Why Inflation Isn’t What You’ve Been Told and Why That Matters

Learn why government policy causes inflation, not corporate greed, where money and wealth come from, and why life feels harder each passing year.

Inflation has often been in the news post-COVID, and with good reason. The price of nearly everything, especially food and housing, has been increasing “faster than normal”, causing difficult choices for many.

Finding ways to grow your wealth faster than inflation is critical for your financial well-being. So, understanding the true nature of inflation is essential to making wise financial decisions.

Greedflation

The most popular explanation for the sudden price increases is that COVID-related supply-chain issues and lockdowns, plus the war in Ukraine, led to widespread shortages and disruptions, driving up prices, which greedy corporations then took advantage of to raise prices further, creating “record and excessive” profits (source, source, source).

A paper published by IPPR in late 2023 bolstered this theory by estimating that “excess” corporate profits represented 25%–42% of inflation in 2022—if only companies weren’t so greedy, prices would have been lower. But when do rising profits become excessive (and thus too greedy)? Isn’t that simply a value judgment or motivated reasoning (imagining a convenient explanation for a result we dislike)?

For example, consider anyone who sold their house or used car during 2022–2023 (at substantially higher than pre-pandemic prices). Should they bear the blame for inflation? If only people weren’t so greedy, housing prices would have been lower. People act in their self-interest, as they should. They will sell their house for whatever price they can get. So, what if companies are simply doing the same—setting their prices based on demand feedback from the market? What if rising prices are the result, not the cause, of what’s happening in the economy? Haven’t corporations always acted primarily in the interest of their bottom line? Even if we accept their claim of corporate greed, 50%–75% of inflation is still unaccounted for. What’s it caused by then?

The biggest problem with the corporate greed story is that it doesn’t make sense looking at the big picture. Assuming we have a fixed amount of money to spend, and food and housing suddenly cost 20% more, we’d spend less elsewhere—we’d have to make sacrifices or trade-offs. Not all companies can price gouge us at the same time. Our spending pattern would change but not grow. But this isn’t what’s happening—disposable income and personal consumption jumped significantly and are higher than ever (data, data).

As improbable as it sounds, the only way all businesses could raise their prices simultaneously and still have customers is if we actually have more money to spend. That is the magic of the free-market system—prices will naturally rise or fall to the level the market can bear. We don’t have to predict or calculate what prices should be—supply and demand dynamics are a self-correcting feedback mechanism when things are mispriced.

Now that the pandemic-related issues have passed, why haven’t prices returned to pre-pandemic levels as competition and supply chains return to normal? Prices have undoubtedly levelled off, but they’re not falling. Something broader and more systematic is happening that is not adequately explained by either the corporate greed story or the supply-chain issues of the pandemic.

For context, governments measure inflation by tracking the price of a basket of consumer products over time—this is called the Consumer Price Index (data):

Public Policy

At a starting point, it’s helpful to return to first principles and ask why prices increase (on average) year after year. Our first clue is that governments want and like perpetually increasing prices, as stated clearly as public policy:

“Federal Reserve policymakers target an inflation rate of 2 percent.” —US Federal Reserve

“The target aims to keep total CPI inflation at the 2 per cent midpoint of a target range of 1 to 3 per cent over the medium term” —Bank of Canada

But there’s no fundamental reason why prices must always go up. For example, most countries experienced no inflation during 1815–1915. So why would central banks want to cause inflation? The standard justification is that if prices were to decrease regularly, you and everyone else would be more likely to defer or delay purchases until later when prices are lower. The result would be that we’d save more and spend less, and economic activity would drop—cue financial Armageddon!

As such, ever-increasing prices (preferably slowly) are apparently the more desirable environment because they “encourage” people to buy more stuff now. Somehow, it’s not enough for us to purchase what we want or need—we need an incentive to consume more. Stable prices, which I suspect are what most people would prefer, aren’t sufficient for the central bank’s purposes—they want increasing prices. So by their logic, spending and consumption (using things up) is “good” (at least for the economy), and saving and investing for later (delaying gratification) is “bad”—and people wonder why we have an increasingly consumerist/disposable society.

