Is inflation truly caused by "government money printing?"
Well, at the margins, it certainly could be. If the government added five zeros to all of our bank accounts, we wouldn't all suddenly be millionaires. If prices didn't adjust, the first people to realize the change would run out and strip the shelves bare. There would be shortages, and eventually prices would have to rise to keep the supply of goods in balance with people's spending power.
But does that explain inflation in the real world outside of academic textbooks?
If inflation really were caused by "too much money" what would we expect to see?
Well, we would expect to see a clear and unambiguous correlation between the growth on the money supply and a rise in the general price level. Further, we would be able to establish such a correlation. So, for example, for every 5 percent growth in the money supply, we might expect to see a 1 percent increase in prices (or whatever). We would also expect this relation to more or less hold in every country around the world and across time.
From this, we could determine exactly how much "excess" money there was and bring down prices almost immediately.
We would also be able to illustrate a clear, causal mechanism between the rise in prices and the increase in the money supply. Recall that it is the amount of money—not rising wages—that is the cause of inflation in the pop theory.
We would face a similar task with interest rates. If interest rate hikes truly did cause inflation to cease, then we would be able to determine a relationship. So, for every 1 percent hike in interest rates, we would expect inflation to reduce by 0.25 percent, or something like that. Once again, this relation would have to more or less hold across time and in every country around the world.
To be truly scientific, there are other tools we would need to contend with. The most significant one is the relationship between correlation and causation. This is a fundamental feature of scientific thought. If two events occur, they are not necessarily related—for example, an expansion of the money supply and inflation.
There are numerous Web pages out there designed to help young, budding scientists understand this concept. For example:
Perhaps you’ve heard the statement “correlation does not imply causation.” This mantra tries to clear up a common misconception. It’s tempting to assume that when two variables are seen changing together, one change causes the other. But this isn’t necessarily the case.
Consider this example. A 2012 study found a strange correlation. The more chocolate a country consumes, the more Nobel Prize winners it produces. But wait before grabbing that candy bar. This correlation doesn’t necessarily mean that eating chocolate causes you to win a Nobel Prize.
There are a few reasons that variables might be correlated but not cause-effect-related. One possibility is a sneaky third variable.
Imagine you’re looking at data showing that people who eat more popsicles also have higher rates of skin cancer. Do popsicles cause skin cancer? It’s possible. But more likely possibilities exist. Maybe people in hot, sunny regions eat more popsicles to cool down. And people in those regions may get more sun exposure than those in cooler places. More direct sunlight might cause more sun-related skin cancers. In this case, sun exposure is the third variable causing the other two.
Scientists Say: Correlation and Causation (Science Explores)
This article has a number of good examples of correlations that turned out to be spurious, including this one:
Storks do not deliver babies. That bit of German folklore likely originated because the white stork’s migration rituals last nine months. (Plus, Hans Christian Andersen helped popularize the myth in his short story “The Storks.”)
But that hasn’t stopped scientists from acknowledging a striking correlation: Between 1970 and 1985, the number of breeding pairs of white storks in Lower Saxony dropped. Over the same period, the birth rate there also fell. Meanwhile, stork numbers increased in Berlin’s suburbs, where doctors delivered more babies. As Robert Matthews writes in Teaching Statistics, “While storks may not deliver babies, unthinking interpretation of correlation ... can certainly deliver unreliable conclusions.”
10 Times Correlation Was Not Causation (Mental Floss)
A related fallacy is called post hoc ergo propter hoc. This is a Latin phrase meaning "after this, therefore, because of this." If one event occurs after another event, people often conclude that the first event must have caused the second event to occur. But this is a fallacy. They might be related. Or they might not. A common example is the rooster crowing just before sunrise every morning. We should hope nothing unfortunate happens to this rooster, or the sun many not come up tomorrow.
This particularly relevant to interest rates. If interest rates increase, and inflation comes down, can we confidently conclude that interest rates caused inflation to come down? After all, prices cannot increase forever. They have to stop rising at some point. How can we be sure that interest rates are the cause and not something else?
