Essay One – Inflation – Part One

Inflation, deflation, economic crisis and so on, getting to the bottom of meanings.

The background.

Not so long ago there was an exchange between me and Dr Sherry Jarrell about the meaning of inflation.  Dr Jarrell is, in every meaning of the words, a qualified economist so when I had the courage/stupidity/ignorance to query her views I could not have been more surprised to receive this:

You won’t reveal a lack of understanding of economics — there are co-existing opposing points of view on the topic – that’s why it made for an interesting discussion! (My italics)

This got me thinking.  If your author, who is reasonably well-read about many things especially protecting what little wealth he has, can miss such a fundamental point, then there must be a huge number of other people who, likewise, miss the point and, even more important, don’t even realise it!

Dr Sherry Jarrell
Dr Sherry Jarrell

Over the last few weeks Dr Jarrell has not only found time to debate with me, she, too, has realised that a more rigorous exploration of what many economic and financial terms mean has real value for readers of this Blog as well her own Blog.

Therefore I am delighted to welcome Sherry Jarrell to the team of authors.

These essays will attempt to distil clarity out of a number of basic economic ideas, starting with inflation. That seems to be a worry widely ‘predicted’ in the general media as well as elsewhere.

The essay is in the form of a debate format, albeit virtually.  We hope it is both informative and educational.  Please let us know by leaving a comment!


Paul starts:


First a huge ‘thank you’ for engaging with me over this.  You are a very busy person and your time is much appreciated.

Here are some definitions of inflation that I gathered from cyberspace:

  • (From your own Blog) Inflation occurs when the rate of growth of the money supply exceeds the level of real growth in the economy.
  • Inflation is an increase in the price of a basket of goods and services that is representative of the economy as a whole.
  • Inflation is an upward movement in the average level of prices.
  • Inflation means a sustained increase in the aggregate or general price level in an economy.
  • The overall general upward price movement of goods and services in an  economy, usually as measured by the Consumer Price Index and the Producer Price Index.
  • In economics, inflation is a rise in the general level of prices of goods and services in an economy over a period of time.
  • … define inflation as an increase in the amount of money and credit in relation to the supply of goods and services

So there we are, then.  That’s really clear!  Well to me, as clear as mud!

The challenge is that although all the above definitions appear to cluster around some common meaning (that economists presumably understand) it is of no real help to those of us that just want to monitor the things that matterInflation and then be able to make best decisions with a minimum of risk to our wealth.

Let’s take my own situation.  The bulk of my investments (personal assets and pension) are US Long-dated Treasuries because:

  • deflation seems to be a much greater risk
  • what other investments are as safe as the US Government and
  • securing a decent guaranteed income that remains for the next 25 years is an important plank to funding our old age. (I’m 65 this year.)

But excessive inflation (whatever that really means) and, worse still, hyperinflation (whatever that too means) are the big enemies of a fixed income, however wonderful the US of A is.

Let me turn to a portion from the last Client’s newsletter issued by the firm that manages my pension (a UK SIPP, self-invested personal pension):

All policy levers are related to the amount of credit in economies and the speed at which that credit circulates. The basic relationship is: more credit brings more prosperity but also a risk of inflation. So, last year’s rescues produced inflation stories.

This argument is superficially attractive, but only a small part of the picture.  More credit also means more debt. Debt has expanded to the point where it is close to unaffordable for many people.

The argument goes on to say that if consumers can’t consume more because of debt servicing and financial insecurity and that continues to ripple up the producer chain how on earth can demand start to overtake supply?

Karl Denninger, Market Ticker guy, has been saying that the real risk is a huge collapse in confidence.  Here’s just one example from many on his Blog.  He says, The recession is not “easing”, it is DEEPENING.”

Well deepening means heading towards deflation, doesn’t it


Sherry replies:


Okay. Let’s begin with a primer on the facts about economic relationships then move on to opinions about what may happen and how one might protect their wealth.

Fact:when the rate of money growth is faster than the rate of real underlying economic growth of an economy, that economy will experience inflation, but only over the longer term (two to three years). In the short run, an increase in the money supply reduces short-term interest rates and increases interest-sensitive business and consumer demand.

But unless demand outstrips the ability of private production to keep up, inflation will not ensue.

What determines the real rate of productivity or growth in an economy?

Answer – Physical capital, labor (quality, experience), processes, managerial skill, lack of excessive fees and taxes on production from the government, and so forth …the liquidity represented by the money supply is the link between the real “chug-a-lug” economy and the monetary economy.

The engine of growth and prosperity in the economy is private industry – the combination of physical capital, labor,

Engine of growth?
Engine of growth?

and management — which is simplified and made more efficient with the liquidity provided by the money market.

The real economy can exist without a money supply, but money is meaningless without the real economy. We can’t eat money. So whether the conditions in an economy produce recession and deflation on the one hand, or growth and inflation on the other, depends on the “race” between the real economic growth capacity of an economy, and the growth rate of the Fed’s money supply.

The current level of economic output and the rate of economic growth is driven by supply (private business) and demand (public and private consumers). Supply is driven by the profit motive of companies. Demand depends critically on consumers and their confidence. If confidence is low, current growth is low, and any particular rate of money growth is more likely to outstrip real growth, producing inflation.

At any particular time in the economy, most any relation between the money growth rate and real growth rate is possible. Recall that, in the short run, an increase in the money supply lowers interest rates and expands the economy. In the long run, that same money supply expansion will raise the fear of inflation which increases interest rates, dampens real growth, and contracts the economy.

Which scenario do we see in the near future?

Well, given the expansion of the Fed’s balance sheet from bailing out AIG and others, and the difficulty they will have in getting those assets off their balance sheets, we may experience a significance increase in the U.S. money supply over the next several months and years, increasing the risk of inflation.

Lenders suffer in inflationary periods because they get paid back in dollars with lower purchasing power: the prices of goods have increased and the paid-back dollars buy less. Borrowers benefit because they make interest and principle payments in deflated dollars, increasing purchasing power.

As usual, the change in the price of a good or service, even the interest cost of borrowing and lending with its unpredictable inflation component, has winners and losers with an essentially negligible effect on the overall health and well-being of the market.

Part Two continues tomorrow. Comments most welcome.


2 thoughts on “Essay One – Inflation – Part One

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