Also, notice that those who want or expect prices to return to pre-pandemic levels will be sorely disappointed. Central banks want lower inflation (prices increasing less quickly) but not lower prices. Central banks have repeatedly said they will do everything possible to avoid price deflation. Prices will never return to “normal”—endlessly rising prices are the goal. The one unintended consequence of this prices-must-always-go-up policy is that sometimes prices rise too quickly, hence the challenging economic situation we find ourselves in post-pandemic.

What is Money?

To understand the mechanics of inflation and how central banks control it, we first need to understand money and where it comes from.

Imagine we lived in a society that had no money or currency. I grow apples, and you produce oranges. You want to acquire some of my apples. I can take oranges in exchange or some form of IOU that I can redeem later—maybe to obtain corn from you when it’s in season. The weakness of this style of barter system is that it doesn’t scale—one-to-one IOUs are very limiting because you don’t always want to exchange goods and services with the same group of people.

Thus, money is just a better form of IOU. It gives us a portable, durable, divisible way to store unspent economic value (energy) we’ve earned until later.

The concept of money also lets us have prices denominated in absolute rather than relative terms. For example, the cost of a car is described as 50,000 units of currency rather than 1,500 bushels of apples or one-tenth of a house.

Money is an arbitrary token that we have agreed to represent stored wealth. This token has no utility value other than what it can be traded for. For as long as people have traded, money has naturally emerged to facilitate it—seashells, glass beads, gold, silver, cigarettes, canned mackerel, etc. Anything can be money, so long as there is consensus.

Money as a Unit of Measure

As a thought experiment, imagine that we collectively have one trillion dollars of unspent wealth stored in our bank accounts. Next, suppose I have a money printing press in my basement that I use to counterfeit bills worth one trillion dollars (thus doubling the money supply). What will happen when I spend my new “money”? It will compete with everybody else’s money for the same goods and services. I have not created any new wealth—there are still the same number of things of value to buy as yesterday. I have simply doubled the number of tokens that can be used to claim those things of value. In effect, I have made the previously existing money much less valuable and transferred (or redistributed) some of that buying power to me. This process is just Economics 101—supply (the number of things of value) versus demand (the amount of money available to claim those things).

Similarly, suppose I counterfeit and generously distribute one trillion dollars to each person in the country. In that case, we’d all have more zeroes on our account balances, but none of us would be wealthier. Creating more money does not create more wealth—just ask the people of Zimbabwe, Argentina, or Venezuela. Money is a unit of measure, and changing the unit of measure does not change the thing being measured (wealth) any more than shrinking the size of an inch makes you any taller.

This effect is the essence of inflation. When the number of dollars in circulation increases (inflates), we make each previous dollar less valuable, which in turn causes pressure on prices to rise to compensate.

The terminology for these concepts is monetary inflation (an increasing money supply—the original meaning of inflation) and price inflation (increasing prices—the modern meaning of inflation).

The Meaning of Price

A price represents a ratio between two values: (1) the inherent value of a thing and (2) the inherent value of the currency we use to transact. Both values can vary over time. For example, the inherent value of something can change due to supply or demand (e.g. lettuce→drought, toilet paper→panic, gasoline→production costs, Beanie Babies→fad). The inherent value of the currency can also change over time—as evidenced by the daily fluctuations in exchange rates between countries’ currencies (e.g. the Canadian Dollar has declined 25% in value compared to the US Dollar between 2013 and 2023).

What we think of as price inflation (the price of everything increasing year after year) is how we notice the value of our currency decreasing. Things (usually) aren’t becoming more expensive to create—your money is becoming less valuable. Price inflation results from monetary inflation (increasing the money supply). This process is the exact mechanism central banks use to manage inflation.

“Inflation is always and everywhere a monetary phenomenon.”, “in the sense that [price inflation] is and can be produced only by a more rapid increase in the quantity of money than in output.” —Milton Friedman

Will increasing the money supply always lead to rising prices? Not necessarily—it depends on the rate of monetary inflation. For example, if the total supply of goods and services (things we create) increases at the same pace as the money supply, we’d expect prices to be flat (on average). Suppose the total supply of things of value increases faster (e.g. productivity improves) than the money supply. In that case, we’d expect prices to decrease. Notice that this logically desirable goal (making things and life cheaper) is one that central banks will not tolerate, as their stated goal is to prevent falling prices.

