With inflation reaching the highest rate in 40 years and a recession looming, what happened to the US economy to create this situation, and what can we expect of the future?
There are many theories about the causes of inflation. A very basic formula put forth by famed economist Milton Friedman posits that “Inflation is caused by too much money chasing after too few goods.” This article will use Friedman’s formula as a basic framework for looking at the current causes of inflation and then attempt to integrate economic perspectives from various schools of thought, including Modern Monetary Theory (MMT). MMT has risen to prominence recently but is at odds with the economic theory espoused by Friedman in many ways.
The cost of goods has been rising steadily since 1974 after the US formally switched from the gold standard to fiat currency in 1971. Fiat money has no physical commodity—such as gold or silver—tied to its value, which means the Federal Reserve (Fed) can create any amount of new money whenever it wants. Some schools of economic thought think that this is a problem, while others don’t.
The cost of goods and services has been on a consistent long-term rise which, according to Friedman’s model, would suggest that money production is outpacing the production of goods and services. However, the Fed has generally kept the rate of inflation within their stated goal of 2% annually and sometimes even undershot it. According to a conversation with MMT policy expert Spencer Veale, the thinking is that deflation is more risky to the economy than inflation, so some slight inflation can help to ensure stability.
Unfortunately, this 2022 inflation spike has surpassed 9%—the highest inflation since 1982.
Let’s dig into how it came about.
Increase in Money Supply
The Federal Reserve Created 33% More US Dollars
In June 2020, Forbes published an article titled “Inflation Baked In As U.S. Money Supply Explodes” which talked about how the available money supply had shot up by 33% in the last twelve months (the majority of that occurring between March and May 2020).
While the Forbes article argues that this means eventually 33% inflation is going to be inevitable, not everyone agrees, and there are certainly other factors to consider. For example, in 2008 the money supply also increased drastically, but this did not cause inflation. In fact, there was short term deflation. This is because the money was kept in bank reserves and wasn’t circulated in the economy. We can see this clearly when we compare the percent change in the reserves held by depository institutions after 2008, where it shot up by over 600% (first graph below), to the percent change in the supply of money circulating in the economy, which shot up by over 110% in 2020 (second graph below).
So the degree to which the newly created money translates into inflation in the economy depends on how much the new money is available to people and actually being spent.
Where did this new money supply go in 2020? The mechanism by which the Fed creates money is by buying treasury bonds and securities. In 2020 the Fed purchased $120 billion in bonds per month from March to December. The money from these bonds funded the multi-trillion dollar government stimulus package which sent money to individual households and provided Paycheck Protection Program loans for businesses in an attempt to avoid mass layoffs.
Thus, much of the increased money supply created by the Fed was put directly into the economy with the goal of keeping markets “flush with cash and chugging along.”
It is worth noting that the Fed had already begun pumping trillions into the economy in September 2019 in the form of repo loans, many months before the first case of Covid-19 was reported in the US. According to the Fed’s December meeting minutes, they planned to extend the money giveaway for Wall Street until April, 2020. As watchdog site, “Wall Street on Parade,” reports, it is unprecedented for the Fed to give out trillions in loans without any publicly announced crisis or discernable financial collapse and says there should have been a congressional investigation.
Federal Reserve Interest Rates
Money must be circulating in the economy—rather than simply held in reserves or savings—to facilitate demand and produce inflationary effects. One factor that plays a significant role in how much money is circulating in the economy is the Fed’s interest rate. The Fed’s interest rate affects the interest rates for taking out credit throughout the economy and is supposed to increase or decrease the amount of lending that is taking place. The Fed’s interest rate was set at almost zero from Spring 2020 until Spring 2022 to encourage borrowing and spending and stave off a recession. However, low interest rates can result in inflation as banks add more money to the economy in the form of credit. As the Fed is currently increasing interest rates to counteract inflation, it encourages people to save but can also increase unemployment and decrease productivity at a time when there are already worker shortages and not enough goods to meet demand in many sectors after the pandemic shut downs. In other words, if the problem is high demand and lack of supply, then raising interest rates is likely to decrease rather than increase supply, though it may also reduce demand. The Fed’s interest rates can have a far-reaching impact and may contribute to the looming global recession.
We’ll talk more about the Fed’s interest rate later on when looking at efforts to fight inflation.
Decrease in Goods and Labor
Going back to Friedman’s simple formula that “Inflation is caused by too much money chasing after too few goods,” there has been a sharp decrease in the amount of goods and labor available in the economy at the same time that there was an increase in the money supply. Let’s look at what happened.
