Inflation, an open air robbery
A few weeks ago, the world’s most important financial power announced a shockingly high statistic : 7,7%.
This figure, as innocent as it may seem, represents the inflation rate that the United States is experiencing for the current year. This is a colossal number, especially for the Western world’s flagship currency.
We are dealing with the highest annual inflation rate in 40 years (in 1981, the country had a record 10.35%), but what about the impact? Who is responsible? What are the solutions and their limits?
In this article I will try to answer these questions, but I would like to make it clear that I do not have a degree or certification in this field, I am simply trying to express my observations in the most relevant and factual way possible.
A silent and unequal war
Have you ever noticed that your usual groceries cost significantly more? If so, you are among the vast majority of people who experience inflation on a daily basis.
Indeed, this effect tends to be greatly increased if you are used to buying so-called “basic” or essential products. In France, the average price of pasta has increased by 15% compared to the previous year in 2022, that of flour +10.93%, that of oil +9.98%, etc. while the inflation announced by the relative calculation of the average basket of goods by INSEE was 4.8%.
In other words, inflation is individual. No two people have the same basket of goods at the end of the year. This is one of the reasons why real inflation is not equivalent to what the measurement institutes are willing to announce. Not to mention the fact that this makes the phenomenon deeply unequal, since the goods mentioned above are among the most consumed by those with a low income.
In other words, inflation affects the poor first.
In addition to this effect, inflation is structurally unequal for the simple reason that the share of income spent on necessities by low-income households increases drastically, while the share of income spent on necessities by higher-income households increases slightly.
If you did not understand this last sentence, I will try to explain it to you by using a telling example:
Let’s imagine a situation in which two households go shopping, in two different years, with inflation approximately equal to 10% for their respective baskets of goods.
Couple 1 has a low income (2000 euros / month for both of them) and is forced to spend 45% of its income on basic necessities (900 euros / month).
Couple 2 has a comfortable income (10,000 euros / month for two) and spends as much on necessities as the first couple (900 euros / month), or 9% of their total income.
Now, what happens when inflation is taken into account in the equation?
Couple 1 now spends 990 euros / month, or 49.5% of their income
Couple 2 spends the same amount (990 euros, or 9.9%), but the impact on their lifestyle is not the same: the first couple has seen its purchasing power decrease by 4.5%, while couple 2 has seen a decrease of only 0.9%. In other words, inflation is not calculated in proportion to income.
If inflation were considered a tax, it would be one of the most unequal taxes in existence.
Unfortunately, this is not the only unequal effect that inflation can have. Indeed, inflation is induced, as explained below, by excessive money creation.
As the financial markets are the first beneficiaries of this creation (see article on the link between the bond market and interest rate), it is quite logical that stocks also increase in value, as we saw after the March 2020 crash. Central banks come to the rescue of an economy that only relies on growth as it is fueled by ever increasing loans.
These rescue actions then boost the markets, which has the direct consequence of drastically increasing the value of shares held for the most part by people with significant wealth: the gap widens.
In other words, in addition to making the poor poorer than they were, the inflation caused by money creation has the effect of making the rich even richer.
Those who are lucky enough to have enough income to own wealth benefit, while those who are not so lucky merely suffer the effects.
Then, who causes inflation?
Now that you understand the profoundly unequal nature of inflation, what about those responsible?
In a word, it is the central banks, but you are beginning to understand that nothing is ever that simple in economics.
Indeed, it is the central banks that have monetary sovereignty and are responsible for creating it.
In the rest of this paragraph, I will only talk about the ex-nihilo creation of money by commercial banks, since this represents the overwhelming majority of the total mass in circulation.
In this case, national central banks (Fed, BoE, BoJ, etc.) or supra-national central banks (ECB) have the exclusive power of money creation. However, this monetary creation is in most cases indirect. In fact, it goes through the commercial banks to take place.
The central banks choose to practice a monetary policy according to the economic situation through the key lending rates. In other words, the CBs define and impose on commercial banks a minimum rate to which individuals must submit in order to take out a loan, which results in injecting more or less money into the economy.
This accounting operation is simply a matter of supply and demand:
The lower the rates, the more loan applicants there will be (households, companies, etc.) and conversely, the higher they are, the more the quantity of loans contracted will be reduced and consequently the money creation will decrease.
However, make no mistake, each CB does not have the same objective and therefore does not serve the same interests for the attached entity. For example, the Fed’s objective is full employment and growth in the US.
This is why they are very reluctant to pursue inflationary monetary policies. In more common language, one would tend to say that they do not hesitate to use “money printing” to achieve their growth objective.
On the other hand, for the European Union, there are a few lines on this subject, dating from 1997 (Treaty of Amsterdam). Article 127 states: “The primary objective of the European Central Bank (ECB) shall be to maintain price stability […] by keeping nominal inflation at around 2% per annum”.