A simple truth we frequently ignore is that technology and innovation dramatically improve and increase our productivity—we get substantially more things of value with significantly less human energy. Automation, digitization, specialization, and cheap energy are the reasons for the explosion of abundance over the past 100 years. Technological advancement should naturally cause prices to fall, which would benefit our standard of living. Imagine what would happen if we could harvest unlimited energy from the sun at zero cost—wouldn’t that lead to a golden age of abundance? Why must falling prices be bad? Perhaps the reason prices are falling (or rising) is more important than whether they’re falling (or rising). But since prices (nearly universally) have been increasing, not decreasing, we must conclude that the money supply has been inflating even faster than these technological deflationary pressures.

Creation of Money

So where does money come from? How do central banks manage the money supply? No, it’s not as simple as the money machine goes brrr, although that amusing meme is more accurate than you’d hope.

In a fractional-reserve, fiat (meaning by decree) money system, as we use nearly everywhere, money is created via new debt. For example, when you go to the bank for a mortgage, they don’t borrow the funds from another client’s account, pay them some interest rate, give you their money, charge you a higher interest rate, and pocket the difference. No, banks effectively “conjure” the money for your mortgage into existence. In the US, reserve requirements for banks used to be 10:1 or 33:1 for the ratio of borrowers’ liabilities versus savers’ assets, but as of 2020, it’s now ∞:1—welcome to no reserve banking! Surprisingly, Canada hasn’t had reserve requirements since 1992. Banks can give out as many loans as they see fit.

Creating new money on demand is possible because our banking system is just zeros and ones in a spreadsheet. Banks loaning out more money than they hold tends to turn out fine during healthy economic periods. But in a financial crisis, banks can go bankrupt when an “unexpected” number of borrowers default on their loans (or many people try to withdraw their money all at once). Banks are leveraged (i.e. they loan out more money than they have), making them highly profitable and potentially fragile.

How do central banks play into this? They set interest rates (which individual banks tend to follow)—lower interest rates mean more consumer borrowing, more money created via new debt, more devaluing of existing dollars, and more pressure on prices to go up.

And Even More Debt

So, if societal wealth increases as we create things of value, and the money supply increases as people borrow, where does it all go wrong? Individuals and businesses aren’t the only ones borrowing. All levels of government borrow too, and at an ever-increasing rate (US data, Canadian data) that dwarfs consumer and business borrowing more than 3:1 (data, data, data). Here is the historical trend of government overspending (a deficit is the amount overspent in a given year, and the debt is the total amount owed).

Whereas people borrow from banks, governments borrow from people and banks (or other governments)—they sell treasuries on which they pay interest. The problem is when interest rates are low because central banks want to encourage consumer borrowing, and people are less inclined to buy government treasuries because the yields are so low. Then what? It turns out that Central Banks will buy the government debt if no one else will. How? They print (i.e. conjure) the money on demand, just like regular banks do for consumers, to ensure that governments can always borrow and thus remain solvent. So, in effect, governments can choose to spend infinitely (ignoring the pretend drama over the US debt ceiling) because the central bank, as the lender of last resort, is always there to finance (buy) their debt.

Central banks creating new money to buy government debt should remind you of the counterfeiting-in-my-basement example from above—because it is. Money printing (regardless of the euphemism they use: aggressive monetary policy, quantitative easing, debt monetization, providing liquidity) is mechanistically the same as counterfeiting—it is new money created from nothing (i.e. monetary inflation). OK for the government, not OK for you and me.

COVID Recession?

During the early stages of COVID, economic activity decreased significantly due to the lockdowns, business closures, layoffs, supply-chain disruptions, and the billions of dollars spent on the healthcare system. Why didn’t we have a severe recession (at least by official GDP measures)? Because governments intervened—they printed enough money (handed out enough “stimulus” cheques to individuals and businesses) to compensate for this lost economic activity (i.e. they borrowed from the future to drive consumption in the present). All this emergency spending is evident in the money supply (M2) (US data, Canadian data), which measures the amount of cash in circulation and bank accounts.

