Explaining Inflation

AI reveals the folly of the conventional wisdom

Someone (or something) signed me up for a newsletter called Explain It Daily. They send me one piece of email daily, each purporting to explain some concept, offering three levels of expertise:

• . . . like I’m 5 years old

• . . . like I’m in college

• . . . like I’m an expert

There is also an “explain it with Lego bricks” option, which I haven’t tried to parse. I almost never follow the link to the website. Most things I either understand well enough or I don’t feel any pressing need to explore at the moment. But I did click on What causes inflation?, because that seems to be one of the more common political misunderstandings of the time. Inflation was arguably the biggest political issue of the 2024 election. Trump was remarkably successful at blaming Biden for inflation, and even more credulously promising to “fix it.” But what is it? And how can it be fixed? Who is responsible? Who is hurt by inflation? And, for that matter, who benefits?

I’ve always assumed that Explain It Daily is some kind of AI demo. I’m not interested here in making any points about AI, except to point out that since AI is trained against conventional wisdom, it reflects it right or wrong. One thing AI may be handy for is for certifying arguments as conventional. Otherwise, formulating strawmen just to knock them down might seem like trick rhetoric.

Inflation is interesting here because what most people think they know about it is mistaken or at least misleading, and that’s mostly a function of politics. That is to say, when people complain about inflation, more often than not they’re trying to advance a policy agenda that is distinctly political.

But before we get into that, I want to start by offering my own relatively narrow definition of inflation. I suppose I should first offer the disclaimer that I’m not an economist, and have no formal training in economics. (I signed up for a 101 class, but dropped it after deciding it was too early in the morning. Since then I’ve read over 50 books on the subject, so I know a few things — like how little agreement there is in the field, and how political those disagreements are — but I’ve probably missed a lot of jargon that real economists spout, and with it a few fine points, as well as a lot of math.)

Most people think inflation is a measure of prices, but it has the peculiar effect of reducing millions of independent decisions by sellers to a single abstract number. That sort of math is usually hard for most people to grasp — think, for instance, of how much trouble people have comprehending a 2°F rise in climate when when we actually feel daily temperature swings of 20-40°F — but when we see price rises across the board, inflation offers us a unifying concept.

The problem is that there are lot of different reasons why prices may rise — unlike climate, which is mostly a matter of solar heat being trapped by increasingly concentrated greenhouse gasses — but grouping everything under inflation suggests a unified problem subject to a simple solution: monetary policy. This wasn’t an arbitrary choice: increasing the money supply can cause prices to rise — as famously happened when Spain stole loads of gold in the 16th century, or with the notorious printing presses of Weimar Germany and Zimbabwe. Markets-loving economists are particularly fond of this explanation, as it fits microeconomic pricing theory (where prices frictionlessly reflect the balance of demand and supply). Milton Friedman’s solution for all macroeconomics problems was to fine-tune the money supply, assuming free markets will optimize everything else (without really saying optimize for whom).

While I agree with Friedman about little else, I like his notion that inflation is really just a function of increasing the money supply. Two reasons: one is that changes to the money supply do have a broad effect on prices; the other is that Fed policy and government borrowing can be used to manage this factor. But real world markets are very different from the ideals. In particular, they assume rational actors, sufficient competition, and perfect information: conditions that are humanly impossible, but worse still, business education is almost totally dedicated to market rigging.

But while massive expansion of the money supply can move prices, it is less clear how much effect small amounts of deficit spending and/or low interest rates actually have on prices. What is obvious is that they reduce unemployment, which can lead to wage increases, which can be passed on as higher prices (if the market can afford them, otherwise they could eat into profits). If you’re so inclined (as people in business often are), you could trace the inflationary spiral of the 1970s back to deficit spending on the Vietnam War (one factor of which, by the way, was the Kennedy tax cuts on the rich). You could also blame Biden’s stimulus and infrastructure bills for the recent inflation. I don’t know that either charge is true, but I do know that pricing decisions are more varied and more complicated than the monetary supply.

One major factor is fluctuations in supply and demand. During the pandemic, demand for some products suddenly shot up (tempting sellers to raise prices), while demand for others dropped (possibly lowering prices, but more often curtailing production, putting people out of work, which further reduced demand). Another example is how wars against Ukraine and Iran took a lot of oil off the market, pushing prices up.

Another major factor is concentration and monopoly rents, which give some companies power to limit production and to maximize prices, especially on items (like health care and education) where demand is close to steady regardless of price. We’ve seen the share of the economy that goes to owners as profits (and especially as rents) increase steadily at least since 1980, as inequality has increased massively. This has had many effects, including that large companies have weeded out smaller ones, while workers and customers have seen their own market power systematically reduced and degraded. I believe this is the major force behind recent rising consumer prices. (It also has led to inflated asset values, which derive from two sources: expectations of higher profits given corporate leverage potential, and the simple effect of rich people having more money than they can productively invest, so they’re bidding up the value of existing exploitation opportunities.)

