The Great Inflation Debate - Who is Winning

Inflation is back (USA, EUROZONE)… On that, basically everybody agrees. However, an intense debate is currently raging about whether or not inflation is here to stay or whether it is just a temporary blip.

The position that inflation is high now but will soon return to its normal level is championed by team transitory. This team consists of heavy hitters such as U.S. treasury secretary Janet Yellen, ECB president Christine Lagarde, and Nobel prize winning economists Joseph Stiglitz (source1).

On the other side of the field, we have team persistent which beliefs that elevated levels of inflation are here to stay and might even increase in the near future. It is represented by prominent economists such as Larry Summers (source1, source2), central bankers like the ex-president of the German Bundesbank Jens Weidman (source1, ), and very very vocally by investors such as Peter Schiff.

But, who should you believe?

Hi, I am Joeri and to help you make sense of it all.

I will first go over the basics of inflation.

Then, I will summarize what might be causing it. And, then, for each cause, why team transitory & team permanent believe what they believe. What’s more, for each cause, myself and UK academic, YouTuber and well known rebel of the economics profession Unlearning Economics, will evaluate the evidence and also the case made by team transitory and team permanent.

2 Inflation Basics

Okay, let’s quickly review the basics.

Inflation is a simultaneous increase in ALL prices in the economy. So, this does not mean that all prices have gone up by the same magnitude. It just means that, on average, prices have gone up.

This sounds straightforward in theory. However, in practice, inflation is insanely difficult to measure.

After all, to measure average prices you would have to keep record of the size and price of each transaction in the economy.

In most economies, this is not possible since privacy laws prevent economists from going through your bank records. And even if they could, it is surprisingly difficult to determine what has been purchased just from bank records.

If you don’t believe me, just have a look at one of friends bank account statement from last month and try to figure out what they purchased.

To get around these problems, economists have constructed a basket of goods & services that is supposed to represent what a household spends on average.

This is the consumer price index or CPI for short.

For each good or service, the CPI basket not only consists of a price but also of a weight that reflects how much important this good or service is for households on average.

For example, since average households spend a lot on rent but not on supporting this channel via Patreon, an increase in rent prices will affect the CPI a lot whereas me increasing the prices of my Patreon tiers will not.

So, what are these weights?

Well, as you can see here (table1), in the USA and Europe weights are fairly similar. The bulk of household expenses go to housing costs as well as to food and transportation.

Notably though, us lazy Europeans spend quite a bit more on recreation.

However, when comparing inflation in Europe and the States one notable difference is the inclusion of house prices.

3 Housing Problem?

Controversially, neither the European nor the American CPI includes house prices directly,

I know, this sounds absolutely mad since house prices have gone through the roof in both areas…,

Importantly, house prices have risen much faster than rents, which are included in the CPI.

However, you can’t just include house prices in the CPI for two reasons.

The first is that a house is not just used for ‘consumption.’ It is also used as an investment.

and the dynamics of consumption and investment goods are very different.

Simply put you … as a consumer would not be very happy if the price of a consumption good like …. I don’t know graphics cards… goes up…

But, if you invested in, say, Gamestop stocks, and its price went through the roof you would be very very happy.

The second reason why you can’t just include house prices is that the price of a house is not the same as what it costs you. The main reason for this is that most people borrow to buy a house. For example, I just bought a house at a price that was much higher than my parents did.

However, I borrowed at close to a 1% interest rate while my parents borrowed at 8%. You’d have to take that into account in the CPI.

To deal with these problems, in 1983, the Americans added a new category to the CPI called owner’s equivalent rent. Owner’s equivalent rent gets around these problems by just asking home owners a simple question ((source)):

“If someone were to rent your home today, how much do you think it would rent for monthly, unfurnished and without utilities?”

The idea here is that, if house prices go up like crazy, owner equivalent rent will go up. But, if mortgage interest rates go down at the same, as they have in both Europe and the USA, owner equivalent rent will rise far slower than house prices..

As you can imagine, this measure is not perfect. However, it is better than leaving it out like the Europeans. After all, how much does rent say if, like in the Netherlands, roughly 69% of people are home owners rather than renters (source).

So, in Europe it could very well be that inflation was actually a bit higher than reported since house prices and maintenance costs have gone up like crazy whereas interest rates have gone down a little bit.

4 Covid Broke the CPI

So, with these weights known, to calculate CPI, economists simply retrieve an average price for everything in the basket, and multiply it by their respective weights.

To then calculate yearly inflation, all economists need to do is look at changes in CPI.

Simple right?

Well, not really, because CPI weights have one big problem and that is that they change over time.

After all, if the CPI was calculated in 1910, there was a likely a significant weight on the price candles. However, the weight for the price of internet would be non-existent. Therefore, economists update the CPI weights every so often.

However, here the pandemic & lockdowns caused a big problem by completely changing consumer behaviour in an instance.

At the same time, the CPI weights had already been determined at the start of the 2020.

Simply put, in 2020 households started buying far more goods and far fewer services.

This pushed up the price of goods more than it made the price of services drop.

At the same time, this drastically increased the number of goods people consumed but not their weight in the CPI.