To do so, we would need at least few things: a valid, causal mechanism; and, second, a clear, unambiguous relationship between the amount of interest rate hikes and the decrease in inflation. If we raise interest rates and inflation comes down almost immediately in one instance, and a year later in the next, we might question how closely the two are related. Imagine if you pushed a button and a light came on. Then you pushed the same button and the light came on again—ten minutes later. Maybe you might question the relationship?
Similarly, if we raise interest rates by 2 percent in one period and inflation comes down, while we had to raise it by 20 percent in the next instance, we may question whether the relationship is really that valid. Scientists typically do controlled experiments to determine this.
Again, these are some of the most basic, fundamental tools and habits of thought in science.
Why do we require these things? Because that's how science works! Science is a method of thought and a suite of tools for investigating the world. If we cannot do these things, that we have to question how much "science" is guiding our actions.
If this is not the case, then raising interest rates would be more akin to, say, a rain dance than any sort of science. Or, as I've said before, cargo cult behavior. It would be a ritual designed to mollify unseen forces we can't understand. This behavior is very common for the human animal, and has been observed by cultures all around the world since the Stone Age. It's a very common feature of human cognition, but it is not, in any way, "scientific."
To take the analogy further, sometimes these actions are done for self-serving reasons. If I can convince people that my enemies in the tribe are the cause of the lack of rain, then perhaps I can convince the rest of tribe to sacrifice them to appease the rain gods. This allows me to take advantage of the circumstances to get rid of my enemies and consolidate my power over the tribe. Then, when the rains come, I will be seen as a powerful figure and gain wealth and influence. No one will know that rains would have come anyway, regardless.
So, clearly, economists—being legitimate scientists—must have established a clear, unambiguous relationship between the money supply and inflation, right? One that holds across time and works for all countries around the world, regardless of the circumstances? And clearly we know just how much to raise the interest rate to tamp inflation down, and how soon it will affect prices. Right?
Right?
Ummm...
Some Questions
Now, I'm prepared to acknowledge that maybe there is evidence of all these things. If there is, I'd like to see it because, as far as I know, these relationships have not been definitively established.
Take some common examples: Japan, since the cratering of their real estate sector in the 1990s, steadily increased the supply of money for decades in order to jumpstart inflation and counteract deflation. Yet inflation didn't budge.
At the same time in the United States, the money supply rose steadily, both M1 and M2, after 2008. At the same time, there was no significant inflation for over a decade. Inflation stayed at or around the 2 percent target, despite a significant increase in the money supply. You would think this alone would be enough to question the narrative. But you'd be wrong. As economist Stephanie Kelton—one of the few dissenters—put it in an interview with the Financial Times:
First, this idea that deficits are inherently inflationary is pretty easily debunked, just by looking at the data. Japan has had large fiscal deficits, persistent deficits for the last three decades and, until Covid, no inflation to show for it. Clearly, you can have very large chronic deficits without an inflation problem.
Then look at the Clinton years. The federal government’s budget was in surplus for four years from 1998 to 2001, but inflation accelerated and ended up at 3 per cent. Then you had the period after the financial crisis, again large fiscal deficits in the US, QE, zero interest rates, and we couldn’t get core inflation up to 2 per cent. There’s no direct relationship between the size of the deficit and inflation.
Prices eventually rose in both countries, but only after the pandemic, when the world's supply chains were shut down, workers were forced to stay home, container ships backed up at ports, fuel prices rose, factories shut down, and so forth. Gee, do think that this might be the "sneaky third variable" referred to in examples above of correlation and causation? Might these have had something to do with inflation?
Well, most economists didn’t think so. Instead, they blamed "government money printing." Big-brained economist Larry Summers insisted that it was the "irresponsible" thousand-dollar checks showered upon the little people who were forced to stay home that caused inflation, even four years later, and the media and massively online libertarians agreed. Summers’ solution? Unemployment needed to get up to at least ten percent (sadly, not starting with himself).