In May 2020—after the first round of COVID shutdowns—the UN Department of Economic and Social Affairs projected cumulative global output losses of nearly $8.5 trillion, saying, “Lockdowns and the closing of national borders enforced by governments have paralyzed economic activities across the board, laying off millions of workers worldwide.”
Many North American automakers halted production for a period in 2020. More than a dozen US meat plants were shut down due to numerous workers falling ill with COVID-19. Worker shortages in service industries hindered their ability to operate at full capacity.
Overseas, factories in China halted production numerous times due to strict lockdowns, affecting the global supply of goods dramatically. The supply chain—which is how goods get from production location to point of sale—has been severely affected, impacting the speed and price of transporting goods.
Many businesses had to lay off workers during the pandemic, and even as the hospitality, service, and travel industries pick up again, there’s a struggle to find workers to meet the need.
Since the 1970s many companies have embraced the just-in-time supply chain model, which means fine-tuning the supply chain process so that the company can move materials right before they’re needed rather than storing large amounts of materials on hand. This saves money and is more efficient in many ways, but it provides little to no backups in case there’s a problem with the supply chain. Thus, many companies were not in a position to maintain production and adapt to the supply chain disruptions and material shortages of the COVID-19 pandemic.
Without a doubt, the unprecedented and sudden decrease in production, transportation, and labor availability due to shutdowns in response to the COVID-19 pandemic continues to impact the supply of goods and services available in the economy. In fact, even if the money supply hadn’t increased, the decrease in goods could have created some inflation.
Impact of Gas Prices
Inflation has not been uniform across all types of goods, and oil and gas have been some of the most impacted. The time lapse clip below shows the prices of various goods and the especially dramatic change in gas prices.
Not only is oil and gas crucial for heating, cooling, transportation, and running our electronic appliances and devices, petroleum is used for much more than just energy production. In the US, most plastic, rubber, and fabrics like acrylic, polyester, nylon, and spandex contain natural gas. Petroleum currently plays a crucial role in maintaining our global food supply as a key ingredient in synthetic fertilizer. Airline and public transportation prices are obviously affected, but behind the scenes oil and gas also plays a large role in the production and transportation of many goods, including for shipping online orders.
This article will not get in-depth into the causes of rising petroleum prices, but it’s clear that with our current demand for petroleum and the alternative sources we have available, a decreased supply of natural gas can have a far-reaching impact on the economy at large and contribute significantly to raising the costs of various goods and services.
Price Gouging and Windfall Profits
Some argue that corporations have used the opportunity provided by the pandemic to increase their prices beyond what is needed to cover their rising expenses, thereby raking in windfall profits and driving up inflation.
We’ve done a whole article digging into the greedflation hypothesis, and the answer is that there is some legitimate evidence for it, there is some counter evidence for it, and there is some evidence that has been misused and exaggerated. Check out our article, “The Greedflation Hypothesis—are corporations price gouging struggling Americans?” to judge the strength of the evidence for yourself.
Efforts to Fight Inflation
Raising interest rates
The Fed only has two tools to influence the economy. The first is quantitative easing—or creating money by buying government bonds or securities. The second is raising or lowering interest rates. Raising interest rates, as the Fed is now doing, is meant to slow the economy by making it more expensive to take out credit. It will likely result in higher unemployment and slowing of production.
Some think that raising interest rates is necessary because they believe there is too much money circulating too fast in the economy and this will help to slow spending and money creation.
Others think that raising interest rates is the wrong move right now since they see the decrease in available goods and labor and supply chain disruptions as driving forces behind inflation, and increasing interest rates would only slow production further.
The Inflation Reduction Act
Senator Joe Manchin (D-WV) says that the Inflation Reduction Act which passed in August 2022 will “address record inflation by paying down our national debt, lowering energy costs and lowering healthcare costs.”
However, the Penn Wharton Budget Model predicts that the Inflation Reduction Act would only reduce the cumulative national deficit by $248 billion, which is a drop in the bucket when the current debt is over $31 trillion. That said, adherents to Modern Monetary Theory see the federal debt as completely different from private debt, and posit that it is more like a ledger of record than debt, and therefore it is never necessary to repay it with taxes.
The Penn Wharton Budget Model finds that the Inflation Reduction Act’s impact on inflation is likely to slightly increase inflation until 2024 and then decrease inflation thereafter, but suggests low confidence that the legislation would ultimately have any impact on inflation.
The Big Picture
Are we in a Recession?
“By the time a recession is officially called, we’ll be either well into it or almost exiting.” —Josh Bivens, director of research at Economic Policy Institute.
