All About Inflation

Podcast Transcript

If you’ve been around long enough, you might have noticed that things are more expensive than they used to be. If you’ve really been around long enough you know that things are a lot more expensive than they used to be.

This is of course known as inflation. It is an economic condition that has been around throughout history, almost everywhere on Earth. In a few cases, it has gotten so bad that it strained the limits of imagination.

Learn more about inflation and how it has manifested throughout history, on this episode of Everything Everywhere Daily.

The definition of inflation is a general increase in the prices of goods and services in an economy. Or, to put it another way, each unit of currency has less value and is able to buy less than it did before.

This is distinct from an increase in the price of a single good or a category of goods.

To demonstrate the idea, I’ll give two hypothetical examples.

Let’s suppose that there is a rare winter freeze in the state of Florida that does severe damage to the orange crop. The number of oranges which will be harvested goes down as does the supply of other products such as orange juice.

Because the supply of orange juice drops so sharply, by the laws of supply and demand, the price will go up because there isn’t as much orange juice to go around. Eventually, more oranges will be produced, the supply of orange juice will increase, and the price will drop back down.

This is not an example of inflation. It is just a supply and demand issue with a single commodity. People who would regularly drink orange juice either would have to pay more or shift to something else like apple juice or grape juice until prices adjust.

You’ve probably seen prices for oil go up and down over the years. This can be due to a host of reasons including decisions to increase or decrease oil production to manipulate oil prices.

Inflation is something else entirely. Inflation is when the price of everything goes up. The cost of a movie ticket 100 years ago in 1921 was only $0.15. Today, the average price is approximately $10, and in many cities much more than that.

A new house was $6,296 and rent averaged $15 per month and you could mail a letter for only $0.02.

The price of everything, including all goods, services, and wages, increases.

What causes this? The general consensus among economists is that inflation is a monetary phenomenon that comes about from an increase in the supply of money.

I’ll use a hypothetical if absurd example to illustrate the point.

Let’s suppose everyone in the United States was given 1 million dollars. Everyone would be a millionaire, right?

Technically, yes they would in that everyone would have a million dollars. However, what a millionaire means would suddenly become radically different. It wouldn’t mean everyone could suddenly have Lamborghinis and mansions because there aren’t that many Lamborghinis and mansions to go around.

The value of a dollar would simply be much less as there would be so many more of them.

It would result in the price of everything increasing many-fold, at least, overnight. Some things which had contractual prices like debts and mortgages could be paid off trivially as they were priced in dollars before everyone became awash in cash.

The price of a single banana might now be $20. You couldn’t get anyone to work for $100 an hour if everyone was sitting on a million.

This is an extreme example, but it illustrates the point of what happens when the money supply dramatically increases.

Inflation has actually been around for several thousand years, although the way it happened was very different than how it works today.

Back in the day, money was based on precious metals like gold, silver, and copper. Governments reserved the right to issue coins which they called seigniorage. There would often be a difference between the face value of a coin and what went into making it, and that difference was a fee that the government would collect.

In ancient Rome, the most common unit of money was the denarius. The denarius originally weighed approximately 4.5 grams with a purity of 98% silver, and it was that way for about 200 years. It was about the size and weight of a quarter or 25 cent piece.

The denarius became a solid reliable unit of coinage because of the power of Rome and the stability of the coins.

However, emperors and kings are always in need of money. The primary way of raising money is to just raise taxes, but there is a limit to how much you can do that. The other way to get money was to debase the currency.

Under the reign of Emperor Augustus, the denarius went from 4.5 grams to 3.9 grams.

Under Emperor Nero, the amount of silver in the coin was reduced to about 93%.

Because all of your payments and debts were denominated in denari, if you reduce the amount of silver in each coin, you now can make more money with the same amount of silver.

The flip side is that the value of the denarius decreased, the quantity of the denari in circulation increased, and prices rose.

Over the next 200 years, Roman Emperors did this over and over until the denarius had almost no sliver in it. By the year 275, the denarius was only 3.5 grams in weight with only 5% silver content.

This same basic story has played out over and over in history.

China was the originator of paper money. During the Mongol rule of China, known as the Yuan Dynasty, they became the first government in history to simply create more paper money to fund wars and other expenses.

When the Yuan Dynasty finally fell and was replaced by the Ming Dynasty, for a time they refused to use paper currency and went back to copper coins because paper became so untrustworthy under the Mongols.

You might be wondering if it was possible to have inflation without debasing coinage as the Romans did. The answer is yes if you can just mine a lot of precious metals.

This basically happened in Europe from the 16th and 17th centuries as tons of silver and gold were brought from the Americas to Europe. Prices increased about sixfold over a period of about 150 years, simply due to the amount of precious metal being produced.

Ancient money always had some sort of limitation. Even if a coin had zero gold or silver, you still had to mint the coin. Chinese paper money was still limited by paper production and printing which wasn’t mechanized. Spain still had to mine silver and ship it back to Europe.

When the 20th century rolled around, these limits were largely removed and some countries were able to enter periods known as hyperinflation.

