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Macro Minute: Week of October 9, 2023

Hello Macro Minute readers!

I have been asked about the topic of inflation. A reader sent a very thoughtful email about all different aspects of inflation, and I thought that the best way to address them would be to do a series of writings about its different aspects. Bear with me on the length of these, because they will be longer than normal.  I don’t plan on releasing one every week as that could get monotonous, and I want to keep the Macro Minute topical and short most of the time with these deeper thoughts sprinkled in. I will also link to the previous writings in the series in future installments so someone can easily find the references.

What is inflation?  The rate of increase of prices over a given time. Another definition is the loss of purchasing power (how much you can buy with your money) over time. Milton Friedman, the famous University of Chicago economist, describes it as: “Inflation is caused by too much money chasing after too few goods.”  All of these definitions point to one thing- over time, we can buy less with the same amount of money. I can remember as a teenager getting paid $100 at a summer job. I knew I could fill up my truck (1980’s Chevy Luv that was way too small for me) for $20 and take out, my now wife, Lori, anywhere we wanted to go. Now a days, if our family of five can go out to eat and only spend $100 I feel good about it. Same thing about filling up the vehicle, and I always laugh at the gas pumps that cut off at $75. We all have experienced that, in general, the cost of goods and services go up over time.

But why is it that a dollar today is worth less than a dollar years ago?

Throughout history humans have established different forms of money to help with the transaction of goods and services. Early civilizations would barter, then a common currency would be developed. Eventually, coins would be adopted and produced by governments. Historically, these currencies would be backed by some hard asset, most commonly gold. Gold made a great backing because of its steady supply and how it has limited industrial uses.

There are problems with the use of a gold backed currency though. The most glaring problems arise when governments need to stimulate the economy out of economic malaise or fund military action to defend its sovereignty. Governments didn’t want to hear that they couldn’t do this or that because they didn’t have enough tax receipts. You can see why a nation would not want to be beholden to a hard currency and because of that, hard money policy was abandoned. Countries no longer have those constraints on the amount of currency that can be created. Now if a government creates a lot of currency to fund its excess spending, it creates inflation; too much money chasing after too few goods.

It’s important to remember that governments have different rules than households when it comes to its ability to pay its obligations. If a household doesn’t earn enough income to pay for its liabilities, it eventually goes bankrupt.  A nation, especially if it is the reserve currency of the world, always has the ability to pay its obligations by creating more of its currency. This is how countries create inflation, they create more currency to pay for its obligations than they take in from taxes. This can be offset for a while through other circumstances in global trade and productivity gains, but eventually, this will end with either inflation, higher interest rates, or weaker currency compared to other nations.

This has played out in many emerging market countries, probably most famously in Zimbabwe. Zimbabwe’s dollar was roughly the same as a US dollar in the 1980’s. By 2009, a US five dollar bill was the same as $100 trillion Zimbabwean dollars. They had the saying, “Where money for projects has not been found, we will print it.”  This is an extreme case and a non-reserve currency, but you can see how things can spiral when a country just creates currency out of thin air without the resources to back it.

In the United States, the deficit currently sits at $26 trillion and is growing annually. The way to think about this is that the US has for years spent more than it has taken in and has to carry that debt and interest cost. The US deficit is measured against the US GDP to provide a basis of which to judge how much it is spending relative to how much it is producing. The Congressional Budget Office (CBO) provides data on this and projections for the next 10 years. It projects that these deficits will be around for the foreseeable future. The CBO predicts the deficit to be 5.3% of GDP in 2023 and rising to 6.9% of GDP in 2033.

I am making no comment on whether the deficit is good or bad. I don’t see how my opinion matters at all, I just factor it in that we have one and it is projected to grow into the future. This should continue to add stimulus into the economy as the US government liability (more money in the economic system) is actually the public sector’s asset. In the years to come this could prove to make inflation more persistent.

I think this is a good place to end the first installment. This should give a basis from which we can begin to think about how we can combat it in our savings and investments. In the next installment, we will dig into how inflation eats away at our savings over time.


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