March 2023. Today, after a year of Federal Reserve interest rate increases without any substantial affect on inflation, economic commentators are looking for explanations. The popular answer is the delay of inflation slowing is caused by an economic event called a response lag.
Investopedia.com defines a response lag, or an impact lag, as “the time it takes for monetary and fiscal policies, designed to smooth out the economic cycle or respond to an adverse economic event, to affect the economy after implementation.” The next question is what causes a response lag. Investopedia answers, “any monetary fiscal policy, once implemented must then work through a series of transactions that occur between market participants.” For inflation, the two global participants are the business community, the private sector, and the government sector, the public sector. The private sector seller sets a higher price and then completes a transaction at that new price level. The government sector records the transaction and makes note of the price raise in period price journals.
Please note, the mere fact that the price increases occur in the private sector does not imply that the private sector is the cause of inflation. In fact, the cause of the price increase is indeterminant at this point. The government sector could be stimulating the private sector to raise prices. The other possibility is the private sector is raising prices. Inflation is a general rise in prices so every business must participate. This scenario requires cross-industry coordination. This raises numerous issues. First, it requires coordination among thousands of companies. That is highly illegal and heavily controlled with anti-trust legislation. From a practical standpoint, the government sector is the only sector with a broad enough reach to cause a general price increase. To quote Milton Friedman, “businessmen do not cause inflation and inflation is a monetary phenomenon.” The monetary system is managed solely by the government. The government is the source of inflation. To believe otherwise, is naive-thinking.
March 2023. The Federal Reserve is expected to continue bashing the business sector with interest rate increases in an effort to wound the economy and force lower prices in the private sector. This technique flies in the face of what the most prominent American economist of the twentieth century counseled. Milton Friedman wrote and spoke numerous times stating that the cause of inflation is excessive government spending. He further said, “In the modern world, inflation is a printing press phenomenon.” Trying to get the private sector to lower prices is the wrong approach. Milton Friedman further stated, “businessmen do not cause inflation. The rise in the prices they charge is a result or reflection of other forces.” Those “other forces” are deficit-spending by government officials who expand the monetary base by printing unearned money.
How does inflation occur? As Milton Friedman stated it is caused by a large government spending bill or a large printing of government securities beyond generally accepted standards. What inflation is not. It is not a private sector price increase. As Rand pointed out earlier, private sector companies do not have the market influence to induce a large general price increase in the economy. We have gobs of evidence of private sector price raises that did not lead to inflation. When energy prices crashed in 2002, the price of milk, bread, bananas, and electricity remained stable. When the price of gas and milk rose in 2008, the price of bread, bananas and electricity stabilized. When gas prices rose in 2012, the price of milk, bread, bananas and electricity were nearly flat. The recent rise in the price of gas in 2021 and 2022 is blamed on high spending by the Democrats in Washington DC, and that seems to born-out by the way other commodities reacted. The Federal Reserve does not have the tools to reduce or hamper government spending, but they have a pulpit that they can use to correct misrepresentations. The Federal Reserve is a government agency and they use their power to deflect blame from the politicians in Washington DC responsible for inflation. They use their pulpit to create and sustain a false narrative that inflation is caused by private sector business. Many governments use their financial officials to slander private industry.
Inflation is always a phenomenon of excessive public spending or money printing. Why is that? Public actions affect everyone. People feel empowered to over-spend since the government is doing it. A similar phenomenon is occurring in the United States. Prosecutors are not trying to reduce criminal activities by legal punishment, so criminals are more active. Humans are far less complicated than the economic world, but both act in predictable ways.
David Rubinstein asked Federal Reserve Chairman Jerome Powell, why the Fed was so insistent on seeking a return to a 2% inflation rate? Powell said, “Because that is the generally accepted rate, here and internationally.” Generally accepted standards play a key role in economics. Jerome Powell is stating 2% inflation is the accepted standard for countries developed over hundreds of years, and if we are smart, we should not deviate from that standard. These types of standards are the foundation of the economic systems that determine the outcomes of a given economy.
If 2% inflation is the standard then the cause of inflation needs to be adjusted not to produce more than 2%. Fortunately, the brilliant American economist, Milton Friedman explained that inflation is from public sector spending. So it is simply a matter of finding a period when inflation was 2% and dividing public sector spending by GDP. This result is the maximum allowable amount of public spending tolerated to stay under a 2% inflation rate.
October 2022: The Federal Reserve Bank officials of the United States have spent a year increasing interest rates without any discernible effect on inflation although that was their goal. Why didn’t the Feds actions work? They were attacking the wrong target. Interest increases are primarily targeted at private business. The effect on the public sector initially is very small. The efforts of the Federal Reserve are aimed at the private sector, but the cause of inflation is spending by the public sector. The public sector in the United States under President Biden committed to $73 trillion of spending on government activities over the next ten years. This money has to be repaid by the private sector. Consequently, prices must increase to counter this spending. If government sows a field of debt, the farmers have no choice but to fertilize. Fertilizer is expensive.
Inflation is a general increase in prices. To get a general increase in prices the motivating activity must be a government action. Even a significant increase in prices by a petroleum company is not sufficient to cause a general increase in prices. All companies in the private sector are subject to competition. Competition prevents any individual company from starting an inflationary spiral unless all companies see a government action justifying the price increase.
Why can extravagant government spending activities generate an inflationary spiral? Government spending unlike business spending does not generate a profit. This makes the two types of spending different. Private business spending increases the wealth in a society. An expenditure to purchase prom dresses will increase the amount of money a shop owner has in her till after the dresses sell. An expenditure by a government on a tank will only drain the government’s monetary reserves.
