Inflation is an increase in the price of goods and services not due to growing demand or shrinking supply for those goods and services (which also affects price) but due instead to the dollar losing its buying power. For example, if the annual inflation rate is 10 percent, then a box of cereal that cost $4.00 last year would sell for $4.40 this year, up 10 percent from the year before. In this example, the demand for cereal has not gone up, nor has the supply of cereal gone down; this cereal just costs more because the dollar is worth less. As someone once said, “In inflation, everything gets more valuable—except money.” Actually, nothing gets more valuable, everything just costs more. Prices go up because the buying power of the dollar goes down.
What Causes the Dollar to Lose Buying Power?
For those of us who are relatively new to the sometimes unfathomable world of economics, it may come as a bit of a surprise to learn that the dollar’s buying power or value comes from the very same economic forces that set the value (or price) of everything: supply and demand. For example, if a lot of people want to buy diamonds (big demand) relative to how many diamonds are available (small supply), then the price of diamonds is high. On the other hand, if diamonds were to become as plentiful as, say, sand grains on a beach (big supply) or if people become less interested in owning diamonds (small demand), then diamonds would become far less valuable. It’s hard to think of money this way, but the truth is that the value of money is also affected by supply and demand: If there are too many dollars available, like sand instead of diamonds, their value falls. Therefore, inflation is caused by an increase in the nation’s money supply.
But increasing the money supply does not always cause inflation. That’s because, for an economy to run smoothly, the amount of money in circulation has to more or less match the need for that money, based on the size and growth rate of the economy. As the economy expands, more money must be created in order to facilitate and keep pace with the amount of trading that is taking place. When additional dollars are created in a growing economy (in the correct amounts to keep up with and encourage that growth), the value of those dollars does not fall, despite the fact that more money has been created. In fact, rather than the value falling, the value of those dollars may rise because more and more people want to own that currency, so they can take part in that booming economy.
However, when the money supply is dramatically expanded in an economy with no or slow growth—as is happening today—the value of the dollar will eventually decline. In short, too many dollars (too much supply), relative to the slow growth of the economy (too little demand), leads to the falling value of the dollar—a.k.a. inflation. The real cause of inflation is increasing the money supply beyond what is needed to keep up with economic growth.
Who is increasing our money supply beyond what is needed to keep up with our current rate of economic growth? As we will see shortly, the size of the U.S. money supply is controlled by the Federal Reserve, and the Fed can add to or subtract from our money supply any time it wishes, by either buying or selling government bonds, as a way of trying to control the money supply. By properly controlling the growth of the money supply, it will help the economy grow without creating inflation. However, in the last two years, the Fed has massively increased the U.S. money supply beyond what is needed to keep up with economic growth in an attempt to stimulate the economy. This massive increase will stimulate the economy, and especially asset prices, such as the stock market, in the short term, but longer term it will create much higher inflation. More on this shortly. But first, we have to answer another pressing question.
Why Is Inflation Bad?
At first look, inflation might not seem so bad. After all, if the cost of everything goes up and if your income goes up, too (because it is part of the cost of everything going up), then there really is no change to your bottom line. You just get paid more dollars, and you spend more dollars. As long as these increases are more or less consistent across the board, nothing has really changed, right?
The first problem is that your income may not rise as fast as inflation. As one of our publishing friends said, “I know that there is inflation, it’s just not in my salary!” To be sure, that will be an increasing problem going forward, but right now, we are going to focus on the other big problem with inflation, especially in a bubble economy.
And that problem is that, as inflation rises, so do interest rates, and as interest rates rise, asset values fall. And again, it is important to emphasize, this is a particularly bad problem when assets are in a bubble because this makes them very vulnerable to a fall when inflation hits. In a bubble, the asset prices will go up with inflation, but like our friend’s income, they won’t go up nearly as fast as inflation.
Let’s break that down into its parts. Rising inflation eventually causes rising interest rates, because when the dollar is losing buying power each year (rising inflation), the only way you can get someone to lend you dollars is if you offer to pay them an interest rate that at the very least compensates them for the inflation rate, plus a bit more so they can make a profit on the loan. Therefore, in time, interest rates tend to be a bit higher than the inflation rate.
Okay, so increasing the money supply causes inflation, and inflation causes interest rates to rise. So what?
Here is where the impact of that already launched inflation missile starts to do its terrible damage. Rising inflation causes interest rates to rise, which makes money more expensive to borrow. When money is more expensive to borrow, less lending occurs. When less lending occurs, less buying occurs, and when less buying occurs, the demand for assets—like our homes, stocks, savings accounts, artwork, jewelry, cars, and all dollar-denominated assets—falls. Demand falls, supplies go up (because fewer buyers), and asset values go south.
How far south will asset values fall? Well, in a normal, healthy, non-bubble economy, not too far south. Certainly, we have had rising inflation before, and we’ve had rising interest rates before, and although it wasn’t great for the economy, nothing too terrible happened.