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With this in mind, I’m going to quote the three paragraphs of the “like I’m 5 years old” explanation:

Inflation is the increase in prices over time, which means that the money you have today buys less tomorrow. When inflation occurs, the value of money decreases, and you may find yourself needing more dollars to buy the same goods or services.

By mapping “inflation” to “increase in prices,” they’re compounding and confusing the issue. They’re taking a tangible problem which affects most people dearly — having to pay more of their hard-earned money for essential goods and services, or less obviously getting shoddier bargains — and blaming it on an obscure quirk of economics, and not on the companies that are actually overcharging or short-changing them.

Moreover, by diagnosing the problem as “inflation,” they can safely ignore direct fixes like price/rent controls as well as less obvious ones like increasing competition, decreasing monopoly rents, and/or better regulation (which corrects or prevents a long list of ills, like shoddy work, hidden costs, and outright fraud). Instead, the only remedies we’re offered are austerity (less government spending, especially on the poor) and higher interest rates (which is meant to slow down demand, especially by laying off workers, but perversely adds to costs, especially for those who have variable-rate debts and/or who depend on loans to float business expenses).

The explanation continues:

There are a few simple reasons why inflation happens. One reason is that when people have more money, they tend to spend more. If everyone starts buying more things, stores can’t keep up with the demand, so they raise prices. Another reason is when the cost of producing goods goes up, like when materials or wages increase; businesses will often pass on these costs to consumers through higher prices.

These are fundamental maxims of economics, but the order gives the game away. Prices are negotiated between sellers and buyers, but this only considers the case of demand exceeding supply, and makes a point of attributing this to consumers having more money than the market can absorb. This is, well, weird. How did we get all this money to burn? And do stores really have so little product they have to ration to the highest bidder?

This sort of thing might happen on rare occasions, like during the early days of the pandemic, when panic buying of things like toilet paper emptied store shelves, allowing retailers to raise prices. And then the government tried to stimulate demand by giving people checks, which led to some extra spending (but also to savings, and for many people the money was already committed). You can grasp the logic here, but in the real world it’s rare to not be able to find things to buy. It’s also rare to have more money than you know what to do with. That’s largely because the way the world works is that sellers are constantly monitoring demand and liquidity (including credit) and adjusting prices to get as much as they can, limited mostly by the risk that price gouging will piss customers off and send them elsewhere (if indeed there is an elsewhere, which rich companies work hard to stave off).

As for rising costs: it’s generally true that when costs increase, the lowest price you can charge and still make a profit also increases, but that’s a floor that companies work hard to stay well above, making it possible to absorb extra costs. While you could go broke, nothing says you have to increase your prices to reflect changes in costs — just as nothing says you have to reduce your prices when you find a way to pinch some pennies. With added costs, businesses like to raise their prices, because they like to make more money. Whether they do so depends on what the market will bear. The phrase “pass on these costs” is just what they want you to hear, because it’s less likely to piss you off then “tightening the screws” or “windfall profits.”

Both sentences in this paragraph are designed to make you feel that higher prices are due to external forces, and not to the everyday greed of businesses. Explain It Daily continues with one more paragraph:

Think of inflation like a balloon. When you blow air into a balloon, it expands. If too much air (or money) is added, the balloon can pop. Similarly, when too much money chases too few goods, prices rise, and the value of money shrinks.

Don’t think like that. Sure, you may have heard economists talk about balloons, but they’re not talking about price inflation, or even inflating the money supply. They’re talking about overvalued assets. When people suddenly have too much money, they may bid up the price of some things, but nothing ever pops. The extra money gets sucked up by businesses, and their customers return to being poor. Businesses may invest some of that money in more production, but only if they expect the market to continue to grow.

More likely, they will save the money, investing it in assets they expect to increase or at least retain value. They may bid up the value of assets — a classic case of too much money chasing too few opportunities, but many economists will tell you that inflation doesn’t apply to assets (which are by some strange magic always deemed to be worth exactly whatever you paid for them). Of course, this is false. Assets can lose value, especially if the value was only a hallucination of a buyer with too much money (assuming, perhaps, that there will always be a bigger sucker down the road).

This is where economists can talk about bubbles, but (given their blind faith in the truth of markets) they rarely recognize them until after they pop and deflate. And that almost always happens not because the asset loses value but because the overvalued asset was bought with debt that can no longer be serviced (let alone be paid off). If you have a sure-fire investment, you can make a little money off it with your own money, but if you really think it’s sure-fire, you can make a lot more money if you borrow other people’s money to invest. This is called leverage, and it’s good way to get rich, as well as a fast way to go broke. Bubbles burst when over-leveraged people go broke. And that can undermine credit markets, up to and including the entire house of cards known as the financial system. (This, by the way, is why the standard solution isn’t to police asset prices, but to keep banks from over-extending leverage.)

Explain It Daily also has more sophisticated explanations — one for college level, another for economics experts — but they make the same mistakes, albeit with fancier jargon. The expert version does add a couple tidbits worth mentioning:

Additionally, the Phillips Curve illustrates the inverse relationship between inflation and unemployment, suggesting that low unemployment can lead to wage inflation, further fueling price increases.

