known example of the first scenario occurred during the Weimar Republic in Germany in the early 1920s. Following World War I, Germany’s government faced extensive debt. To address this, it opted to print a substantial amount of money. This approach was effective in quickly repaying the debt. However, this strategy led to hyperinflation, an extreme form of inflation. By 1923, prices had skyrocketed, with an astonishing increase of 29,500 percent. This rapid devaluation of currency wiped out a significant portion of the population’s material wealth almost overnight.

Fortunately, hyperinflation is rare. More commonly, increases in the money supply occur when private banks issue loans, as banks lend out money that they do not physically possess.

What’s crucial to remember is that the size of the money supply influences inflation, but there’s an additional complexity: this relationship is more pronounced in the medium term. In the short and long terms, the connection between the money supply and inflation is relatively weak. Let’s delve into this in more detail.

Key idea 2

Inflation generally follows a cyclical pattern, where prices increase, stabilize for a period, and then rise again.

So, while changes in the money supply influence inflation in the medium term, other factors affect inflation in the short and long term. What are these factors?

In the short term, the money supply is less significant because its effects on prices aren’t immediate. Initially, increases in the money supply often lead people to save, delaying their spending. Moreover, most new money comes from bank loans, which are typically invested in assets like real estate rather than being spent on goods and services directly.

Rather than the money supply, other factors drive short-term inflation. Economist John Maynard Keynes identified these in the early twentieth century, suggesting that inflation can occur when demand exceeds supply. He also noted that inflation can be ingrained in an economic system through regular wage increases. Many believe their annual salary hikes are due to their performance, but these increases are often a response to inflation.

In the long term, inflation is primarily influenced by population growth. This is straightforward: as the population increases, more people compete for limited resources, driving prices up. Between 1950 and 2013, the global population grew from 2.5 billion to 7.2 billion, a period that also experienced the most significant rise in prices ever recorded. This correlation is likely not coincidental.

According to the author’s Inflationary Wave Theory, inflation follows a distinct wave-like pattern over time. It gradually increases over approximately a century, followed by a turbulent period with wild price fluctuations. This is succeeded by a phase of equilibrium where prices stay relatively stable. Eventually, a new wave of inflation starts, repeating the cycle. Each subsequent price rise is exponential, though the duration and intensity of these waves vary.

In 1996, historian David Hackett Fischer proposed a similar theory. He suggested that after a period of price stability, a new inflationary wave is often triggered. Fischer argued that during stable times, people tend to view life more positively, leading to higher birth rates. Eventually, this population growth puts additional pressure on resources, resulting in a gradual but persistent increase in prices.

Given how inflation occurs at predictable intervals, does this imply that individuals can take advantage of these cycles for their own benefit? Absolutely.

Key idea 3

Governments and other borrowers derive advantages from inflation, while savers experience its negative effects.

Firstly, let’s address this point upfront: inflation isn’t entirely negative. However, it also isn’t entirely positive.

Let’s begin with the positives. Initially, inflation can stimulate the economy. Firstly, rising prices encourage people to spend money instead of saving it, as they understand that the value of money held in checking and savings accounts will gradually decrease. Similarly, individuals who own assets such as real estate and stocks benefit from inflation by realizing gains, which they subsequently spend on goods and services. All of these factors contribute to economic growth.

However, the primary beneficiary of inflation is the government. There are numerous advantages for the government, such as inflation making the country’s GDP appear larger. This enhances the country’s reputation on the global stage. While GDP is adjusted to account for inflation, there are methods of calculation that can present more favorable outcomes — and it’s easy to speculate which methods the government favors.

The most significant advantage of inflation for the government, though, is debt relief. We previously touched on this when discussing the hyperinflation in the Weimar Republic of Germany. Inflation lowers the actual burden of government debts.

That’s why governments establish targets to maintain inflation at specific levels. Their aim isn’t to eliminate inflation entirely but to keep it below a predetermined threshold. Consequently, this target is often dubbed the “inflation tax” because tax revenues increase alongside inflation. In the UK, the inflation tax generates approximately 30 billion pounds annually. What’s more advantageous for governments is that this type of taxation is essentially invisible, thereby avoiding the public backlash that would accompany more visible forms of taxation.

And who bears the brunt of this tax? That would be the average person. Despite the advantages inflation offers to the government and others benefiting from debt relief, it adversely affects average individuals—especially those who save in cash. Inflation gradually erodes the value of their savings, silently diminishing their purchasing power over time.

Currently, anyone who keeps cash in their wallets, checking accounts, or instant savings accounts is losing purchasing power at the same rate as inflation. In the UK, this means they’re losing about £2.50 for every £100 they hold in cash. However, most people aren’t fully aware of how much inflation diminishes the value of their savings.

