Where is the inflation?

In the past 6 years the Fed has created more than 4 trillion new dollars. Many were expecting a burst of inflation and then were surprised by its absence. This was a false alarm; in fact this amount of new money entering the market isn’t a new phenomenon at all. Since the 1971 cancellation of the Bretton Woods system and the 1968 Gold Reserve Requirements Elimination Act, the US economy has created almost 56.5 trillion dollars. These were created in the shape of new debt as money is typically created as debt instruments. Furthermore, in the past 20 years, more than 40 trillion dollars were created: a rate of 2 trillion dollars per year. Yet since mid-2010 the creation totaled 6.3 trillion dollars around 1.5 trillion dollars a year little lower than the past 20 year average rate.

Source: Federal Reserve Economic Data – FRED – Federal Reserve Bank of St. Louis

So per the new and old money creation the question looms: where is the inflation? How can such a massive increase in the money supply not result in a classical big inflation -i.e. an increase in prices all across the consumer market, as opposed to only asset prices?
First, it’s worth mentioning that though no huge inflation occurred, the dollar lost almost 90% of its value in this period of 50 years.

Source: Federal Reserve Economic Data – FRED – Federal Reserve Bank of St. Louis

Still, how did it drop 90% in 50 years and not 90% in a decade?

The answer breaks down into a few parts.

First, the US was able to avoid high inflation by exporting some of its inflationary pressure to China and other developing markets, replacing US labor with cheap Chinese and other labor. This outsourcing used about $10 trillion of this new money and made sure that the labor cost stayed low. In fact the income of the bottom 40% of Americans didn’t even catch up with the official inflation numbers, and median household income in 2014 hasn’t changed (in inflation-adjusted numbers) in the past 25 years. Compare this to GDP per capita which grew 200%, the S&P 500 which jumped 400% in inflation-adjusted terms and Wall Street bonuses which jumped 2500%.

Second, we do not have full data on real inflation rates since the official CPI (price index) does not reflect reality because of the way it is calculated. In the words of the Bureau of Labor and Statistics, “CPI’s objective is to calculate the change in the amount consumers need to spend to maintain a constant level of satisfaction.” (http://www.bls.gov/cpi/cpiqa.htm ) This is a startling admission that the CPI isn’t an accurate tool to measure objective changes in pricing but rather a subjective “level of satisfaction.”

But the most important and significant element is far more hidden. In a system with a limited amount of money, growth in productivity would cause prices to drop and living standards to rise. The same amount of money is chasing more products: a reverse picture of inflation. Such was the case during most of the 1800s, excluding the Civil War years. On average, between 1815 and 1895, prices went down 4% annuallyi. Meanwhile, annual per capita GDP went up around 1.5% a year, spelling a threefold increase in per capita GDP between 1820 and 1900ii. So while prices were dropping sharply, output was skyrocketing – a combination that yielded an important improvement in most Americans’ standard of living.

In the last thirty years the world experienced an historic shift: the Digital Revolution. This extraordinary technological milestone brought huge improvements in productivity, so much so that we cannot even imagine running the world today without computers and the Internet. Yet prices for the most part did not go down. On the contrary, prices kept climbing. How can this be? Where did all this productivity growth go?

The simple answer is that money creation consumed this price reduction. All the productivity gains, which should have translated into society-wide improvements in living standards, were instead eaten up by the flood of newly-created money. Money creation produced inflationary pressure that pushed prices back up. Instead of lower prices and a higher standard of living for all people, the government got away with printing more money and the financial sector got away with taking on more leverage. Hence, for all intents and purposes, our vast productivity gains were struck by a mammoth hidden tax, similar to inflation, yet even more subtle.

The fact that CPI increased by “only” an official average of 2.5% a year is not a result of some sort of miraculous new reality where unlimited money creation has no inflationary consequences. The reality is much bleaker than this fantasy. It was due to the Digital Revolution that such a super stealthy tax—an unthinkably huge seizure of resources and a transfer of purchasing power from the masses to the few—could have occurred while producing a “reasonable” official rate of inflation.

The table below compares the real GDP per capita (per person) growth in four periods of 25 years each.

PeriodGDP Per Capita GrowthInflationComments
1825-184924.80%- 10.80%Gold and silver money
1850-187436.71%- 23.10%The three years of the Civil War and greenbacks- excluded
1875-189952.67%- 29.60%The classic gold standard era
1989-201342.15%+78.50%The fiat money era

Source: Inflation: Federal Reserve of Minneapolis. GDP: The Maddison Project

This table clearly proves the above point. In the 25 years between 1875 and 1900, per capita growth dwarfed even that of the height of the past 25 years (52.7% vs. 42%). Yet prices simultaneously dropped by almost 30%. By contrast, prices increased by almost 80% between 1989 and 2013. If not for the fiat money era’s constant increase of the money supply, we could have enjoyed the same economic bounty as in previous times of technological progress. The above table also disproves a commonly accepted “truth” of the fiat money era, namely that money creation and inflation lead to growth while price drops are indicators of depression and contraction. This fallacy mixes steady price drops due to productivity improvement with sharp price drops as a result of quick disappearance of demand created by financial bubbles.

As times goes by, the Digital Revolution’s productivity growth will slow and with it also its deflationary contribution. Slowly too, the cost of Chinese and other outsourced labor will increase as the world economy becomes more and more global in nature. Thus through time, the constant money creation which shows no sign of tapering and in fact cannot stop, will result in growing inflationary pressures. With the Fed locked and committed to a zero interest rate policy due to the huge Federal and other debt, it will be interesting to see if and what monetary policy would be applied. Or perhaps the term coined by Mr. Bernanke “positive inflation” will be extended to include not only 2% a year but perhaps 6% a year. After all, eroding inflation is a very effective tool to reduce debt levels and tax imaginary capital gains.

The writer is the author of the book “A Brief History of Money- How We Got Here and What’s Next” available also in eBook at Apple-iBook and Amazon-Kindle

i Federal Reserve Bank of Minnesota, consumer price index 1800 http://www.minneapolisfed.org/community_education/teacher/calc/hist1800.cfm
ii Maddison Angus, The World Economy Historical Statistics, Pg. 247
Plus, Economic History Association http://eh.net/encyclopedia/a-history-of-the-standard-of-living-in-the-united-states

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