In five-year-old terms, this is saying that higher wages cause inflation, so workers can never improve their lot. It also says that the way to fight inflation is to lay off workers. This is the point of the Fed raising interest rates. In even fancier terms, this theory is called NAIRU (non-accelerating inflation rate of unemployment), which is a big part of why economics has been called “the dismal science.” This was the thinking in 1979 when Volcker decided to break the economy. It’s also a big part of the logic why Powell raised interest rates after the pandemic price spikes (and why economists like Larry Summers wanted him to inflict even more pain on the economy). Most people in a position to do something about the economy accept this trade off without giving any deeper thought to the issues involved. Like why does inflation matter? (It’s too complicated to go into here, but yes it matters, but not more than everything else — which is the position a lot of suspiciously rich people would like you to believe. I will point out that a small amount of inflation is necessary for lubrication, which is the Fed sets inflation targets at 2% instead of 0%.)

And why should workers be the ones who pay the heaviest price for keeping inflation low? As Lewis Lapham often said, “money is good for the rich and bad for the poor.” Fed policy from Volcker through Greenspan and Bernanke to Powell has consistently done one thing: make the rich richer, while stagnating wages. Many economists were surprised when the Reagan and Clinton economies expanded robustly with little or no inflation, but what they failed to note (or maybe just didn’t care about) was that all of the increasing wealth accrued to the wealthy. Aside from the very few super-rich (who turn out mostly to be assholes), the nation as a whole is more divided, less secure, more precarious, more dishonest, more corrupt, and a lot more brittle than it was 40-50 years ago.

A lot of political choices have gone into that, but the focus on limiting inflation is central and crucial, and rarely reflected upon. One last tidbit:

The complexities of inflation are further compounded by expectations; the adaptive expectations theory implies that if individuals anticipate inflation, they may adjust their behavior, leading to wage-price spirals. Central banks play a critical role in managing inflation expectations through monetary policy, targeting inflation rates to stabilize the economy.

It is, of course, telling that they always put “wage” up front in “wage-price spirals,” as if businesses are only trying to keep up with exorbitant wage demands from a way-too-tight labor market. Even in the 1970s, when some unions still had enough power to insist on COLAs (cost-of-living adjustments), workers were almost never able to get out front of prices. The oil price shocks kicked things off here — especially after 1969, when US oil production peaked, after which the the US became a net importer of foreign oil, and started running trade deficits. Even before the shocks, Nixon scrapped the Bretton-Woods system, took the US off the last vestiges of the gold standard, and temporarily imposed wage-and-price controls (hated by everyone, but again, note that “wage” is listed first). Trade deficits were recycled through the now-globalized financial system, allowing foreigners to buy up American properties and companies at a premium, while Americans invested their profits abroad. Businesses got even greedier, more ambitious politically (aided by both parties, but more carelessly and compulsively by Republicans), and ever more systematic in their exploitation of both customers and workers. In tech, Cory Doctorow calls this enshittification, but it’s increasingly prevalent in all corners of the global economy.

But note that controlling inflation did little to “stabilize” the economy. All it really did was to tilt the playing field in favor of the rich. One odd thing was that they were able to do this by getting nearly everyone on board with the anti-inflation agenda. (Carter nominated Volcker, and Clinton even bought into the whole balanced budget nonsense. Obama too, as he brought Volcker back as a key member of his economic team, discarding his promise of change to sacrifice his administration at the altar of Wall Street.)

It wasn’t always like that. Back in the 1890s, Republicans and Democrats were sharply divided on inflation, with William Jennings Bryan decrying “the cross of gold” and looking to inflate the money supply with silver. (Debtors, including nearly everyone in America who owned a farm, were looking to pay back their debts with cheaper money, and bankers, same as today, insisted on the hardest currency possible.) Inflation isn’t an absolute bad or good thing. It always has winners and losers, and as such has political advocates for and against. But for many decades now, nobody explicitly argues for inflation: the best you can do is to argue for the Fed shifting slightly in favor of more employment at the expense of a bit more inflation.

The best prospect at present is to bury the word “inflation,” and focus on “affordability” instead. That word actually has to do with real world prices and wages, and taxes and benefits, without invoking the voodoo of macroeconomics. That’s a word that gives us full rein to consider policies that can both reduce costs and increase incomes for the overwhelming majority of people (which is what a democracy should concern itself with), both using market forces and regulation, including tax policy. It demands that we identify actual villains. (Doctorow’s book fingers dozens, and explains how to identify hundreds or thousands more.) It shouldn’t be hard to come up with policies that work, especially to reduce the profit extraction levels that are currently stifling the economy and endangering democracy. Bucking the oligarchy to get them implemented is a taller order, but once you see what’s going on, it quickly becomes clear what to do.

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PS: I expect to write about this some more in my next blog post (probably under Music Week, which in addition to dozens of album reviews is a good place for my weekly everyday life update).