Inflation is a term lightly thrown around by media, economists, and analysts. The lack of understanding of how money is created, and where inflation and deflation come from causes a lot of confusion. Let’s set the record straight.

Recessions

First, I have to briefly mention recessions, as they are directly related to inflation. Recessions are primarily a result of demand and supply mismatch (Say’s law). If everyone got what they needed to conduct productive economic activity at a reasonable price, and if skills across households were matched to produce desired goods and services sufficiently, we would not have recessions. However, every now and then, typically in congruence with the business cycle, the economy falls in and out of sync, causing boom and busts.

Inflation

When we observe recessions, we usually see something else: inflation. Why do recessions coincide with inflationary periods (peaks)? Well, if households and businesses cannot obtain desired goods and services at a reasonable price, they bid up the things they need. This causes a chain effect across many economic activities, creating inflation.

• A simple example: pick a reason why there might be a shortage of tyres, causing their price to rise. Garages then pass on the higher cost to consumers. Some consumers might delay changing tyres, while the rest will be forced to pay a higher price for them, leaving less household income left over. Those consumers might then skip a weekly meal at a restaurant, leading to lower revenue for the them, and so on. Some consumers will perhaps drive less, and use public transport in winter because they weren't willing to pay for adequate winter tyres. One can see the ripple effects when markets get inefficient. The economy is made up of millions of those transactions, and in aggregate, they accelerate or decelerate an economy.

To no surprise, we see that every typical recession was preceded by a rise in inflation - i.e. a rise in inefficiency.

US CPI (%)

Inflation can be demand or supply-side-driven, or both.

Supply-side driven: a lack of flexibility to changes in demand, tastes and disruptions in the efficient delivery of goods and services to households is the major cause of inflation.

Demand-side driven: usually as a result of excessive private credit and/or public deficit creation - i.e. real money creation. Excessive private sector money printing doesn’t have to, but typically causes inflation, particularly when money creation directly targets consumerism (helicopter money), such as direct checks to households.

During Covid19 for example, we had both. So, despite the secular deflationary forces of an ageing population, (tech) innovation and the perfection of supply chains brought about by globalisation, shutting down economies while handing out stimulus checks to people has been one of the most reckless policies since a long time.

In essence, inflation (and by extension recessions) is caused by poor allocation of resources and at times, poorly allocated government spending. Changing demographics and labour force dynamics are often a cause of imbalances and at the root of many larger inflationary surges.

Meanwhile, monetary policy has almost nothing to do with it. At times, a misaligned neutral policy rate may exacerbate inefficient investments; and cause a mal-allocation of resources to goods and services that are not actually needed. This can contribute to inflation, albeit to a much lesser extent than many other factors, as evidenced by the 2010-2020 period of ultra-low rates and QE, when there was no meaningful inflation in sight.

Mainstream economists have it all wrong when they claim that fiscal policy sets real rates, and monetary policy should be used to deal with inflation – a myth that dates back many centuries. It’s the exact opposite. Like with most of modern macroeconomics, very little of it makes sense in the real world. Many mainstream economists (still) seem to believe central banks create real-world money. When the first principles are wrong - no matter how elegant the mathematical formulas and theories on top of it are - every subsequent analysis becomes rather pointless.

Debasement

Debasement is another thing. While inflation has to do with day-to-day consumer goods and services i.e. the well-functioning of governments and the economy, debasement is about the price of investment assets. Debasement is mainly caused by (1) excessive money creation (financial and private sector) and to a lesser extent by (2) the lack of overall growth in the economy.

(1) Excessive money creation: Currencies are the denominator of every asset. It’s very simple: if the value of the denominator decreases, whatever asset you then denominate in that currency goes up, ceteris paribus. This gives us long-term price charts that are rather meaningless.

• We can demonstrate this on many long-term charts. Here is just one of these painful examples: A bushel of wheat in US Dollars - one of the most abundant agricultural resources on the planet.

• Either you believe the order of magnitude efficiency gains in fertilisers, agri-tech and gene-tech have not happened and because of population growth alone the wheat price increased from c. $150 to $550 since 1970 in a near perfectly competitive industry, or there is something very wrong with the denominator.

One of the causes of debasement is the central and commercial banks' purchasing of assets. They mostly buy government bonds and MBS, causing an increase in financial money (reserves) supply, leading to asset debasement. This money is however not anything the private sector can use, and it does not cause inflation. The other major cause of debasement is money printing for the private sector. Private sector money is created via bank credit. (see the article: the origin of real economy money)

(2) Lack of growth: If growth slows, the value of money decreases. In this case, money produces less income and capital gains. Applying a mutliple on lower income gets you a lower valuation. Let’s use an extreme example and say you earn a 10% yield on your money. Your money will be worth a multiple of those 10%. If you’re only able to earn a yield of 1% on your money, that money is worth a lot less, i.e. your money is debased.

Conclusion

The difference between inflation and debasement is that debasement comes from any new money creation – from the central bank buying assets and the government creating deficits and banks monetising it, whereas inflation stems from a myraid of reasons, including excessive private sector money creation (demand) that is primarily used for consumption purposes and as well as inefficiencies in the supply of goods and services in the economy. Inflation is largely offset by demographic decline and an increase in the efficiency (globalisation) of the economy. QE does not lead to inflation. The debasement of currency mostly affects investment asset prices, while the first-order effect of inflation is in goods and services.

The problem lies herein: almost every financial analyst looks at asset price charts in terms of a currency. However, if that money debases say between 1-8% in any given year, what good are those long-term price charts? In further publications, I will explore with you ways to more accurately measure the value of assets over time.