Therefore, actual inflation in 2020 was likely quite a bit higher than official inflation.

Taking this into account, research by Harvard professor Cavalla estimated that official CPI in the US likely was likely 0.8% too low.

This can partially explain why we see such shocking inflation numbers today.

But, then the question becomes, by how much?

Well, according to my own calculations, if Cavalla was right, US inflation this year would only have be 5.3% rather than the reported 6.2%.

While that is still a very high number, it does demonstrate that we shouldn’t just take headline inflation numbers and run with them to produce sensationalist YouTube videos.

Another reason is that lockdown also messed up the service price data collection. For example, while they were closed, restaurants did not technically have a price. This means that while the fundamental factors driving these prices, such as wages and food prices, might have continued to rise, the economists measuring CPI weren’t able to see that in restaurant prices because they weren’t being posted. Therefore, they just assumed these prices remained the same that year.

While I couldn’t find an estimate for how big this effect was. However, it does mean that inflation in 2020 was likely even more understated and thus inflation today is even more overstated.

The combination of these two effects has been dubbed: base effects. Base effects are mostly emphasized by team transitory in an attempt to re-assure us that current high inflation numbers will drop once Covid stops messing with the statistics.

Clip Lagarde or ECB podcast. (source from 7:02 to 7:11)

“inflation collapsed last year when lockdowns were imposed, which is creating strong base effects as activity recovers”

That being said, some of us are again in a lockdown and many are still afraid to go to restaurants or to travel. So, it could be that inflation is still understated today.

Or, even if current headline numbers are overstated thanks to base effects, both team transitory and team permanent do agree that inflation still very high today.

So, the debate is still on!

But, before we can assess both positions, we need to do a quick recap of the three ways that inflation can come about.

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6 What Causes inflation?

To understand what causes inflation, economists typically use the age old concepts of supply and demand.

However, for a macroeconomic concept such as inflation, they use total, also known as aggregate, supply and demand.

You see, if aggregate demand rises faster than aggregate supply, average price will rise. And if aggregate supply rises faster than aggregate demand, prices will fall.

Now, what is nice about this framework is that helps us to better understand inflation by breaking the problem down into smaller pieces.

For example, if aggregate demand rises faster than aggregate supply, economists classify this as demand-pull inflation. On the other hand, if aggregate supply falls but aggregate demand remains the same they call this supply-push inflation.

Now hold on, let me just interrupt you writing an angry comment that the internet told you that inflation is caused by money printing.

We will get to this under the demand pull inflation section.

But, first, let’s address the supply chain disruptions that both camps agree on is a major source of inflation today.

7 Supply-push Inflation

Both teams recognize that we have seen a perfect supply-push inflation storm these last few months.

The first big contributor this this has been a massive energy crisis. One part of this story are flooded coal mines in china and fires near oil fields in Canada. Another part of the story is that certain princes in Saudi Arabia have turned off the oil tap and certain presidents have turned off the gas tap for political reasons. But there is also just an energy sector that hadn’t invested for a long time because energy prices had been so low for so long.

Then, Global Covid Lockdowns have contributed in two ways. First, they have shut down production in countries affected. For example, very recently a renewed shutdown in Malaysia, where a lot of the worlds chip testing and packaging is done, has reduced chip production by so much that it forced Ford to suspend its U.S. production of the F-150 trucks. The second effect of Covid lockdowns has been to disrupt global supply chains by, for example, shutting down ports in China. In a global supply chain that ran on maximum efficiency but minimal buffers, this has greatly driven up transport prices. And on top of that it slowed down production, and contributed to global supply push inflation even more.

By how much you might ask? Well, in all honesty that is very difficult to properly estimate.

But, just to get an idea, researchers from the Bank for International Settlements have recently estimated (here) that, without supply disruptions, inflation would have been at least 2.8 and 1.3% lower in the USA & Europe respectively.

And you know what even Larry Summers from team permanent recognizes that:

“Larry Summers clip 1:58-2:07”

“Annual inflation last month, according to core-CPI was above 10%. The majority of that is surely transient”

For a large part the disagreement is just about how temporary supply chain disruptions will last.

Here, the position of team permanent is best captured by the following quote from German central banker Jens Weidman:

“The supply-side bottlenecks of the kind we are seeing for semiconductors might turn out to be more persistent. In addition: if we want to meet the climate targets, there will be no getting around significantly higher carbon prices. That will drive energy prices for many years.”

On the other hand, team transitory members like ECB president Christine Lagarde have stated that they believe supply bottlenecks to end early next year.

Although that quote was before the emergence of the new Covid variant.

The most extreme position taken by members of team transitory is best captured by the analogy of the bottleneck economy from the Financial Time’s Martin Sandbu. He thinks that our current supply chain situation could be comparable to a ketchup bottle where we are shaking and shaking …. but no products are coming out,

thanks to backed up supply chains…

but as we speak big manufacturers are building new factories and containers all over the world… and once these are done

The product ketchup might come out all at the same time… leading to potentially severe supply-push deflation.

To a certain extend this has already happened with Lumber and Steel… which were huge concerns for inflation at the start of the pandemic but have since come down in price.