In summary, a modest expenditure by government can be absorbed by a vigorous private sector and have only modest inflationary impacts. This is why small government is best, and large governments like those in China and Russia are doomed to fail.
September 2022: There is an obligation to question the strategy used by the banking agencies around the world, especially when the approach of two allies, the Bank of Japan and the Federal Reserve of the United States differ. The basic question is whether raising interest rates is the optimal method to tame inflation. It is a counter-intuitive approach, since we know raising interest rates increases the cost of goods and the result we are after is lowering the cost of goods and services. Making the approach even more indirect is the knowledge that the financial community defines inflation as a general increase in the price of goods and services in an economy. Just to be clear, central bankers suggest making products cost more and then, assures us that this action will cause the market to deteriorate and force prices to fall.
What is the proof this approach will work? Economists and central bankers defend this approach based on the experience of the Great Depression. Unfortunately, the Great Depression did not begin with an inflationary spiral. It began with a government action to control prices, now known as the Smoot-Hawley Tariff passed in 1930 putting tariffs on more than 20,000 imported goods. This incident may not be a good comparable, but the inflationary period in Europe especially in the Weimar Republic between the World Wars surely is. This is a situation where an infant government printed money to pay for rebuilding after a war and paying a robust bureaucracy. That sounds like what the United States did after the Covid Pandemic. Printing money without earning led to inflation in 1921 and again in 2021. Interest rates played no role in the 1921 scenario. What does play a role is spending without earning.
Based on history the best way to fight inflation is to reduce government spending. And I would add, especially when adding employees in the bureaucracy to win a second term.
August 2022: The statements of President Joe Biden of the United States reflect the economic origins of his party in the 1930s during the Great Depression. There is not a cabal of profiteering by corporations making inflation more egregious in 2022. Most price increases are set by international trading exchanges. Food price increases are not set by farmers, but largely by huge commodity trading houses that owe their power and influence to government mandates. Government’s insatiable desire to control every aspect of living reduces competition and makes winners of large organizations and losers of individual operators. This is the exact opposite of what New Market Economics suggests is the right path.
New Market Economics wants to maximize participation and increase diversity of participants. The greater the population of participants the more variety of product offerings and the greater the range of prices and opportunities.
June 2022: At the beginning of the second quarter in 2022. The Associated Press Wire Service reported on May 27, 2022, a dip in a key inflation gauge. The inflation figure the Commerce Department reported was below the four-decade high of 6% set in March (2022). This is an interesting development since it might indicate that inflation is a self-correcting financial factor. If so, some of the 5.2 billion dollars in Federal Reserve Bank operating expenses may be unnecessary.
May 1, 2022: Inflation is a percentage increase in the price of a product or service over a specific period of time. Inflation is caused by the producer of a product or service attempting to gain a fair return in a time of increasing input costs. It can be due to simple greed by the producer, but that is rare. The most common reason is government action that requires the expenditure of additional labor to produce the product such as mandated testing, or special and more expensive additives for environmental reasons. Another common cause is the enforcement of government restrictions on where and how a product can be manufactured resulting in increased costs for the producer.
If you just watched tv and got your news from the internet, you would think inflation was a government responsibility, like taxes or national security. But it is not. Actions that raise or lower inflation lie outside of government’s purview. In most of the world with only a few exceptions, like in North Korea or Cuba raising prices occurs in the business sector. This ability is central to the effective and unhindered functioning of the free market system. To allow government a role in setting or adjusting prices would upset the basic tenets of the free market system. The term “free” in free market system means free of government influence. Prices in the free market system are set by consumer demand and not by mandate from either a business concern or a concerned government regulator. To allow government to interfere with price setting would make prices subject to political forces and not market forces.
Is adjusting interest rates an effective strategy to control inflation? The simple answer is no, but the long answer is informative. Interest rate adjustments do not deter the people who set prices since the action is not targeted. It is an indirect strategy that works by damaging the entire economy. It is a shotgun blast at the entire economy that has many unintended victims. It is a lazy approach. A much better approach is to use regulatory actions, tax policy and accounting processes to ensure targeted financial change is achieved.
As an example how this should be done consider the following case. Suppose the grocery industry is trying to recover from a pandemic where government required grocery stores to close for three months. Upon reopening costs of labor have increased due to a government increase in the minimum wage. The store owner feels compelled to increase product prices to ensure his store has sufficient revenue to pay the higher wages. The government sees what is happening in the grocery industry and ponders whether to raise interest rates to tamp-down price increases, or try a new strategy of working with industry to reset the price equation. Government decides on trying to reset the price equation. Grocers show the impact of price increases on their bottom line and how the costs of government impact their bottom-line. The two entities agree on a strategy to manage the cost impact by adjusting their role in the cost increases. In this case the government reduces their requirements for replacing coal-fired furnaces in 12 months, reduces employee taxes, and closes roads to all but grocery delivery traffic between 3 am and 4 am. The grocer agrees to adjust all company wages to the mandated minimum immediately. The result of the combined changes is to bring the price-revenue structure back into equilibrium. This solution is achieved without increasing interest rates. A solution is found where the private sector and the government sector each share in the pain. The grocer is satisfied since his margins are not affected and the government sector is satisfied since the economy is not disrupted. The government may receive less in taxes, but the business reality requires a downward adjustment. Revenues will go up and down with market conditions. Government never objects when revenues increase, so they should tolerate an occasional downward movement.