During 2020–2022, governments everywhere ran record deficits. The US Federal Reserve more than doubled its balance sheet (i.e. the amount of government debt they own because no one else will) from $2.5 trillion to $5+ trillion (data). The Bank of Canada did similarly, increasing its balance sheet from $110 billion to $550+ billion (data). This debt creation is pure monetary inflation—billions or trillions of new money printed by central banks to finance the enormous COVID-induced deficits—and why we’re seeing so much price inflation. The cost of steak didn’t go up 20%—the value of the currency we’re using to buy the steak went down 20% because of monetary inflation. Rising prices are the result of inflation, not the cause.

Instead of a recession, the government chose inflation (even if it didn’t mean to). We each paid for COVID by forfeiting 20%–30% of our wealth (salary/savings) via an inflation “tax”.

Money printing to pay for government deficits is the illusion of something for nothing. But it can’t be so. Otherwise, why wouldn’t they do much more of it? The answer should be obvious: government don’t and can’t create wealth. Wealth comes from productive businesses creating things people want—governments merely redistribute it.

Measuring Price Inflation

Why does it feel more challenging to keep up with life every year? Why could a single wage-earner provide for a whole family decades ago, whereas now two full-time wage-earners struggle to make ends meet?

Despite how it feels, the average inflation-adjusted hourly wage in the US has been roughly flat over the past 50 years, as have housing prices (ignoring the 2005 and 2021 spikes). So, it makes no sense that people should be struggling. Our standard of living since 1960 should be essentially the same unless the consumer price index (CPI)) does not measure what we think it does.

Indeed, governments have been tinkering with how they choose to calculate inflation since the 1980s. The justification in the US was that politicians believed at the time that CPI overstated inflation and would result in substantial budgetary problems because many government programs (e.g. social security) are linked to CPI. So, they went looking for a rationalization to “reduce” reported inflation (so they could pay people less)—and found it they did.

The trick was that CPI in the 1980s measured a fixed basket of goods and services. So, the argument was, what if people’s preferences change over time? For example, what if people buy chicken rather than steak because they believe it’s healthier? If steak prices rise faster than chicken, then weighting them equally in inflation calculations would not reflect people’s actual costs, which is a fair point. The devious part is, what if people switch from steak to ground beef, not because they prefer it, but because they can’t afford it? Voluntary and involuntary behaviour changes are not (and cannot be) distinguished.

As a result, rather than a fixed basket of goods, we now measure an ever-changing basket based on what people are actually buying. CPI is calculated as the price change between last year’s basket of goods versus this year’s basket of goods. This disconnect is why CPI feels unmoored from your daily reality—because it completely discounts lifestyle sacrifices.

CPI is now better considered a what-you’re-paying-to-live index, not a consumer price index. Your standard of living may be declining, but that’s irrelevant and not factored into CPI calculations.

Using the original methodology for calculating CPI, inflation has probably been understated by 3%–6% annually since the 1980s. We tend to think of the 1970s as having high inflation, but if we compare using the same methodology, the COVID-related US inflation rate peak is probably higher (17% in 2021 versus 15% in the late 70s). Living with 4%–9% price inflation per year (rather than the advertised 1%–3%) for the past 30 years would explain why things seem much harder. Have your salary and savings kept pace with this higher rate of inflation?

Income Redistribution

So, if we accept that monetary inflation (money printing) is not wealth creation but wealth redistribution, is it still a problem? Isn’t that the purpose of government?

Politicians of all stripes have fallen into the lazy habit of trying to “buy our votes”—people seem to prefer politicians who promise them the most “free” stuff (e.g. subsidized daycare/healthcare/dental care/pharmacare, universal basic income, lower taxes, tax deductions). Politicians have two avenues for paying for increased spending: raising taxes or running a deficit. Raising taxes is currently politically “challenging”, so they naturally avoid it. Yet taxes disproportionately affect the wealthy, so raising taxes would be the more logical solution—take from those who have the most. Unfortunately for the average person, the rich hold significant influence (both politically and with the ability to vote with their feet), so instead, politicians take the easy way out and run deficits.

This perpetual deficit strategy is problematic because deficit spending is inflationary (as I detailed above), and inflation primarily harms those with the least. Consider the most significant difference between the wealthy and poor—the rich own assets (i.e. investments), the poor do not (data), and instead live paycheque to paycheque or on social assistance. The value of assets typically increases as fast as (or faster than) CPI. Therefore, the wealthy are largely unaffected by inflation. Meanwhile, lower-income people are clearly at the mercy of inflation because they rely on government assistance that tracks inflation rates purposely underreported for decades. Thus, the more price inflation we have, the more the gap between the wealthy and the poor grows.

