How Inflation Works

This might be a long post, but in the context of the current election, and broader, I wanted to write up a primer on how inflation works. This is a hot topic at the moment, and one of the strongest talking points in politics, particularly within the right-leaning circles. It's also one of the least understood topics generally, and thus one of the easiest to inaccurately blame on people or actions for political purposes. Furthermore, actions related to inflation are the perhaps surprising cause of several pressing societal woes (eg: housing prices, wage stagnation, etc.), so it would be great if the general population better understood what was going on. So, hopefully, this will help.

What causes inflation

Milton Friedman (famous economist) once observed: "Inflation is always and everywhere a monetary phenomenon." This is, broadly, true: inflation happens when more money is competing for the same amount of goods and services, and thus the people with the goods ans services can (and usually do) demand more money for them. This does tell the whole story, but there is quite a bit of nuance which can also be ignored here, so let's unpack this a bit more.

First, in passing, I'll mention that "money" can be thought of as "stored value for work product". The explanation for why this mental model is accurate is outside the scope of this post, but this is probably the most accurate mental model. I mention this because when the government creates additional currency, they are implicitly stealing this stored value (as they did not create a corresponding work product), from everyone else who is currently holding that currency as stored value. This is important to keep in mind: government monetary creation is effectively stealing work product from people. There are reasons why the government does this, of course, but that's an underlying fact.

Next, it turns out it's hard to measure the amount of "money" which is competing for goods and services, because not all money is hard currency. The Fed has three main measures, which they call the M1 (https://fred.stlouisfed.org/series/M1SL), M2 (https://fred.stlouisfed.org/series/M2SL), and M3 (https://fred.stlouisfed.org/series/MABMM301USM189S). Broadly, the M1 is the supply of "hard" currency, the M2 is the total amount of money in depository accounts, and the M3 is the total amount of "money like" currency active in circulation. Because of fractional reserve banking and borrowing, the M3 is generally the most accurate accounting of how much money is potentially competing for goods and services, but is also the most nebulous to track, because borrowing fluctuates quite a bit.

For an example of this, consider if everyone in the US took out an 80% mortgage in their home. The total amount of value in US homes is roughly $50,000,000M (https://www.investopedia.com/us-homes-got-a-usd2-trillion-value-boost-in-2023-8603202). Those mortgages would create ~$40T in additional money, in the M3 sense. That would roughly triple the current estimated M3, with no other change in the economy, and since the M3 represents the most accurate measure of the amount of money (for purposes of costs of goods and services), could have a profound and overnight affect on inflation. This is one reason inflation can fluctuate quite a bit outside of just when the government "prints" money.

Note: I'm glossing over a lot of detail above: the M3 is more like "velocity of money in the economy", but this is even more nebulous. Generally it is intended to be the most accurate measurement of effective money in circulation at any given time.

The other side of the nuance is money "competing" for goods and services. When people are saving money, and/or are cautious with borrowed money, that money isn't competing for purchasing goods and services. During these times, for example, the government could create trillions of additional currently, and not affect inflation immediately at all, since that money would just be squirreled away. This is what happened during Covid, for example: the government created a massive amount of money, but no immediate inflationary effects, since people were very cautious with spending at that time.

Over longer periods of time, the M2/M3 trend to an average equilibrium as a multiple of the amount of hard currency in circulation. If/when this is skewed, you can think of the economy as having "deferred inflation"; that is, inflation which has already been created, but has not affected prices yet. This is what happens when the government creates money during periods of economic uncertainty: they are creating future inflation, but it does not manifest immediately.

Aside: Fed rates and inflation

One question which might arise here: how does the Fed try to control the inflation rate via their lending rate? This has to do with the M2/M3. While the Fed cannot control the monetary supply (the M1, which is controlled by Congress and national borrowing/spending), the Fed influences the M2 and M3 via the Fed rate, which essentially controls the rate of interest for borrowing against deposits. By raising the rate, the Fed can discourage borrowing, and thus reduce the M3, which reduces the immediate effects of inflation. Conversely, the Fed can lower the rate, which creates more immediate inflation, but also stimulates the economy (because easier access to money allows more risk taking for businesses). Neither of these really affect long-term inflation (remember: inflation trends toward equilibrium based on the amount of money the government prints), but can affect short-term inflationary effects.

Aside: Deferred inflation and politics

One of the things which makes inflation a tricky (and juicy) political talking point is how far removed the effects are from the causes, which makes it easy for political messaging to take advantage of under-educated people, and blame inflation on people and factors that essentially have no effect on it. For example, the President has virtually no effect on inflation, except in the sense of suggesting spending for a national budget. Moreover, inflation from spending under one administration is very likely to be felt under the next administration, generally. Hopefully if you're reading this, you will soon not be one of the ignorant masses whom these disingenuous political smears work on.

