Why Inflation Prophecies for 2021 Are Plain Wrong
Ever since central banks started printing money without limits to support their economies in lockdown, the press has been unanimous about the consequences: there is going to be inflation, even maybe stagflation.
“Money loses value as it is being printed”, they tell us. “Look at what happened to Venezuela, look at what happened to Zimbabwe, or Germany in the 1920s. They printed money like crazy and the inflation killed the economy”.
The mainstream narrative likes to link money printing to inflation. However, as we are about to see in this article, while one may cause the other, it is in practice, rarely the case.
The First Cause of Inflation
Inflation can be caused in two different situations: the first case concerns a situation in which demand becomes superior to supply. The second concerns a devaluation of the currency in the context of international trade.
Let’s look at the first case with a basic example: the supply and demand for bread.
Let’s imagine a village in which a baker bakes 100 pieces of bread per day. Every day, he sells about 95 pieces of bread. One day, the government decides to print money and give it to people to buy bread. The baker becomes assaulted with customers and demand climbs to 150 pieces per day. However, the baker only has 100 to sell. What does he do then? He increases his prices.
Now, only people that have enough money can afford to buy bread. Consumption goes back to 95 pieces of bread but soon falls to 75 because it is too expensive, and the government stopped giving free money. The baker is not selling enough, so he decides to lower his prices. Bread is now cheaper to buy, so consumption goes back to the former level of 95 pieces per day.
Inflation arises when the consumption of goods is superior to demand.
This is the most important message of this article.
The reason why it is believed that printing money triggers inflation is that when people receive free money (which is usually printed), they usually go spend it on goods which increases demand, which increases prices. However, prices do not increase because the money has been printed, but because the money has been spent.
Let’s look at the same example, but with different variables. Let’s imagine that the baker bakes every day 200 pieces of bread but only sells 95 of them. The government gives people money, and the demand for bread rises to 150. Will the prices change? No. The baker will simply be making more money and has no reason to increase his price since he can sustain the new demand for bread.
Governmental printing did not trigger inflation, because demand remained inferior to supply.
Let’s have a look at a third example. The baker is making 100 pieces of bread per day and sells 95 daily. One day, people decide to withdraw their savings from the bank and go buy bread. The demand for bread spikes to 150, which the baker cannot meet, so he increases his prices.
When the demand for a good becomes superior to its supply level, prices increase. As we can see in this example, inflation happened without government printing anything.
Conclusion: inflation is a consequence of an increase in demand for goods and services compared to the available supply. As long as supply remains superior to demand, there should not be any inflation.
Should a good or a service increase in prices while its ratio supply/demand remains constant, this would outline the existence of a bubble that will eventually pop and realign correct prices for the good or service sold.
The Second Cause of Inflation
The second cause of inflation concerns the loss of value of a currency.
There are three ways with which a currency can lose value in the context of international trade.
When the American DOJ decides to prosecute anyone dealing with Iran, international buyers in the economy will stop buying from Iran which triggers a dive in the value of the Iranian rial since no one wants it anymore. When the demand for Iranian currency falls, Iranians will need to come up with more rials to buy international goods. This results in a spike in prices for goods bought outside of Iran.
Eg: Mister A, an Iranian businessman, buys medicines in Russia and sells them in Iran. To do so, he needs to exchange his rial against rubles to do business in Russia. Let’s say that 1 rial = 1 ruble. Mister A exchanges 10 rials for 10 rubles, buys the medicine, brings it back to Russia, and sells it for 15 rials.
When the Americans suddenly decide that no one can buy from Iran anymore, the rial loses value. 1 rial is now = 2 rubles. Now, Mister A needs to exchange 20 rials for 10 rubles to buy medicine. When he brings it back to Iran, he has to sell his medicine for 25 rials to make a profit, which is 10 rials more than the original price Iranians could buy the medicine at.
A loss of currency value due to sanctions triggers inflation.
2. Decrease in economic output
Let’s imagine that Saudi Arabia is the only country with oil. As long as the world needs the oil, businessmen will be eager to exchange their currency against Saudi riyal to buy oil and bring it home.
The riyal has value because it gives access to oil in Saudi Arabia.
Now, let’s imagine that the world decides to stop using oil and rely on another energy technology. Will the riyal keep its value? No, because there is nothing else but oil in Saudi Arabia, so no one will be interested to buy Saudi riyal to get oil since oil is no longer needed.
The principle is the same as the economic sanction principle. When an economy is not producing anything interesting, or when it is no longer allowed to buy goods from the economy, the currency loses value, which triggers inflation for goods and services purchased outside of the country.
Despite what is often said, it is the very poor economic output that bankrupted Zimbabwe and Venezuela, not its excessive money printing. In the case of Zimbabwe, when the government confiscated white farmers’ land to redistribute it, the amount of food produced collapsed, which spiked prices. Unaware that the printing of money does not make food magically appear, the government printed currency thinking that people would be able to buy food with that money.
However, there was no more food to buy. So inflation spiked.
3. Increase of value of other currencies/excessive exchange
When the US central bank prints money for the US government so that the government can spend it (it’s called a deficit), inflation should not arise as long as the government spends the money in its country’s economy and as long as demand remains inferior to supply.
However, if the US government exchanges its currency against another currency to buy international goods, excessive currency exchange will trigger inflation as it will simultaneously increase the value of the sought currency while decreasing the value of the original currency.