The Biden Administration has been insisting that there is no recession, pointing to the 372,000 jobs added to the economy in June 2022 as well as high consumer spending and savings. However, as of October, Harvard’s COVID recovery tracker showed a 5% cumulative decrease in employment rates since January 2020, meaning many of those new jobs are probably jobs that came back after being shut down during the pandemic. Also, when adjusted for inflation, consumer spending started falling in May of 2022.
While a common definition of recession is two consecutive quarters of negative GDP growth—which has already happened in 2022—in the US, recessions are officially declared by a committee of eight economists from the National Bureau of Economic Research, and they have yet to declare one.
Whether we’ve already entered a recession or not, according to Bloomberg Economics model projections as of October 2022, a recession in the next 12 months is at 100% likelihood.
Government Spending and Debt
The graph above suggests that the US economy has been sustained by debt for many years—though MMT makes the distinction that this is public, rather than private debt, so it can be repaid by issuing more currency. One article explains that “without debt, there is little to no organic economic growth [in the US economy].” One example of this was the Fed buying $8.7 billion worth of Exchange Traded Funds in 2020 to provide liquidity for businesses and a buyer for traders who wanted to sell. This may also explain the massive loans that the Fed had started giving out in late 2019, before the Covid-19 pandemic.
Economist Michael Hudson posits that the introduction of fiat money and the US dollar’s establishment as the global reserve currency locked in America’s control of the world with our main export becoming treasury bonds/US dollars (USD). Under this understanding of the economy, national debt is just seen as a ledger of how much USD has been created, and we can infinitely create more as needed. Under this model, the US prints and exports dollars to import goods.
A more traditional take on government spending is that government spending can be so effective at increasing economic growth that it can pay for itself and more. However, a recent study from 2021 found that “government purchases likely reduce the size of the private sector as they increase the size of the government sector. On net, incomes grow, but privately produced incomes shrink.” That said, we should note that as of September 2022—after all the COVID stimulus packages—the number of small businesses open across the US had increased by 3.1% over the number opened in January 2020.
On the other hand, in agreement with the Mercatus Center study, a working paper from the Bank of Mexico also concluded that “an increase in government spending in a high-debt country may signal either difficulty of payment later or inflationary concerns, driven by an increase in the interest rate.”
As of today, the US government is nearly $31 trillion in debt, spending $3.95 trillion on the COVID-19 response alone. The question to consider for the future is whether the spending resulted in enough economic benefits to be worth the consequences.
Exporting Our Inflation
The majority of global trade takes place with US Dollars (USD) because the USD is the world reserve currency. This means the United States can export its inflation. Many countries also use USD as their national currency, and goods such as oil, gold, and silver are priced in USD. When the Fed increases the USD supply, it affects economies all around the world because their holdings of USD become less valuable. Being the world reserve currency is a powerful position, but is threatened if the Fed prints too much money to the point that other countries lose faith in the dollar and find alternative money to use, such as El Salvador making Bitcoin legal tender. In fact, Russia, China, and other BRICS nations have teamed up to start a new reserve currency which is a direct challenge to the US position as the sole global reserve currency.
Regarding the Fed’s ability to generate new money out of thin air, economist Saifedean Ammous contends that “a money that is easy to produce is no money at all, and easy money does not make a society richer; on the contrary, it makes it poorer by placing all its hard-earned wealth for sale in exchange for something easy to produce.”1
On the other hand, we spoke with MMT expert and Policy Director for Our Money, Spencer Veale, who explained that from an MMT perspective, “Money creation is a public function. It is as easy as typing numbers into a computer screen. Public institutions uphold the value of the currency so that it can continue to function. Money is an accounting system, a public infrastructure that facilitates economic activity much as roads and bridges facilitate transportation. The challenge is to hold our public money system accountable to the public interest, and ensure it is created on behalf of the public interest, in a responsible manner which maintains reasonable price stability.” However, he also had criticisms of the Fed’s approach in 2020.
We know for a fact that the Fed began providing billions in repo loans for Wall Street in late 2019 and that the US money supply increased by trillions in 2020. We also know that a good deal of production, shipping, and selling of goods and services was shut down at that same time, in response to the Covid-19 pandemic. We know that the availability of natural gas has been disrupted. According to many economists the increase in money supply and decrease in goods are classic factors that could contribute to inflation.
- Saifedean Ammous, “The Bitcoin Standard: The Decentralized Alternative to Central Banking”
Editors: Craig Carroll Peer Review Completed By 8 Individuals