Why does the CPI seem "wrong"?

If you have observed that the CPI, which the government touts as the official measurement of inflation, seems wrong/low, congratulations, you have taken the first step toward becoming less ignorant. The CPI as originally construed, was a reasonably accurate measurement of inflation, and was so for a good while.

A funny thing happened in the 80's, though: many government benefits programs were tied to the CPI for annual increases, including Social Security. The government knew that SS (as the pyramid scheme that is it) would eventually collapse the economy, but reducing benefits was political suicide, because older people were the strongest voting bloc. So Bill Clinton (or his advisors) hit on a plan: they would LIE in the CPI, and understate inflation on purpose, which would reduce Social Security payments over time automatically without needing to tell the public about it. Thus, they affected what is probably the single most damaging public policy change in the history of the United States, by purposefully disconnecting the CPI from actual inflation.

The mechanics for the changes are somewhat immaterial to this discussion; if interested, you can read up on Hedonic Regression and/or Product Substitution, and become educated on the depth of the open conspiracy. Suffice it to say, since the mid 1980's, the CPI intentionally understates the actual inflation rate by approximated 4% annually. Interestingly, the raw data is still available from the BLS, so you can get/track actual inflation if you know where to look. See https://www.shadowstats.com/alternate_data/inflation-charts, for example.

Why is this terrible (housing price edition)?

Housing prices, as a tangible good with upkeep costs which are proportional to actual inflation, will rise with actual inflation (regardless of the government's lies). If you track housing prices since the 80's compared to actual inflation, they are surprisingly pretty close; maybe 20% over inflation or so, but not wildly out of line. It is more/less correct to say that housing prices and rents are around where they should be for the actual inflation which has been caused (by government spending) since that point. There are other market issues with supply, of course (eg: government red tape prohibits fixing supply issues in lots of cases), but generally the market is not too far off where it should be. That means housing is becoming unaffordable for most people, primarily because of the next point.

Why is this terrible (wage stagnation edition)?

Most private organizations try to pay as little as possible for employees (maximizing profits for owners), generally, but most give some allowance for annual Cost of Living increases. Naturally this is tied to the CPI, and this less than the actual cost of living increases by ~4% annually. This means that, for the last 40 years, employees have been getting wage increases which were around 4% less than what they needed to be in order for wages to keep up with actual inflation. At this point, that disparity amounts to roughly a 50% under-payment in wages compared to actual cost of living (even notwithstanding stagnant minimum wages and such). If the government hadn't lied with the CPI, employers would have been pressured to keep up with inflation, and salaries today across most industries would be literally double what the actually are.

In that context, for example, housing prices would not be nearly as unreasonable, and while things like food and energy cost increases are high, they would be much easier for the working class to absorb. Instead, the government has funneled that massive amount of money to the wealthy: property and business owners, where the profits match or exceed actual inflation. The CPI changes in the 80's (which, again, were done 100% maliciously and purposefully) were arguably the single most damaging impact on the middle class in US history, and certainly the largest driver in the increase in wealth disparity in the country.

Why is this terrible (seniors edition)?

It would be remiss to not mention, at least as an addendum, that the CPI change also obviously affect seniors, particularly those who are dependent on fixed income and/or social security. This was, of course, the intended direct effect of the changes: to reduce social security payments over time, in a surreptitious manner. Still, I feel bad for seniors on fixed income, because the government absolutely screwed them, without most of them even realizing such.

The blame game, and ramifications

This brings the discussion around to the blame game, where people seek to take advantage of other people's ignorance to assign the blame for inflation on people (eg: Biden). Often the people assigning the blame are also ignorant/useful idiots, just spreading propaganda which they do not understand. Inflation, it seems, is a topic which most people in the country do not really understand, and unfortunately most people also do not have much awareness of the extent to which the government also lies about it. Furthermore, there are many other useful idiots who will lie on the government's behalf, echoing any number of other theories as to why "this time is different" with respect to inflation.

My hope is that, by reading and understanding the above (and chasing references as necessary, to convince oneself of the validity of the info provided), you will not be one of those ignorant pawns, or be swayed by garbage propaganda. The first step in fixing problems (nationally or otherwise) is understanding the actual cases, and not making them worse by pushing to change the wrong things. If you happen to find yourself in a position where you can possibly make someone else a bit less ignorant on this topic, feel free to point them here, and hopefully we can also get a little better informed, and make better collective political decisions as a result.