Nothing elicits as much finger pointing and arm waving as the topic of inflation. No one wants to fess up to creating it. No one really wants to commit to fighting it.
Inflation silently swipes value from the unsuspecting. In, The Old Man and the Apple, we showed how the degradation in the value of a currency affects some items in an economy faster than others, handing people like Earnest Hemmingway a bargain when he bought apples in Germany in the 1920s while at the same time crushing the Germans who had their wealth stored in the wrong places.
In Consumer Squeeze, we showed how every inflation in history has sapped consumer purchasing power by increasing consumer expenses faster than consumer income.
As inflation has rippled through the U.S. economy this time, the intellectual elite initially claimed the price increases were transitory, then blamed the supply chain, then accused the energy companies, and now seem to lay blame for higher prices squarely at the feet of Vladimir Putin.
What is the true root cause of inflation?
The value of a currency, it turns out, is no different than the value of any economic good or service. If supply exceeds demand, the value of a currency declines. If demand exceeds supply, its value will increase.
If I pay you a dollar for a banana, you accept the dollar in exchange for the banana and I accept a banana in exchange for a dollar. You value a dollar more than a banana and I value a banana greater than a dollar. We describe the transaction in terms of a ratio: the price of the banana was $1 per banana. A price is the ratio of two values.
If several other people appeared and they all wanted your banana and you had just one banana, you would in all likelihood receive more for it. Demand increased and the supply stayed the same. The price of a banana increased because incremental demand bid up its price. The value of a banana increased. We call these denominator-driven price increases because the value of the denominator in the price ratio increased.
The price of a banana can also increase due to the value of the currency declining. If the value you place on a dollar declines, you might actually value the banana more than a dollar and refuse to accept a dollar in exchange for a banana. If the value I put on a dollar likewise declines, I might offer $1.50 in exchange for your banana. If we make an exchange at $1.50 per banana, the price of bananas just increased 50%. This had nothing to do with bananas. The value of the currency changed, which affected our preferences. We call price increases related to the currency numerator-driven price increases because they affect the numerator in the price ratio.
The problem with the two types of price increases – denominator-driven and numerator-driven – is they both look exactly the same. A price increase is a price increase. One type of price increase can be easily confused with the other.
The two types of price increases, however, convey completely different information on the economy. Denominator-driven price increases convey information on the supply and demand of the good or service in question. A higher price is a signal to entrepreneurs and capital allocators that incremental demand is outstripping incremental supply. A numerator-driven price increase conveys no such information. One of the great hidden costs of a numerator-driven price increase is entrepreneurs and capital allocators mistake them for denominator-driven price increases and allocate capital under the mistaken belief that higher prices are the result of higher demand. Some of the worst capital ever allocated has been the result of this head fake associated with numerator-driven price increases.
The key difference between a denominator-driven price increase and a numerator-driven price increase is the former affects the price of that one good or service while the latter affects the prices of all the goods and services denominated in that currency. Numerator-driven price increases are broad-based and pervasive.
A denominator-driven price increase cannot increase prices broadly across the entire economy. It isn’t possible. If the price of a banana increased due to a shortage of bananas and I still insisted on buying the banana at the new higher price, I would have less money to spend on other things. The incremental demand for other items would by definition decline; the prices for those other items would consequently decline. Taken across an entire economy, a spike in prices for one item due solely to supply and demand dynamics for that item must translate into price reductions elsewhere. That is just the way the math works.
Numerator-driven price increases, on the other hand, affect the prices of large swaths of products and services in the economy, not all at the same time, but certainly all in the same direction. Over time, as the value of a currency declines and its effects ripple through an economy, the prices of everything denominated in that currency adjust higher.
That was the U.S. in the 1970s. It is Argentina and Brazil today. Prices didn’t rise in those instances due to the supply and demand of goods and services. They rose because the value of the currency declined. The value of the currency declined in all cases because the supply of the currency exceeded the demand for the currency. When supply exceeds demand, the value of the currency falls, setting in motion a broad-based numerator-driven inflation in prices. That is what we are seeing in the U.S. again today.
The root cause of a numerator-driven price inflation is too much supply of the currency. The U.S. Federal Reserve controls the supply of U.S. Dollars; it controls the supply of dollars not just in the U.S. economy, but in the global economy. The Fed has been buying assets at scale since the beginning of the global financial crisis in 2008. When the Fed buys an asset, it pays for it with newly-created dollars, in most cases a mere electronic entry on the books of the seller. Every dollar the Fed spends on an asset is a dollar injected into the global economy. The Fed’s cumulative asset purchases from the day it was founded in 1913 through 2007, a span of nearly 100 years, was about $700 billion. In the 15 years since 2007, it has bought $8,000 billion worth of assets first to fight the global financial crisis, then to fight the European Euro crisis, and most recently to fight the economic effects of COVID 19. Each crisis brings a fresh round of purchases which injects a fresh rush of methamphetamines into the economy. A numerator-driven broad-based inflation is what you get. A numerator-driven broad-based inflation is what we have.