If we truly believe that "too much money" causes prices to rise, this should be easy to determine. We would be able to definitively correlate the expansion of the money supply with periods of high inflation. Furthermore, we would expect to see such inflation within a certain time frame (say, three months). We would also be able to determine how much prices will rise based on how fast and by how much the money supply is increasing. And we would see this relationship hold reliably across countries.
To do our due diligence, we would also have to determine in what direction the arrow of causality ran. If prices rise, it is logical that more money must be issued in order to pay the higher prices. This would obviously increase the money supply. This raises the possibility that the increase in the money supply may be the result of higher prices rather than the cause. To be truly scientific, we would have to eliminate this possibility.
Can economists do all this? To my knowledge, there has never been a study proving these correlations definitively, despite it being featured in all the economic textbooks. I am aware of one study invalidating it, however. Richard Vague looked at data from countries around the world and found no evidence of inflation following a rapid increase in the money supply. Nor were correlations found between government debt, spending, or central bank balance sheets. And, in many cases, inflation periods were accompanied by no increase at all in the money supply.
In our review of 47 countries, generally from 1960 forward, we found that more often than not high inflation does not follow rapid money supply growth, and in contrast to this, high inflation has occurred frequently when it has not been preceded by rapid money supply growth.
Rapid Money Supply Growth Does Not Cause Inflation (Evonomics)
A similar thing would be expected for interest rates. We would expect see a correlation between raising interest rates, the money supply, and inflation. Is that what we see?
Again, maybe there's a study proving this, but I haven't seen it. There have been attempts to invalidate it, however. Economist Blair Fix pulled the data for countries around the world from the World Bank database for the past several decades. When he plotted the data, he found that, in most cases, an increase in interest rates correlated with an increase in the money supply. Furthermore, higher interest rates were more often correlated with an increase in the rate of inflation, not a decrease. As I noted last time, countries with the highest inflation often have some of the highest interest rates as well.
Do High Interest Rates Reduce Inflation? A Test of Monetary Faith (Economics from the Top Down)
Interest Rates and Inflation: Knives Out (Economics from the Top Down)
What's going on here? Consider what would happen in literally any other scientific endeavor if scientists were presented with these data. What would they conclude? They would conclude that their stories don't hold up, that they would have to review their thinking, and that they would have look much closer and think deeper in order to understand the phenomena at hand rather than relying on intuition and making bold, sweeping claims, especially when people's lives and livelihoods are at stake.
Consider what happened in medicine when a study found a correlation between coffee drinking and pancreatic cancer:
Feinstein told me that he and his colleagues at Yale had analyzed the MacMahon study and found a number of biases that invalidated its conclusion. He criticized the use of a case-control study in studying such a prevalent practice as coffee drinking and its link to a specific cancer. He believed that the control population, even if some characteristics were well matched, was unlikely to be completely comparable in view of the dramatic differences among individuals.
He believed that a more rigorous study design such as a randomized controlled trial or a cohort study would have been preferable. He also concluded that such a major conclusion as the causation of pancreatic cancer by coffee drinking should not have been brought into such public prominence based on a single, imperfect study. And the lack of a compelling scientific mechanism by which coffee could be oncogenic weakened such epidemiologic evidence.
I suggested that he write up his findings concerning possible biases in the MacMahon study and send them to me at JAMA for peer review and possible publication, which is what he did. Peer review and an analysis of the paper by an expert in statistics were favorable, and it was published in JAMA. There was some wrangling between the two groups of epidemiologists, but when another study of the possible coffee/pancreatic cancer association was published in the New England Journal, and no such link was found, most observers agreed that the findings of the MacMahon study were not valid.
Unfortunately, there was no public coverage of the debate and its resolution, so most people continued to think that coffee drinking could cause pancreatic cancer. However, a survey indicated that in spite of the prevalent misconception, coffee consumption was not affected.
Post hoc ergo propter hoc (National Institutes of Health)
That's how you do science.
