What causes inflation?

Inflation means prices rising, doesn’t it?

It’s true that we think of inflation as rising prices, and inflation indices do indeed measure the amount by which prices rise across a range of goods and services. But the history of the word is more revealing.

Inflation as increase in money supply

In its original meaning of the word, inflation was the process of creating more money – printing money, if you like. The most famous example of this was during the Weimar Republic from 1921. Following their defeat at the end of The Great War, Germany was required to pay reparations in the form of hard, foreign currency. In order to buy that currency, it printed more of its own and exchanged this for foreign currency which it used to repay the debt. Clearly this devalued its own currency – who would want to exchange their pounds or dollars for barrowfulls of paper? Indeed they got away with it for only as long as the mark was worth anything meaningful at all, after which creditors accepted hard goods in place of currency.

The consequence of all this was that as foreign goods became increasingly unaffordable, so in mark terms did their prices rise as “hyperinflation”, inflation that’s out of control. This was an extreme example, but it has been a warning to governments since then not to create money too readily, because inflation of money supply leads to inflation of consumer prices.

So inflation is ultimately caused by governments?

Arguably, yes. Although prices will rise in any particular market for a number of reasons. In South Africa, the fall in the price of gold has meant that there is less demand for its Rand currency and consequently its exchange rate moved from ten to the dollar down to 15 to the dollar in two years. The price of foreign imports rose by 50% as a consequence. But that’s not inflation as caused my government monetary policy.

We tend to think of prices of goods as being worth a certain amount of currency. But we can equally think of currency as being worth a certain amount of goods. In other words, price rises are equally falls in the value of a national currency as measured against the goods which we buy with them. It’s easy to see that the more currency there is in circulation, the less desirable that currency is to anyone selling the goods. It’s simple supply and demand.

However currency (money) is created in more than one way. And it involves debt.

Money created by governments

Governments create money out of nothing by creating a debt. The national bank (the Federal Reserve in the USA, ECB in the Euro zone, Bank of England in the UK) creates money as banknotes, or as electronic money, and hands it to the government. In return, the government has a debt to the central bank. When the debt is paid off, the money is cancelled. Although that part tends not to happen. The various tranches of Quantitative Easing have been precisely this. In the face of deflation and a stagnant economy, the government created new money and used it to buy illiquid assets from banks. In the UK £375 billion was created but consensus is that it failed to achieve what it set out to achieve. In the Euro zone, QE has not prevented interest rates falling to zero or lower.

Whereas deflation may have been avoided, the new money had to find a home somewhere, and that seems to have been the stock market and property. This video from Positive Money explains it better

Money created by commercial banks

If we think £375 billion is a lot of money in the UK, well it is. But how do we feel about £2.2 trillion? That’s the amount of money that’s been created by commercial banks, mostly in the last 20-30 years and a good part of that to create mortgages. Banks don’t print notes and they certainly don’t mint coins. This money is electronic money. I estimated the UK housing stock makes up 75% of the wealth of the UK and with a value of £6 trillion we see that this new money has been complicit in pushing up prices year upon year.

It’s a fallacy to think that banks lend out money that they already own. Our reserve banking system lets them create money from nothing, and the more they create, the more inflation we are likely to see.

What can be done to stimulate the economy other than create money?

One way of stimulating spending is to penalise saving. That’s the point of negative interest rates, although they’re not sold to us like that. Negative interest rates are the weapon of choice of Harvard’s Professor Mark Rogoff. But in order to impose negative interest rates, we have to go cashless. Why? Because we can all stuff cash under the proverbial mattress rather than keeping it in a shrinking bank account. It sounds far-fetched, but it’s not. It’s an idea that’s already being discussed around the world.

My preferred approach is to scrap transaction taxes. In the UK we have Stamp Duty Land Tax on property transactions, Capital Gains Tax on asset transactions and Inheritance Tax on estates. Stamp Duty Land Tax, in particular, penalises moving house and it would surely be better to tax every home owner, whether moving or not, rather than picking on those providing stimulus to the housing market.

Or perhaps we are simply looking at this problem wrongly. Perhaps all we need to do is lower our expectations, and live within our means rather than borrowing money for a more immediate improvement to our lives.

QE with a difference

Another way of stimulating the economy is to encourage the use of alternative currencies alongside the national currency. Bitcoin is the best known “altcoin”, but there is no reason why a national government couldn’t create a similar technology. Arguably this is QE by the back door, as money supply is still increased, just not the national currency.

A more populist form of QE is Helicopter Money or Quantitative Easing for the People (QE4P). Essentially, it’s the same as QE except that rather than using the new money to buy illiquid assets, it’s used to increase government spending, perhaps as infrastructure projects or, as some have suggested, simply giving everyone a bundle of notes. Again, this inflates the money supply but arguably in a more democratic way – everyone benefits not just asset owners.

Money Questioner’s summary

Inflation means the increase in money supply, money that’s mostly created by commercial banks but also by governments. Both lead to price rises, in these two cases, rises in the prices of property and equities. This isn’t the type of economic stimulus that was intended after the 2007/2008 “credit crunch” banking collapse. What was intended was more business lending, leading to an economic recovery. The lesson to be learned is: the banking model we rely on isn’t working.