But in an already falling, vulnerable multibubble economy, high inflation and high interest rates will make asset values across the board drop like a rock. Rising interest rates will cause bond values to fall, businesses to do poorly, stock prices to drop, and home prices to decline even further. In a multibubble economy on the way down, rising inflation and rising interest rates lead to falling asset values. What economists call “nominal prices” go up due to inflation, but in inflation-adjusted dollars “real prices” do not go up. In a falling bubble economy, real prices go down, which means wealth (mostly “bubble money”) is disappearing. Can you see why rising inflation and rising interest rates are bad, especially in a falling multibubble economy?
Inflation is not just bad for the general economy, it is bad for your investments. During inflation, the real value of your assets will fall significantly, and those asset value losses could be tremendous. But, in addition, any income from those investments (interest, dividends, rent, etc.) will have to outpace inflation for you to receive any real income. It’s as if your investments are on a boat trying to go upstream: the only way to make any headway is to travel faster than the current pushes you backwards. The same goes for your job. With inflation, you will have to get a pay raise every year equal to the annual inflation rate just to stay even. Otherwise you are getting paid less and less, even if the dollar amount on your paycheck is unchanged.
Inflation does have some limited silver linings. If the value of the dollar declines with inflation, we get to pay back our previously borrowed loans, mortgages, and other debts with cheaper dollars than we originally borrowed, assuming these debts are at fixed interest rates that do not increase. Inflation makes it possible for the government to pay back some of its debts with cheaper dollars than the dollars they originally borrowed.
But, what’s good for borrowers is bad for lenders.
For the federal government, which has to keep refinancing its debt over and over again because a lot of its debt is short term, each time it refinances its debt, the new refinanced debt is subject to higher and higher interest rates, which can get very expensive very quickly. Having to keep refinancing massive debt and also running massive budget deficits means the federal government—and the massive government debt bubble—is acutely vulnerable to massive inflation-generated increases in interest rates.
Higher interest rates also spell trouble for the already falling real estate bubble. Higher interest rates will mean more expensive mortgages, which will discourage home buyers and keep home values from rising as everyone would like. When higher interest rates stop many people from buying homes, home inventories will rise and home prices will fall further (falling demand plus rising supply equals falling prices). Even a 3 percent rise in interest rates can have dire consequences for real estate and other asset values. Figure 3.1 shows just how much home prices have to go down to maintain the same mortgage payment, if mortgage rates increase even fairly modestly from 4 percent. Remember when mortgage rates were 15 percent in the early 1980s? A mortgage rate of 7.5 percent is pretty reasonable, but it would mean that home prices would have to decrease by 32 percent.
Figure 3.1 Decrease in Home Values When Mortgage Rates Increase
The chart assumes the current mortgage rate is 4 percent. An increase to 5 percent would force home prices down 11 percent to maintain the same monthly payment.
Source: The Foresight Group.
Even worse, as interest rates rise, the value of mortgage bonds falls drastically, which means there won’t be much mortgage money to lend, even if home buyers wanted to borrow it at the high rate. So rising inflation and rising interest rates will help further pop the real estate bubble. Increasingly, lenders won’t grant mortgages at fixed rates. They will only lend if the interest rate adjusts with inflation. That will make it very difficult for most home buyers to borrow money to buy a house. As mentioned in the last chapter, the falling real estate bubble negatively impacts the wider economy in many, many ways.
And our troubles won’t end there. Higher interest rates will also mean that businesses won’t borrow as much as they would at lower interest rates. With less borrowed money, businesses don’t make as many purchases from other businesses, so there is no good reason for businesses to expand their outputs or hire more employees. That adds to rising unemployment, hurting the economy further. And of course, rising interest rates have a negative impact on the value of stocks and bonds, and the higher interest rates go, the deeper stocks and bonds fall. Moderate inflation and interest rates don’t cause immediate, significant damage, but as inflation and interest rates continue to rise, the negative consequences accelerate until no one wants to lend money anymore, or they offer impossible terms.
So the limited benefits of inflation are far overshadowed by the huge negatives to investors, businesses, real estate, the federal government, and the overall economy. While rising inflation and interest rates are not great for any economy, they are really bad for a falling multibubble economy. It is true that with tremendous government stimulus, falling bubbles can be temporarily blocked from falling further and sometimes even temporarily reinflated to a moderate extent. But even tremendous stimulus cannot push falling bubbles back up to their previous highs or support them for very long, because in time that tremendous stimulus itself (massive increases in the money supply and massive government deficit spending) ends up causing high inflation and high interest rates, which will eventually help deflate the bubbles. In a normal, healthy, nonbubble economy, a bit of stimulus can do the trick without very bad consequences later. But any temporary boost to a falling bubble economy is doomed to fail, when the negative consequences of high inflation and high interest rates eventually kick in.
Fortunately, right now inflation and interest rates are quite low, so why do we say that future inflation is racing toward us like an already launched missile?