However, no such thing ever happens in the "science" of economics. As Steve Keen has pointed out, much of economic theory historically hasn't even considered money, banking and debt, only idealized exchanges taking place in frictionless markets between perfectly rational individuals documented in chalkboard graphs and hypothetical computer models. Neglecting a thorough and accurate understanding of inflation—one of the most pressing economic issues of our time—amounts to possibly the greatest single incidence of scientific malpractice in history.
Problem 2: Monetarism
Part of the explanation for the reluctance to accept the data is the adoption of "moneteraism" by economists due to the influence of Milton Friedman.
Monetarism is often misunderstood. It's not the idea that inflation is caused by an increase in the money supply. That idea had been broadly accepted by economists of all stripes for a long time, for better or worse, before Milton Friedman came along.
The classic example is the importation of silver from Bolivia into Spain causing a dramatic rise in prices during the 1600s and 1700s. This is used as an illustration of the dangers of increasing the money supply too quickly.
However, even this incident is hardly so cut-and-dry. During this same time period, Spain was also experiencing a population boom due to, among other things, the importation of New World crops like the potato. Of course, lots more people consuming a fixed supply of goods is going to cause prices to rise as well. What role did this play in inflation compared to other factors? Economics don't seem to care very much, and certainly don't show much interest in finding out—they've already found their truth.
Rather, monetarism is the argument that inflation is ONLY caused by an excess of money, summarized in the famous dictum that it is, "always and everywhere a monetary phenomenon." Monetarism argued that the ONLY role for government was to manage the money supply, and that the magic of the market would take care of the rest. Any other actions to bring down inflation, monetarists said, was "interference" and "counterproductive."
This should be contrasted with the economic thinking before monetarism. In those days, economists believed that inflation was a multivariate phenomenon which could be caused by any number of factors. The correct approach to bringing down inflation depended on ascertaining what the actual cause was. In other words, there were many different causes of inflation, and potentially many different remedies. In order to fight inflation effectively, then, you needed to know what was causing it. Excess money was just one possible cause, and perhaps not even the main one.
Critically, inflation wasn't seen as inherently bad if was caused by a strong economy and rising wages. If items were getting more expensive because people were getting paid more, that wasn't necessarily a bad thing. And people might be getting paid more because they were becoming more productive, in which case, throttling back the economy would cause more harm than benefit.
More importantly, when it came to raising interest rates, many economists thought that,"the cure was worse than the disease." Raising interest rates would cause economic hardship which might make inflation a better prospect than depressed business activity, more expensive mortgages, higher debt burdens, an overvalued currency, and mass unemployment. The thinking was that inflation in a thriving economy was better than the alternative—stagnation and recession.
All that thinking was swept away in the 1970s when both inflation and stagnation occurred at the same time. Monetarism was part of a whole suite of free-market fundamentalist policies backed by wealthy plutocrats which became collectively known as neoliberalism. Neoliberalism was a key part of the counterrevolution against Keynesianism and the State which has been ongoing since the 1970s with no signs of stopping. Much the above story is taken from the book The Economist's Hour by Binyamin Applebaum, a former New York Times reporter.
Many people believe that monetarism was somehow validated by the experience of the United States in the 1970s. Inflation was really high, so interest rates were raised and inflation came back down again. But that is to rewrite history. Rates were jacked up and up and up, and yet inflation continued to rise! In fact, interest rates were steadily increased by the Federal Reserve over the better part of a decade, with no significant decrease in inflation. It continued to increase to an eye-watering 17 percent, effectively destroying the American economy, before inflation finally cooled. To me that seems more like an invalidation of the theory rather than a confirmation of it. If you slam the brakes and your car comes to a halt ten minutes later by hitting a wall, you might question whether your brakes were really working at all.
Of course, other explanations might have been considered. You had a massive increase in military spending at the time due to the Vietnam war. Military spending tends to turbocharge economies. Lots more civilians and soldiers have jobs and incomes, however, most of what they're producing is shipped to the other side of the world and blown up (in this case), so there is no complimentary expansion of goods and services domestically to absorb the extra income. That is why war bonds were issued during World War Two—to soak up the excess money in the economy, not because the government needed to "borrow" money from it's own citizens in order to fight the war (plus, the population had just suffered the Great Depression, so they didn't have any). Government spending drove increased tax receipts, not taxation driving increased spending. Military spending during Vietnam, however, was accompanied by tax cuts, not tax increases.