This is where the singular difference lies between the CB across the Atlantic and the one we know in Europe. This is due in particular to the omniscient character of the dollar compared to the euro, since trade around the world is still largely dominated by Uncle Sam’s currency.
The dollar does not necessarily need to be the strongest currency, since growth is ensured by liberal fiscal policies that facilitate economic expansion, with little social action.
Inflation also makes U.S. products more competitive internationally, which also explains the Fed’s positions on this issue over the past decade.
Despite these advantages of inflation, it seems that some of its negative effects have been underestimated. Indeed, inflation, although it may be attractive because of the semblance of growth and recovery it offers, always ends up paying for itself in one way or another.
After being in debt by more than 460 billion euros in only two years, France has seen its tax revenues increase drastically. In fact, we are talking about a 27% increase in tax revenues in the last year alone. We have known 63 billion euros of annual tax revenue against 79 billion currently.
This is a figure that must be correlated with the sanitary crisis, but which is not irrelevant in comparison with the increase of the public debt, and consequently of inflation.
Among these revenues, one in particular stands out for its profitability: VAT (+17.6% profitability over one year).
Once again, it is possible to find an unequal character in it, since VAT is the same for all, but only variable according to the product (normal rate: 20%, intermediate: 10%, reduced: 5.5% and special: 2.1% for certain products).
It is also possible to correlate the boost in profitability of this tax with the increase in the price of gasoline that France has experienced in recent months.
Debt costs, and inflation is only a symptom of an economy that has already asked too much from the borrowing markets.
What solutions exist and what are their limitations?
To fight inflation, there are several solutions, or more precisely several ways to approach the problem. I will therefore try to illustrate some of them while remaining objective and consequently to show their limits as well.
In this spirit, we can use the instruments available to the state to practice fiscal policies that are favorable to deflation.
Let us be more concrete: what is inflation?
It is simply a sustained increase in prices, due to too much demand and too little supply, most of the time due to a money supply growing too fast.
The state can therefore limit demand while fighting against the lack of supply. This is more commonly known as a fiscal austerity policy. The state decides to freeze its spending and consequently to voluntarily reduce the purchasing power of its citizens, by limiting the number of civil servants, by freezing salaries, etc. This is a particularly effective solution, but it is not a solution that can be applied to all countries.
This is a particularly effective solution, but one that is economically painful for the most precarious households. We have an example in French history with Mitterrand during his mandate in 1981, who had an austerity policy from March 1983 when inflation at the time became unmanageable.
This anecdote is rather ironic since he was the first president of the Fifth Republic to belong to a socialist party.
Let’s get back to the point: the austerity policy is effective, but its purpose is to increase inequalities, since those who receive aid do not see their social benefits increase, on the contrary.
Moreover, since the state’s revenues are largely bailed out by VAT, which is itself increased when demand increases, the accounting operation may not be so profitable after all.
However, this is not the only way to fight inflation in a sustainable way. It is also possible to use deflationary monetary policies for this purpose; this includes raising interest rates, but not only.
The CB can also have recourse to an increase in reserve requirements, in order to limit the loans granted by banks to economic actors.
Indeed, when a bank decides to lend money to a household or a company, it must have a minimum amount required to ensure a part of the loan in fiduciary money.
Today, when a European bank lends money to its clients, it must have 2% of the amount of the loan in cash, i.e. 2,000 euros for a loan of 100,000 euros for example. This ratio is defined by the CBs and inevitably affects the supply and demand of money, which has a direct impact on money creation, and therefore on inflation.
This monetary policy will also have the consequence of reducing the granting of loans and therefore the money supply in circulation.
Inflation can then decrease.
The last monetary policy that the CB can practice is simply to limit the volume of loans granted by commercial banks: in other words, to cut the evil at the root. This is part of the so-called “unconventional” monetary policies, which are rarely used in the world we know.
On the other hand, the State can intervene deeply in the markets, notably by practicing an ultra-competitive fiscal policy (dissolving monopolies and oligopolies, boosting the competitiveness of companies, etc.) in order to multiply the presence of players on the markets so that prices are pulled down.
In my opinion, there is no real limit to this type of policy, since competition is always favourable to capitalism and economic development through innovation, but this practice has the disadvantage of being effective only in the long term.
Finally, the policy that the state can practice and that would imply even greater intervention is simply to freeze prices on certain products, and to condemn companies that do not respect these measures. This measure was the key word of many socialist candidates’ programs during the French presidential campaign of 2022.
What can we conclude in the end ?
To conclude, I think it is important to understand that inflation is not a trivial issue, and that it is even important for the economic future of the country we live in.
The two are intrinsically linked, and the fate of those countries that are no longer able to get rid of this scourge should serve as an example for us (Turkey, Venezuela, Argentina, etc.)
Will we repeat once again the mistakes of history?
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