For example, here is a sample of the relative change in US prices and costs during COVID (from Jan 2020 to Jan 2023). Notice the disparity between the things that affect the rich versus the poor.

“By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens. By this method they not only confiscate, but they confiscate arbitrarily; and, while the process impoverishes many, it actually enriches some.” —John Maynard Keynes

Conclusion

Corporate profits are not the problem—prices and profits will take care of themselves if we allow free markets to do what they do best. If people don’t have the money to buy something, they won’t. Natural market forces will lead companies to lower prices or sell less stuff. Price controls are not the solution—they will worsen the problem. Without the huge government deficits and monetary inflation, prices would risen temporarily during COVID due to the supply-chain issues and the Ukraine war, but then returned to baseline afterwards.

The permanent rise in prices is due to government policy. If we don’t want rising prices, we must stop inflating the money supply (making our money less valuable) via enormous government spending and borrowing.

I believe that perpetual government deficit spending is deceitful and immoral—unless your country is under attack, run a balanced budget. Have the guts to have a principled debate about the hard choices between new program spending, existing program spending, and raising taxes. The desire for more government programs is natural, but deficit spending is a lie. At best, it is borrowing (taking) from the future (and our children and grandchildren). At worst, it is borrowing (taking) from everyone now (via inflation). There’s no such thing as something for nothing—not for individuals or governments.

Taxes primarily take from the wealthy, whereas inflation primarily takes from the poor. Inflation (and thus deficit spending) is driving the growing wealth gap. Adding more and more government debt to fund more programs is not the solution—it is the problem.

“There are no solutions, only trade-offs.” —Thomas Sowell

At the individual level, if you want to beat inflation, you need to invest some of your income so you’re spending less than you earn and growing your wealth. You need to own growth assets that increase in value faster than the inflation rate and benefit from compound interest. The endless spigot of “free” government money can’t last forever. When it does end, those who are financially self-sufficient will be the ones who thrive.

Key Points

• Inflation is the ongoing decrease of the purchasing power of your money caused by the money supply increasing faster than total wealth. Deflation is the opposite.
• The annualized inflation rate (CPI) has likely been understated by 3%–6% for decades.
• If you want to increase your wealth, you must outpace inflation—you need to invest and own assets and can’t afford to settle for mediocre rates of return. Cash loses value every year, so you want to minimize how much you hold.
• Inflation is deliberate and purposeful and is caused by government policy—central banks are mandated to ensure rising prices.
• Inflation is a primary cause of the widening wealth gap between the wealthy and the poor.

Points to Ponder

• Are you saving all that you could be?
• Have you considered the rates of return of your investments? Could you be earning more?
• Will you have enough to retire (betting on the government to provide for your retirement may be risky)?
• Are the politicians you vote for improving or exacerbating this problem (probably the latter since most are on board the deficit spending train these days—either more programs or tax cuts)? Are they bribing you with your own money to get elected, or are they genuinely concerned about the long-term financial trade-offs of their policies?

Related Concepts

• Why Compound Interest Is the Secret to Growing Your Wealth
• Why Passively Managed, Low-Fee Index Funds Are Ideal Assets
• Why Aggressive Portfolios Are Usually Safer Than Conservative
• Why Dollar-Cost Averaging Outperforms Lump-Sum Investing

Recommended Reading

• The Changing World Order: Why Nations Succeed and Fail (Ray Dalio, 2021)
• The Price of Tomorrow: Why Deflation is the Key to an Abundant Future (Jeff Booth, 2020)
• The Bitcoin Standard: The Decentralized Alternative to Central Banking (Saifedean Ammous, 2018)
• Broken Money: Why Our Financial System is Failing Us and How We Can Make It Better (Lyn Alden, 2023)
• Hidden Repression: How the IMF and World Bank Sell Exploitation as Development (Alex Gladstein, 2023)
• Antifragile: Things That Gain from Disorder (Nassim Nicholas Taleb, 2014)

If you have comments, questions, or constructive feedback, you can contact us by email at questions@essentialsofinvesting.com.