Why Government Leaders Are to Blame for High Inflation

The word inflation, pregnant with horror, has been in the headlines almost every day for the past year. Considering that the world economy has experienced its highest inflation rate in four decades, the attention has been warranted.

But should we really be terrified of inflation? What do we understand about the causes and effects of inflationary conditions?

This straightforward answer will explain inflation and its impact on the economy without any confusing or complicated jargon.

What Is Inflation?

A good technical definition of inflation is "a general increase in prices and fall in the purchasing value of money" (emphasis mine).

The second part about a loss of purchasing power is the key piece to the inflation puzzle. Inflation is not simply a rise in prices, which could be due to things like increased demand, reduced supply, or other normal economic factors. It is broadly a rise in all prices.

Milton Friedman, an economist who won the Nobel Prize for his work on inflation, viewed inflation as "anywhere and everywhere, always a monetary phenomenon." In other words, inflation is due to an excess growth of the money supply relative to the goods and services available in the economy. Although this "monetarist" view of inflation has to some degree fallen out of favor within the economics profession, the data still strongly supports Friedman's assertion.

Treasury Secretary Yellen recently apologized for being wrong about inflation.

On the margins, the level of interest rates and the health of supply chains can also drive inflation higher. However, the fact remains that there has never been a period of inflation that didn't coincide with a massive increase in the supply of money.

What Is the Economic Impact of Inflation?

Changes in interest rates or the money supply typically have an inflationary effect with a lag time of 9 months to 18 months. Inflation tends to creep up slowly, and then all at once.

The rate of inflation directly impacts manufacturers' expectations about future prices. It likewise influences what consumers expect to pay for products. So the key point here is for inflation to be consistent and predictable in order for the economy to run most efficiently. Otherwise, "surprise" inflation has pernicious effects on consumption, investment, and the orderly functioning of supply chains. This is why the U.S. Congress created a 2% annual inflation target for the Federal Reserve, the country's central bank.

Inflation has the worst impact on low-income families, who already spend a higher proportion of their money on basic necessities like food and housing. The ultra-wealthy tend to be insulated from the effects of inflation because the assets they own, such as stocks and real estate, also rise in price during an inflationary episode.

Such an unequal outcome is predicted by an economic principle known as the Cantillon Effect. This is why Friedman often insisted that inflation is a hidden tax that nobody got to vote on, given that decision-makers at central banks, such as the Fed, are unelected.

Finally, rampant inflation also has a habit of leading to heavy-handed responses from government policymakers. Not only do these actions invariably come too late—remember the lag time mentioned above—but they also can "make the cure worse than the disease," so to speak. We will discuss this more below.

Why Our Leaders Got Inflation So Wrong

Policymakers at the Fed, the European Central Bank (ECB), and other government bureaucracies were apparently caught off-guard entirely by the explosion in inflation in 2022. This dubious list includes Christine Lagarde, the head of the ECB and former managing director of the International Monetary Fund (IMF), as well as Janet Yellen, the Secretary of the Treasury in the United States and herself the former chair of the Federal Reserve.

Rising inflation has become a problem multiple times in the past century.

Similarly, the current Fed chief, Jerome Powell, incorrectly characterized the current bout of inflation as "transitory." Powell later admitted that Fed members were "still learning" about the phenomenon of inflation. This is despite decades of academic literature about inflation, in addition to numerous historical examples.

In point of fact, an eventual rise in inflation was all but inevitable. Central banks kept interest rates near zero (or in some cases even used negative interest rates) for nearly a decade following the global financial crisis. At some point, this policy was always going to end in high inflation. Trillions of dollars in emergency spending by governments during the covid pandemic added fuel to the fire.

Sadly, plenty of thought leaders in economics and government have since tried to spin higher inflation as actually a good thing. (It does make the national debt easier to pay off, after all.) This flip-flopping and lack of accountability significantly erodes confidence in our leadership. Overall it causes more social upheaval.

Even worse, the shift in policy to respond to high inflation—rapidly raising interest rates—is going to have its own negative effects. As rates quickly climb, lower growth in the economy and higher unemployment are largely unavoidable consequences. Raising interest rates by itself is a rather blunt tool with which to manage the economy. Without a thoughtful change in fiscal policy (i.e. government spending), the "cure" will indeed be no better than the disease of inflation itself.

For more information about how gold interacts with the current economic environment, follow the links below.

Read more about precious metals and the economy from the expert authors at Gainesville Coins:

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