Hyperinflation, as the name would imply, is inflation on steroids.

Perhaps the best-known example was the Weimer Republic in the early 1920s.

In 1914, Germany took the Mark off of the gold standard to pay for the war. They almost exclusively used debt to pay for their war effort instead of taxes, because their plan was to win the war and use reparations to pay off the debt.

Needless to say, that didn’t happen. The Treaty of Versailles required Germany to pay in gold, so Germany was forced to use the paper Mark for internal purposes.

The Mark steadily declined in value from 1914.

In 1914, 1 US dollar was worth 4.2 Marks
In 1919, a dollar was worth 32.8 Marks

In 1921 it was worth 83 Marks

In 1922 it was worth 430 Marks

That is a 100 fold increase in just 8 years. However, bad this seems, at this point, the Weimar Republic said, “Hold my beer”.

In 1923 it took 50,000 marks to buy a dollar and in November of 1924, it reach a peak of 4,210,500,000,000 Marks to get 1 US dollar.

It turns out, printing a bill with a few more zeros costs the same as printing one with less.

This is where the famous metaphor of someone paying for a loaf of bread with a wheelbarrow full of money came from.

However, this wasn’t the only or even the worse case of hyperinflation in the 20th century.

Hungary after World War II suffered the worst hyperinflation in history. In 1944, the highest denomination Hungarian currency was a 1,000 pengo note. By the middle of 1946, their largest note was for 100 quintillion. (100,000,000,000,000,000,000).

At one point prices were doubling every 15 hours.

The best known recent case of hyperinflation was in Zimbabwe which had a peak annual inflation rate of 89.7 sextillion percent in November 2008. This was the same month they released their famous 100 trillion dollar bill.

You can actually buy these on eBay and they are worth more today as collector’s items than they were when they were printed. I purchased several billion Zimbabwe dollars when I was there.

All of the worst cases of hyperinflation in history have occurred within the last 100 years, usually after major wars or the collapse of the Soviet Union.

When a country goes through hyperinflation, it really changes everything. Fortunes, great and small, are wiped out if they are held in that currency. Prices change so frequently that you need people dedicated to just buying things. You want to get rid of your money as fast as possible because the next day it might be worth half as much. Many places of employment have to pay people every day, or sometimes more than once a day.

Recently in Venezuela, people would go to a families member’s place of work to get cash so they could immediately go and spend it before prices went up.

So, yeah, inflation can be really bad if it gets out of hand. But how do you measure the price of everything?

This is actually a very difficult problem. In the United States, they calculate what is known as the Consumer Price Index or the CPI.

The CPI is supposed to measure the changes in price of a basket of consumer goods. That sounds easy, but is actually really challenging.

Let’s assume you price the cost of an internet connection and a computer. Something that most people in a developed country might have.

When comparing prices from 15 years ago, you are comparing very different things. An average internet connection today is much faster. A computer is going to be better and cheaper than it was 15 years ago. Simply looking at the cost of a computer doesn’t reflect the qualitative changes which occurred.

That doesn’t even address the problem of how you compare those prices to 1970 when none of those things even existed.

There are some products which have stayed relatively the same, like wheat, except that really isn’t true. Modern strains of wheat plus mechanized farming has made the cost of wheat go down considerably.

Other things like the cost of college in the United States have gone up enormously, even though there has been little in the way of technical changes or improvements in productivity.

Many people think that the way the CPI is calculated has changed over time and it underestimates the actual rate of inflation. Even if it is just a few percent per year, that can have enormous implications over time.

There is another index called the Producer Price Index or PPI, which measures costs of inputs for domestic companies.

Another way to measure inflation is to just look at the supply of money. The Federal Reserve in the United States has an index called M1 which counts all the physical currency plus money in checking accounts.

The Federal Reserve is the primary agency responsible for monetary policy in the United States. The main way they increase or decrease the money supply is through what is called open market operations.

The Fed owns a great deal of the federal government’s debt. If they want to increase the money supply, they can buy debt on the open market bringing the debt to the Fed and putting money out in circulation.

To decrease the money supply, they do the opposite, They sell bonds, taking money out of circulation.

Another tool they have is adjusting the reserve amount that banks have to hold. By increasing the reserve requirement, banks have to sit on more money, taking it out of circulation.

If you are wondering if you can have negative inflation, the answer is yes, and it’s called deflation, and that can also be bad for a whole host of other reasons I’ll address in a future episode.

Most economists think that the best approach is to have a small, predictable rate of annual inflation around 1-3%. However, given the magic of compound interest, even a 1% rate of inflation will cause prices to almost triple over the course of a century.

Inflation doesn’t have to reach Weimar Republic levels to cause problems. The United States had a peak inflation rate of almost 14% in 1980, and that made it one of the biggest economic issues at the time.

For most developed countries over the last 40 years, inflation hasn’t really been a problem. Central banks, for the most part, have learned the lessons of the past and have avoided high rates of inflation.

Nonetheless, no matter how long it has been kept in check, if history teaches us anything, inflation can always rear its head.