Inflation for dummies

We’re really in the self-evident department here, but many arguments still float around which seem to forget the basics, so a little refresher may help.

Let’s start with the definition: what is inflation?

Inflation is too much money chasing too few goods.

From there it follows simply that to get inflation these two conditions must be fulfilled at the same time:

  1. Too much money
  2. Too few goods

People tend to watch reason #1 too closely, and often even get that wrong. For instance Quantitative Easing (QE) is an operation which is mainly about swapping different kind of money with each other to twist the yield curve at the margin which has a much smaller impact than really “printing money” and throwing it away through the central bank’s window would have. Most countries’ central banks are either not actually allowed, or do not actually practice, direct money printing. So it is in reality quite hard for a central banker, should they wish to, really to “print money”.

Now let’s just  assume that excess money is successfully injected in an economy. We still need condition #2, too few goods. If people find themselves with bundles of cash, and spend them — they must “chase goods”, if they save, no inflation — we’ve got suppliers of stuff and services facing facing an influx of customers. What do you do if you’re in business and see customers coming your way? You push your production/servicing capacities to the max, get more staff, etc. Under competition, you can’t really put your prices up by much in the medium or long term, otherwise someone will turn up and undercut you, opening a new café next to yours when they see yours is full.

So, in peacetime in a functioning economy, the supply side is very responsive: you can always get more staff or more equipment, for this to become strained you need to run out of staff so that staff become scarce and can name their price when negotiating wages. That is full employment, which brings us to the simple truism:

Inflation = Full employment

Exceptions to this require either inflation so frantic that it’s faster than people can advertise for jobs, or political disruptions that prevent normal operations of the jobs and equipment market. As far as I know all the historical episodes of major inflation occurred in time of full employment or major political disruption (war, civil or otherwise, etc).

Further it’s worth noting that full employment requires not only employing the people looking for a job, but people who are not currently looking but would if they saw opportunities, which in current circumstances are probably quite numerous in most mature economies (less people who are chronically unemployable due to personal or systemic circumstances, probably a percent or two of the workforce).

It also requires, in technological societies, running out of jobs that can be relatively easily automated but have not yet because staff was cheap and plentiful.

Conclusion: if you want to predict inflation, don’t ask an economist but a geopolitics expert re their views on major upcoming wars. If there is a green light here, and there are still plenty of people wishing to work, inflation risk is very low. Moreover, there’s a natural hedge for people of working age: if there’s inflation, it will be easy to get a job.

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