You also had women flowing to the workforce for the first time in the post-War period. Women were earning their own incomes, not controlled by their husbands, and they wanted to spend those extra incomes. Since women lived at home with their families, those incomes didn't have to go for rent or food, unlike much of today's wages. All that extra spending surely must have put some pressure on prices.
And then you had the price of oil—the economy's most fundamental resource—basically triple in price during that decade. Massive amounts of money flowed to the oil producers of OPEC, especially in the Middle East. Since oil is an input in just about every economic process (shipping and transportation, if nothing else), prices must rise. The extra money to pay those higher prices had to come from somewhere, regardless of what the Fed did with interest rates.
Might those things have played a role as well? Well, if you're an economist, at least, you don't know and you don't care. Inflation is caused by an "overheated economy," or by "government money printing," full stop. End of story.
Never mind the fact that, despite raising interest rates for a decade, inflation stopped rising only when the Vietnam war ended, women were fully integrated into the workforce, and the price of oil came back down again due to the opening of new oil fields and a decline in the power of the OPEC cartel.
No, it must have been the interest rates!
Conclusion.
Like my rain-maker example above, the true explanation is probably more political than scientific. If the government is always responsible for inflation by "money printing," than the government must cut back, which is always the conclusion of any kind of economic reasoning regardless of the actual evidence. After all, evidence can always be manufactured and cherry-picked. Remember that this theory was promoted by Milton Friedman, a radical anti-government ideologue, for whom any kind of constraint on government's ability to spend would have been highly desirable, regardless of the circumstances. Since then, all of mainstream economics has effectively been captured by radical anti-government libertarian ideology.
Raising interest rates accomplishes two important things. First, it raises the incomes of the investor class, since their investments now command higher interest rates (which may be one reason why Fix found that the money supply often expands when interest rates rise).
Secondly, it also causes the economy to slow, preventing workers from pressing for higher wages. If too much employment causes prices to rise, then raising unemployment will bring them back down again, goes the theory. Conveniently, this is another highly desirable outcome from the point of view of the investor class. That's why the business press was in a near-panic over low unemployment rates in 2023:
Unexpectedly strong jobs report alarms media hoping for mass unemployment to kick in (BoingBoing)
Inconveniently for this theory, inflation has continued to decelerate even as the unemployment rate continues to hit all-time lows. Has this affected economic thinking one iota? Of course not!
Other remedies are not considered because they are less amenable to the ruling class. For example, if inflation truly were caused by "printing money," then taxes are a way of "unprinting money." Taxes aren't needed for revenue, at least not for a currency-issuing government, as has been known since the 1930s. Furthermore, unlike increasing interest rates, tax hikes can be specifically targeted to the instances where prices are rising, unlike the “blunt object” of interest rate hikes. But, unlike interest rate hikes, tax hikes don't benefit the ruling class, so they are not considered. We might also look at the power monopolies have to raise their prices, but once again, that would inconvenience the ruling class who own stock in those companies. So, instead we're told that interest rate hikes, unemployment and austerity are the only way to go.
Thus, we see that a lot of the stories we're told about inflation don't seem to square with the evidence. They do reinforce class power, however. Are we really doing "science" at all? And is there really any hard evidence that increasing interest rates is what has caused inflation to come down in the latest instance, rather than, say, supply chains opening up and companies no longer being able to hike prices anymore due to overstretched consumers?
James K. Galbraith, an economics professor and the son of John F. Kennedy economic advisor John Kenneth Galbraith, is one of the few dissenting voices. He is skeptical of the idea that interest rates are why inflation has come down. Rather than the rain dance or cargo cult analogies that I've used, he uses the analogy of medieval medicine, in which sickness was assumed to be caused by an imbalance in the four bodily humors:
Smialek admits that other factors were at work, noting that “higher interest rates didn’t heal supply chains.” She could have gone further, reminding readers that inflation peaked back in June 2022, only three months after the Fed started hiking interest rates. At that time, the Fed’s policy rate had risen just 75 basis points, and no one knew how much higher it might go. In fact, we have no evidence that monetary policy had any significant effect on the course taken by prices – certainly not before the June 2022 turning point, and not thereafter, either.
