After a brief hiatus, the Guerrilla Economics blog is back. We want to use this blog as a way to help our clients and other interested individuals understand in an unbiased way how economic concepts, statistics, indicators, theories and other factors influence both the political and business climate.
To kick things off, our first post examines the ill-understood concept of price inflation. Inflation has been in the news a lot lately as consumers face a sustained and substantial rise in the prices of many of the products that they purchase every day. At the same time the Bard of Princeton himself, Chairman Bernanke, continues to claim that there is no inflation. How can this be?
Economists define inflation as an “increase in the general level of prices of goods and services over a period of time.” Students struggling to stay awake in introductory economics classes are told in complex detail about how inflation can occur when markets get out of balance, or what is called demand-pull and cost-push inflation. Recent worldwide oil price increases and rising corn prices in the United States are examples of demand-pull and cost-push inflation. This type of price increase will generally moderate over time as new production is brought online (the development of tar sands), or as consumers change their purchasing patterns (like purchasing more fuel efficient vehicles).
The inflation that makes economists stay awake at night – yes we actually stay awake at night drinking tea, writing formulae and worrying about this sort of stuff – is when there is a general rise in the level of prices across the economy. There are basically three things that can cause this type of sustained inflation all of which are the result of policy decisions.
In basic terms, prices reflect a relationship between money and products and inflation occurs when there are changes in this relationship. The first, and probably the most common historical cause of inflation is what is called the debasing of currency. This occurs when a government reduces the intrinsic value of its currency by either removing the amount of a commodity (generally gold, silver or copper) in its coins, or by printing banknotes. Simply put, there are more dollars chasing the same amount of goods and as with the supply and demand for anything, the value of the currency falls. If the amount of goods and services rise in line with the increase in the money supply there would be no inflation, but if the money supply rises faster than the amount of production then inflation will occur.
The second cause of inflation is the opposite. If the money supply does not grow, but the amount of goods and services available in the economy falls there will also be inflation. This often happens after a war or natural disaster but can also occur if regulations, demographics or economic conditions lead to a general reduction in the amount of production or productivity in an economy.
Finally, inflation can occur if there are expectations that either of the other two events will occur. This was a big part of the inflation spiral that occurred in the United States in the 1970s when powerful industrial unions pushed up wages in anticipation of higher inflation.
So what is happening in America? Is the country experiencing inflation, or are some products like oil and food simply in short supply?
It is difficult to measure inflation against any single commodity (even gold) since there could be market as well as monetary forces at play. But overall, the value of the dollar has been falling as of late against both commodities and other currencies. As the chart shows, oil prices rose faster in dollar terms than in euro terms over the period from 1999 until 2007. That difference represented higher inflation in the US relative to the Eurozone. In fact, one of the reasons for the depth of the 2008-2009 recession was the rapid increase in US inflation in the 2006-2007 period.
When the recession hit, the Federal Reserve and both the Bush and Obama administrations worked tirelessly to increase the money supply by both encouraging banks to lend and by borrowing from abroad to send checks to thousands of taxpayers, government contractors and civil servants. While some short term increases may have been necessary in order to help stabilize the nation’s banking system, the oxygen that fuels the inflation fire comes from a long, sustained run of the government printing presses. The result of this is now being seen in high prices for commodities and imports and in the number of European tourists clogging the streets outside of our offices in Brooklyn to take advantage of the cheap dollar.
Even so, Chairman Bernanke is correct in claiming that the main measure of the inflation in the United States, the Consumer Price Index has barely budged over the past two years. We will examine the CPI next week to try to understand how this measure of inflation may not be particularly accurate.