At this juncture, you might be feeling some concern and wondering: Will inflation keep rising in the future? The answer is somewhat complex, and we’ll delve into it next.

Key idea 4

Experiencing a continual, exponential rise in inflation isn’t necessarily inevitable.

In the future, inflation is expected to start decreasing due to a shift in one of the factors that promote inflation, as mentioned earlier. Can you guess which one it might be? It’s related to demographic changes, specifically the global aging population.

Currently, the global population continues to grow, with significant growth occurring mainly in Africa and Southeast Asia—regions that consume fewer resources and therefore have less impact on inflation compared to high-consumption countries. In countries like Japan, Russia, and Germany, birth rates are below replacement levels. According to forecasts from Deutsche Bank, the world population will reach its peak around 2050 and then start to decline.

Further research indicates that throughout a person’s lifetime, consumption typically rises until approximately age 46, after which it declines. Consequently, as the global population ages, demand will start to decrease, exerting downward pressure on prices. This pattern is evident in Japan, where both prices and GDP growth have stalled to some extent due to demographic shifts. Japan currently boasts the world’s highest average age, reaching 46 in 2012, precisely when individuals begin to consume fewer resources.

The aging population and anticipated decline in population are expected to considerably reduce inflation in the decades following 2050. Furthermore, another significant banking crisis, if it were to happen, might compel governments to reform the banking system rather than relying on inflation to address debt-related issues.

A potential solution might be found in blockchain technology, which underpins digital currencies such as Bitcoin. The blockchain operates as a transparent and public ledger of all transactions. Currencies on the blockchain are governed by predetermined algorithms, reducing susceptibility to misuse by individuals or governments. Looking ahead, blockchain could potentially support a new global monetary system that mitigates inflation.

Certainly, this scenario has yet to materialize. Therefore, is there anything you, as an ordinary citizen, can do to protect yourself against inflation?

Key idea 5

Understanding the pattern of inflation can assist you in planning for the future.

Contrary to what most economists might claim, accurately predicting the financial future is not feasible. Even the most skilled experts in the field have a success rate no better than chance! This serves as a disclaimer to emphasize that for thorough financial advice, it’s best to consult with a professional.

However, having a fundamental understanding of inflation cycles can assist you in managing your investments. Specifically, it’s wise to be ready to adjust your asset allocations as needed.

We are now more than 120 years into the current period of inflationary growth. This suggests that we might be approaching the end of this wave of price increases. However, it’s prudent to expect inflation to persist as long as it serves the interests of central bankers and the government. Therefore, even after this inflationary wave reaches its peak, it’s more probable that we’ll experience “lowflation” in the near term rather than outright deflation — in essence, a slowdown in inflation rather than a decrease in prices.

In a lowflation environment, interest rates will be minimal, accompanied by occasional money creation and economic stimuli from central banks. These low rates will promote borrowing, gradually stabilizing real wages. Stock values are expected to rise due to central banks’ monetary expansions supporting higher asset prices. Furthermore, low interest rates will sustain property and land values. However, individuals saving in cash will continue to experience erosion of their savings due to inflation.

If a significant event such as a major bond crisis were to occur, leading to widespread debt restructuring and the collapse of banks, the situation would change dramatically. Savings held in banks could be at risk of loss, and housing prices would likely decline. Stock market values would probably also drop sharply. Assets like gold and digital currencies would likely increase in value, as they are typically viewed as safe havens during times of uncertainty. This could potentially mark a pivotal moment for digital currencies to establish a more prominent role in the global economy, particularly if a banking crisis were to trigger the end of the current inflationary cycle.

Following the turbulent transition phase, a period of stability and consolidation would ensue, characterized by less volatility and more consistent pricing over time. During this phase, stock prices would recover, although their long-term growth would be less pronounced without the support of inflation. Borrowing would also become more cautious, as companies would no longer benefit from inflation gradually reducing the real value of their debts over time. Demographic changes would lead to lower consumer demand for products and services, resulting in generally lower investment returns becoming the norm.

Currently, inflation allows individuals to generate money through borrowing without any real effort. In a non-inflationary world, those seeking more money would need to earn it through work or invest their capital in actual business ventures, which involve risk. In such a scenario, the overall environment would likely be fairer, as it would eliminate the unseen mechanism of inflation that transfers wealth from savers to debtors and borrowers—predominantly benefiting powerful entities like central governments.

Final Overview

The key takeaway is:

Inflation generally stems from an increase in the money supply, leading to higher prices and reduced purchasing power of money. Governments and other debtors favor keeping inflation above zero since it helps lower the real cost of debts. However, this erodes the wealth of savers over time. To protect against inflation, being ready to adjust your asset allocations can be a wise strategy.