In modern medicine, a specific diagnosis normally leads to a specific treatment. But that is not the case in modern economics. Instead, the absence of an orderly sequence in the recent episode recalls the medieval approach to medicine, according to which all disease stemmed from an imbalance of the four bodily “humors.” And, as in pre-modern medicine, the treatment is always the same, regardless of the nature of the humoral imbalance. Medieval doctors drew blood; modern central bankers raise interest rates. The parallel is exact, because the thinking hasn’t changed.
In mainstream macroeconomics today, blood, phlegm, yellow bile, and black bile have been replaced by money, government spending, jobs, and expectations. While the few remaining monetarists blame “money printing,” fiscalists focus on budget deficits. Then there are the Phillips-curve holdovers, for whom a low unemployment rate must signal danger. Expectations theories cover the gaps left by the other three…
On December 18, 2023, Washington Post reporters Rachel Siegel and Jeff Stein wrote that “the economy is ending the year in a remarkably better position than almost anyone … in mainstream economics had predicted.” The reference to “mainstream” reminds us that there is an alternative, whose predictions, on this occasion, were more accurate. The Post writers explain the temporary factors that actually drove the 2021-22 quasi-inflation: energy shocks, supply-chain disruptions, housing. And then they venture a step closer to the forbidden line.
While still crediting the Fed, they also point to steps that the Biden administration took to address these specific problems. This is half right. White House policies – including sales from the strategic petroleum reserve and pressure on ports to stay open around the clock – were important. So were market forces and the simple passage of time. Fed policy had nothing to do with it.
Of course, conceding that much would be a step too far. It would mean that economics is moving from the age of bloodletting and incantations to one inspired by, say, Louis Pasteur (a pioneer of immunology) and Alexander Fleming (the discoverer of penicillin). If economics finally became a discipline in which specific diagnostics led to specific cures, the necromancers would have to go. We are not there yet, but perhaps that time will come.
Mainstream Economics’ Medieval Inflation Medicine (Project Syndicate)
If the mainstream story doesn't hold up, what are some alternative explanations? We'll take a look at those next time.
Money creation only causes inflation if a) the money is spent and b) aggregate supply is constrained e.g. by full employment. QE doesn't cause inflation even though it increases the money supply.
To see why, let's suppose you have a $100 investment portfolio with $10 in cash and $90 in stocks+bonds, then the government comes along and does QE (swapping bonds for newly-printed cash), and now you have $20 in cash and $80 in stocks+bonds. BUT you still want that original 10/90 allocation because that's the portfolio structure you had decided was best, so you immediately buy more stocks+bonds with the $10 cash you just got. Now imagine the entire world is one giant investment portfolio with a specific target allocation to the various asset classes, and it's obvious how increasing the supply of cash must also increase the dollar prices of "everything but cash". In this manner QE sends asset prices into the stratosphere, and indirectly turbo-charges financial activities like private-equity buyouts, without creating inflation in "consumer prices".
The pandemic-era measures did cause inflation because the government sent cash stimmy checks to average people who were quite likely to spend it, at the same time as supply was constrained by a multitude of factors: a tight labor market, WFH inefficiencies, rolling lockdowns including occasional huge ones in China, restricted international travel, direct effects of workers out sick, etc.
You are correct that increasing taxes is a means of fighting inflation, but there are many practical issues. Tax rises in and of themselves are very unpopular (much more so than rising interest rates), and the tax rises would have to be very regressive and applied to consumption rather than to the wealthy or to capital etc. A nationwide VAT which can be raised and lowered directly by the Fed would be effective, but is politically a non-starter.
Am enjoying this dive into economics though it's something I've never been interested in. Again and again it's shown that economists are living in another world.