Inflation On the Rise?

When I was in elementary school, we were taught about inflation and deflation. In a wonderfully simple graphic, the textbook explained that deflation occurs when too many goods chase too few dollars. Inflation is the opposite–too many dollars chase too few goods.

Though I have learned much since then, this explanation continues to be the best one I have found of why prices generally rise or fall in an economy. Neither deflation nor inflation are desirable if they occur too rapidly. A rapidly deflating economy means that it is preferable to wait to purchase things or invest in business expansion. A rapidly inflating economy means that the value of every dollar held for any length of time is diminished. Both wreak havoc.

In order for an economy to function well over the long haul, participants have to be able to plan for purchases (in the case of consumers) and investments (in the case of businesses). History shows repeatedly that when governments decree what is to be used as money, they invariably start to manipulate its value. The easiest way to do this is by diluting coins (by replacing gold with a less valuable metal) or printing money (including its electronic equivalent).

Inflation is the inevitable outcome of manipulating a currency’s value. This occurs because it is to the government’s advantage to create money by diluting its value. Not only does this provide politicians with “free” money to spend, it also gives them the power to claim they saved the day by jolting an economy into health with a shock of “quantitative easing” and such.

The problem is that: 1) it is not at all clear that this tactic even works–it sure hasn’t lately, and 2) it is like taking heroin for morphine addiction–the cure is worse than the disease. Thus here we are now with a sluggish economy and a Federal Reserve that keeping dumping more currency into the economy in hopes of reviving it.

Here and there, the first signs of the end game are emerging. India and China have seen spurts of inflation. Europe now reports the worst upwards price pressure since 2008. The US’s energy and food prices have gone up as well, we just don’t count those in our inflation calculations (go figure). We are getting along as well as we are only because banks and businesses are not putting that newly created money into circulation. Why not?

Imagine a field of crops in an area with little rainfall. In order to make them grow, the crops have to be watered, so we build an irrigation system. The pipe that brings water from the reservoir is a great boon to the area, but unbeknownst to us, it has become plugged. The first thing we notice are some parched plants. The engineers who built the system tell us over the phone that it should work. Thinking we need more water, we turn the spigot to the left so that more water enters the pipe. Our plants are still parched. We open the valve more, and our plants are still parched. Finally, after several iterations, the gob of mud that has gummed up the works dislodges, flooding the crop with far too much water. We are ruined.

So it is with inflation. Banks and businesses are holding vast amounts of cash courtesy of the Fed, but the current Administration is a gob of mud. Having no understanding of how the system works and little inclination to learn, it will keep turning up the volume of water until something gives. When it does, we will be swimming our way around a swamp until the water recedes. That could take years. If the flood is bad enough, it could destroy the cropland forever, replacing it with a fetid lake.

Washington’s obsession with regulation and taxation has put all of us on the wet end of a bad deal. No one wants to plant because they know what is coming. At some point, though, the pressure of the water on the obstruction will be too much. On that day, we will all wish for an Ark.

About Terry Noel

I am an Associate Professor of Management and Quantitative Methods at Illinois State University. My specialty is entrepreneurship.
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