April 17, 2022 by Anders Ingemarson
I’ve recently tried to brush up on my inflation skills. Being young and ignorant the last time it seriously impacted us in the late 70s/early 80s, I admittedly hadn’t kept the subject at the top of my personal development to-do list. So far, the best illustration of inflation I’ve come across is John Greenwood and Steve H. Hanke’s “bathtub theory of money and inflation in an October 21 WSJ OpEd. Money flows into the bathtub through the faucet, and out through three drains: (1) economic growth, (2) savings, and (3) inflation overflow. The authors explain the state of the U.S. monetary bathtub as follows:
“During the early months of the Covid-19 pandemic, the faucet was wide open. Between December 2019 and August 2021, the U.S. money supply, measured by M2 [my link], grew by $5.5 trillion, a stunning 35.7% increase in only a year and a half, driven primarily by the Fed’s purchases of Treasurys and mortgage-backed securities. In light of anticipated Federal Reserve tapering, we estimate that by the end of 2024 the money supply will grow another $5.1 trillion.
“Out of the total $10.6 trillion in new money, real GDP growth will drain roughly $1.4 trillion. Another $1 trillion will flow down the money demand drain. Since the amount of money flowing into the bathtub far exceeds the two outflows, the excess money in the tub—around $8.2 trillion—will hit the inflation overflow drain.
“The huge monetary expansion—$5.5 trillion already in the bathtub—is starting to reach the overflow. Persistent, not transitory, inflation will be with us for the next two to three years.”
Six months after publishing it, their bathtub theory pans out in practice—U.S. inflation hit 8.5% in March with no end in sight. Translated to personal finance terms, we should be prepared to see the real value of both our savings and earnings further decline for the foreseeable future.
The bathtub analogy echoes the economist Milton Friedman’s famed explanation of inflation: “Inflation is always and everywhere a monetary phenomenon, in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.” In other words, we should forget what we hear about price increases caused by greedy businessmen, oil shortages, and supply chain constraints; those are effects of too much fictitious money flooding the system, not causes. As Messrs. Friedman, Greenwood and Hanke explains, there is only one cause of inflation: the government increasing the quantity of money faster than the economy grows when lacking the funds (= taxes) to pay for everything from war expenditures to welfare schemes, which in the past two years has included the trillions of Covid related outlays.
In days of old, statist rulers indirectly increased the quantity of money by diluting their gold, silver and copper precious metal coinage with less valuable base metals. This made the precious stuff seem to go further, although producers soon caught on and increased their prices in response to the debased currency.
When paper money was invented, the printing press took the place of base metals. Again, producers adjusted their prices in response to the overflowing bathtub. If it got really bad as during the 1920’s Weimar Republic in Germany, hyperinflation set in, meaning that you soon needed a wheelbarrow with Reichmarks to buy a loaf of bread.
With the advent of information technology, electronic transactions mostly replaced the printing press in the government money-creation scheme. Exhibit 1, the Federal Reserve imagining up new dollar balances and electronically crediting them to other accounts to pay for the trillions of Treasurys and mortgage backed securities it buys.
Inflation is a backdoor violation of our individual rights to life, liberty, property and the pursuit of happiness. Taxes, while also rights violating, are in a way more honest—the
To understand the scope of the rights violations, consider the following: with each percentage point inflation, the government erodes our savings and makes it harder to work towards a secure, financial future. $100 today with 2% inflation for the next 10 years are only worth about $82 10 years from now. With 4% inflation, they are worth $66. And with 8.5% inflation no more than $40; if the current inflation rate continues for 10 years you will have lost 60% of your wealth.
What’s the solution? Another OpEd in the WSJ, Inflation, Deficits and Paul Volcker by Thomas Sargent and William Silber also quotes Milton Friedman:
“‘We have been having inflation,’ Milton Friedman observed in 1978, ‘not because evil men at the Fed have been willfully turning the printing press, but because John Q. Public has been demanding inflation and aborting every attempt to stop inflation. We, the public, have been asking Congress to provide us with ever more goodies—yet not to raise our taxes.’
“How do you square this with his more famous pronouncement, ‘Inflation is everywhere and always a monetary phenomenon’? Friedman’s answer: ‘Financing government spending by increasing the quantity of money is often the most politically attractive method to both presidents and members of Congress.’”
In other words, while our politicians conveniently hide behind the nebulous inflationary cause and effect relationships, in the end, we, the American people, have ourselves to blame. Politicians are good at putting a finger in the air to sense where the wind is blowing. For much too long we have asked for government handouts without being willing to pay for them with tax dollars. But the answer is not to increase taxes as it would compound the rights violations. The only solution that will stop the sucking sound of the bathtub inflation overflow drain is curtailing government spending, i.e. the handouts. No more Covid relief packages, no Build-Back-Better billions, and getting serious about reforming Social Security and Medicare which are underfunded to the tune of trillions of dollars.
Much publicity has been given to former Fed Chairman Paul Volcker’s interest rate shock treatment back in the 1980s to get inflation under control. The 1985 Gramm-Rudman-Hollings Balanced Budget Act has received less attention. It required across-the-board cuts in federal spending if Congress fell short of predetermined targets. The act, and its followers, never succeeded in preventing federal budget deficits or we would not have seen the massive Covid spending binge. But it initially sent positive signals to the markets which, along with Volcker’s interest rate treatment, helped getting inflation under control. We need a new or revised Balanced Budget Act. And this time we, the people, must demand that it be enforced in the name of respecting our individual right to plan for a financially secure future without the threat of inflation. If not, we better get used to this right going down the inflation overflow drain.
Admin note: This is the last post at SEPARATE!. I’m moving to Substack and changing name of the newsletter to Think Right or Wrong, Not Left or Right. Subscriptions are free, although donations are welcome. As a current subscriber you don’t need to do anything other than checking your spam folder if you don’t see the corresponding Substack email. Hope to see you over there.