Let’s imagine that the US government exchanges every day $100 million against €90 million, and that the EU exchanges every day €90 million against $100 million. As long as the other variables don’t change, the price of each currency will remain equal. $1 for €0,90.
Now, let’s imagine that the US government decides it needs to buy more European goods, and prints money hoping to exchange dollars for €100 million instead of €90 million.
An increase in the volume of dollars exchanged will make the dollars lose value. Not because it has been printed, but because it has been exchanged. When the European central bank sees that the Americans are ready to give them more dollars to buy more euros, the dollar will lose value because there will be more dollars offered to be exchanged against euros, while the euro will gain value because the Americans will want it more than before.
As we can see, it is not merely the printing of dollars that has triggered inflation, but the increase of volume of currency exchanged.
Why Inflation’s Prophecies Are Flat Wrong
1. Inflation arises when demand is superior to supply. When demand is superior to supply, it usually means that agents in the economy are spending a lot of money, which means they are earning a lot of money, which means the economy is good.
NB: the case of inflation in Venezuela or Zimbabwe was not linked to the economy being dynamic and growing, but due to a collapse in production which led demand to be superior to supply because supply collapsed, not because demand increased. In developed economies, inflation is usually a case of superior demand.
2. Inflation arises when a currency loses value against another currency, which can happen in the context of economic sanctions, a collapse in production output, or excessive spending and currency exchange.
When we look at the situations we have outlined above, we realize that none of them apply to the current economic situation worldwide.
People don’t have more money to spend (which could trigger inflation,) but LESS money to spend as many lost their jobs.
Currencies won’t be losing value compared to one another, because all central banks have printed money at the same time, keeping the ratios of currency volume pretty much similar to what they were prior to printing.
The Case for Deflation
Rather than seeing inflation, I would argue that we are about to enter a deflationary period, for the following reasons:
1. People have less money to spend: when consumers spend less, prices decrease because demand falls.
2. People will spend differently: the few friends of mine that did not lose their jobs were happy to see their bank account growing during the pandemic, and won’t go back to a pre-pandemic level of spending since they realize most of that money was spent on useless goods and services.
3. The fall of rent prices: the age of the office is over. Many employees have already left city centers to relocate into smaller country-side towns which decreased rental prices in big cities. The surface of offices will shrink since they won’t be needed anymore, and these offices will most likely be transformed into housing, which will increase the supply of real estate in big cities, which will decrease prices even further.
But Where Has All The Printed Money Gone?
This is a valid question. Trillions have been printed. Where are they if not in a hike of prices?
The economic cycle is a circle. The baker spends money at the butcher which spends money at the tailor which spends money at the restaurant which spends money at the baker, and everything starts again.
One man’s salary is another man’s income.
When bars and restaurants were cut from access to the economic cycle, the state stepped in to give them an income.
Suddenly, the economic cycle looked like this: the baker spends money at the butcher which spends money at the tailor which…did not spend money at the restaurant, which spent money at the baker.
The cycle does not look so much like a cycle anymore but like a straight line…
Since the tailor did not spend any money at the restaurant, he finished the month with more money. As for the restaurant, he receives money printed by the state in order to survive.
In other words, what the tailor did not spend at the restaurant was printed by the state. As such, we could say that…
The money that was not spent on businesses that were closed is the money that was printed by the state.
The money printed by the state therefore ended up in the pockets of the people that should have spent that money on services and goods sold by businesses that were closed. They are the customers of the horeca sectors.
The big question, therefore, remains on what people will do with that money. Will they go back to the restaurant to spend it as soon as this is all over? Will they invest it? Or will they just keep it on their account?
A look at the different financial assets is telling.
Firstly, the stock market. In the US, the different indices are higher as I am writing this than they were before the pandemic started. However, the economy is in a much worse state which could let us guess that the stock market is overvalued.
In Europe, indices have recovered, but not at their all-time high.
Secondly, we can have a look at gold. Gold peaked in August, then plunged at the end of the year, at a level still much higher than it was in January 2021.
Finally, the last financial asset worth looking at is cryptocurrencies. Bitcoin and other litecoins have seen their values exploding since the beginning of fall 2020 as companies and institutional investors started pouring cash into them.
What does this mean?
It means that the businesses and consumers “at the end of the economic line” (supermarkets, Amazon, Netflix, Zoom, etc) saw a surge in cash that they couldn’t spend on the businesses that were closed. Faced with no other choice, they bought whatever there was to buy, in this case, financial assets.
When the government printed money to give it to restaurants, that money was spent on the baker all the way to the tailor, which, unable to spend it on restaurants, bought bitcoins, stocks, and gold, which fueled the growth of these assets since the beginning of the pandemic.
The Bottom Line
The mainstream narrative pretends that the trillions of printed cash would be spent in the economy and would trigger inflation.
That will not happen for several reasons. First, supply remains much bigger than demand. Second, demand is weak. Third, demand will remain weak. Fourth, currencies won’t lose value compared to other currencies since everyone printed at the same time. Fifth, the money printed ended up in financial assets, which has grown the price of stocks, gold, and bitcoin, instead of inflating prices of consumer goods and services.
In a way, we could argue that this matter concerns behavioral economics. The mainstream narrative believes that agents would spend the money they received in the economy, hence inflating prices.
However, they did not. They preferred spending it buying financial assets.
The consequence has been a spike in asset value instead of a spike in prices.
No inflation here.
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