What's Going On? - Part 2, Inflation

We all feel the bite of inflation when we buy anything nowadays.  It's pretty obvious that prices have risen rapidly over the past couple of years, but why?  There are several reasons, but first let's define what Inflation actually is.

In economic terms, inflation is defined as an increase in the supply of money.  When the Federal Reserve Bank, hereafter referred to as "the Fed", creates or "prints" money, it "inflates" the money supply.  The Fed also artificially sets interest rates, or the cost of money, very low and sometimes to zero in order to stimulate borrowing and spending.  The Fed does this when the economy dips into a deep recession in order to provide easy money to the government, banks, businesses, and individuals.  This easy money keeps everyone spending in order to support the economy and prevent it from falling further.

Some will remember the housing market crash, and subsequent financial crisis of 2008-2009.  This was directly caused by reckless Fed policies, namely low interest rates for too long, and reckless govt. policies, such as securitizing and backstopping billions in mortgage loans through the government subsidized financial corporations Fannie Mae and Freddie Mac.  In fact, both Republican and Democratic govts. coerced these institutions to provide mortgage loans to low and middle income families(remember the "ownership society"?), thereby forcing them to come up with a way to cover up the risk inherent in the loans they'd have to provide.  The politicians, with the help of the Fed, interfered in the market, and then it ultimately, and inevitably, fell apart - because it was all propped up by artificially low rates and govt. manipulation. Yes, the banks were at fault, too, because they made billions in risky loans due to greed(remember NINJA(No Income No Job) loans?).  The banks believed that they could get away with making lots of loans, including very risky ones, and then packaging them all up into supposed AAA-rated securities and selling them to investors, but the scheme only lasted until investors caught on to it, and then the collapse happened rather quickly, almost taking down the entire banking sector.

I only point out the 2008-2009 crisis to illustrate the problems that bad monetary and govt. economic policy can cause.  Case in point: the recent price inflation we're all experiencing.

The recent price inflation is due to 2 factors: 1)a shortage of supply, and 2)massive govt. borrowing and spending.

The supply shortage was caused by the shutdown and reduced activity of many businesses resulting in layoffs and less production.  When there is less "stuff" to buy, but the same amount of demand by consumers, prices of that stuff generally rise.  This was evident when one went to the store only to find they were out of many items, toilet paper being a prime, and somewhat bizarre, example.  People panicked due to the pandemic scare and went nuts buying everything they could get their hands on, and since not enough things were being produced, the prices went up.

If our govt. had stayed out of this mess, what would have happened is that an equilibrium would have eventually been reached wherein over time, about a year or so, demand would have fallen due to layoffs and people pulling back on spending, demand would have dropped, and prices would have fallen back to normal levels. There would have been some pain for a lot of folks, but it would have been temporary, plus unemployment and other benefits would have prevented folks from falling into poverty. Once the pandemic emergency ended, people would have gradually went back to work, production would have increased back to normal levels, and demand would have risen back to normal levels.  Prices therefore would not have risen much, if at all. 

Unfortunately, the govt. panicked as well, fearing a deep recession, so the politicians and President decided to stimulate the economy.  Of course, like they always do if there is even the slightest chance of a recession, the Fed lowered interest rates to near zero, which stimulated more borrowing and spending.  Then, the govt. borrowed unprecedented amounts of money and not only spent it, but also provided direct stimulus money to individuals and businesses to keep everything propped up.  I won't even go into the massive amounts of fraud in the stimulus programs which created a whole other mess of problems and distortions.

All this additional spending created excess demand, and with the already short supply of goods and services, prices went up. 

Unfortunately, in a market economy, unless there is another recession where demand falls and the govt. wisely gets out of the way and lets it play out, prices never go back down.  There is also a greed factor with prices, whereby once merchants have increased them, they really don't care to lower them even though production has returned to normal, as they enjoy the increased profits.