8 Demand-pull Inflation

Now, what happens if people try to buy so much stuff that an economies production just can’t keep up? That’s right.. demand-pull inflation.

And you know, this is the one that gets both teams really worked because these millionaires and billionaires are just really concerned about the fate of the lower & middle classes of course.

For example, investor Peter Schiff (3:00-3:30) from team permanent typically stresses the dangers of giving money to people who don’t produce anything, this is what happened under Covid

we were expanding the money supply at the same time people were not working. People were leaving their jobs. They weren’t being productive. They weren’t producing goods. They weren’t producing services. Yet the Federal reserve flooded the economy with new money. And so, even though people didn’t work, they were spending more money than they did when they were still employed. And so you have all this money chasing a declining goods and services. And so prices are exploding.

And he typically argues that the resulting inflation will come at the expense of the middle class. After all, they spend a large fraction of their income the goods & services that will be affected by inflation.

At same time, Nobel prize winning economist Joseph Stiglitz from team transitory argues that more demand than supply is actually good for the working & middle class because it increases wages. (source 0:41 - 0:58)

“So, you are absolutely right, I’m welcoming this tight labor market. The only time United States has succeeded in including marginalized groups into the labour force, reducing inequality is when we have a very tight labour market”

This contradiction may seem confusing at first until you realise they are talking about different channels of demand-pull inflation. You could say that Schiff is talking about the money printing channel & Stiglitz about the overheating labour market channel.

9 Money Printing

Let’s tackle the one that the internet loves the most first: money printing.

To view money printing as the source of all price inflation actually has a very long tradition in economics. The most prominent economist to support this idea was Nobel prize winner Milton Friedman (11:49) who said that.

“The reason we have inflation in the United States, or for that matter anywhere in the world, is because these pieces of papers and the accompanying book entry or their counterparts in other nations are growing more rapidly than the quantity of goods and services produced”

His thinking was inspired by one of the most famous equations in economics and that is the Quantity Theory of Money which states that

Money * Velocity of Money = Prices * Quantities.

This equation is true by definition… you can see this by looking at the following example..

If in an economy there were 2 dollars, and these exchanged hands once, and there were two loafs of bread in the economy, then we can deduce that the price of each bread was 1 dollar.

Now, in itself, this equation is an accounting identity which means that it only tells us that there can be a relationship between these variables. But, it doesn’t tell us what that relationship will be.

Crucially, Friedman inspired economists often assume that velocity and production are roughly constant.

Remember that clip from Peter Schiff arguing that stimulus checks for people at home would be inflationary? Crucially, he made the implicit assumption there that this didn’t prevent a further collapse of production.

If the money supply is increased while velocity and production stay roughly the same, this new money will lead to an increase in average demand and so prices will go up. Then it makes sense to say (source 3:45 - 4:07 & 4:15 - 4:19):

“Everything is getting more expensive. And if people think that is transitory, it is because they don’t understand the problem. In fact, they don’t even understand inflation or where it comes from because inflation is about money. You are inflating the money supply. That’s what’s being expanded and none of this is transitory because these deficits aren’t transitory. The money printing isn’t transitory. It’s here to stay. — and that means prices are going to continue to go up because we continue to destroy the value of the dollar as we expand the supply”

Sounds pretty convincing right?

However, the monetary theory of inflation has almost completely disappeared from universities.

Why?

Well, because the data doesn’t support this simple explanation in most economies. For example, check out this graph of the CPI for Europe and compare it to the graph of central bank printed M1 money supply… You can clearly see that the money supply has accelerated while price growth has slowed.

To a less extend this disconnect also exists for the USA (CPI, M2),

But, if you really want to see this simple theory fail, you only need to look at Japan.

Even if we take into account the more expansive M3 money supply measure, which include money created by private banks, and compare it to the CPI. You can clearly see that while M3 kept going up, the CPI had its ups and downs.

What can explain this disconnect?

Using the quantity theory of money framework, it must mean that either production has increased or velocity has slowed down or a little bit of both of course. If velocity indeed slowed, this means people saved money rather than spent it and this should be reflected in higher asset prices or lower interest rates.

Indeed, in Europe and Japan, we have seen falling interest rates and rising asset prices.

At this point, members of team permanent might say that okay okay… But, people will start spending all of that money at some point and then cases will truly explode.

But, again if we look at Japan, they have been waiting for almost 30 years now.

So team permanent should come up with an explanation, why would people suddenly start spending all their money?

The only explanation I could find is one made by economists Charles Goodhart and Manoj Pradhan, if I pronounce that correctly.

They say that as people got older they were saving for retirement. But, as many countries are now ageing, the elderly should start switching from saving to spending more..

however, Japan is again a problem because here this didn’t happen …

However, they argue that Japan is unique because many Japanese companies moved production facilities abroad to neighbouring countries that didn’t really have this ageing problem. As the world in total gets older, this would not be possible anymore.

But, okay that is the future. What about inflation today?

Because let’s face it, saying that increases in the money supply don’t ALWAYS push up prices does not mean that they NEVER push up inflation.

And indeed, even members of team transitory, such as Joseph Stiglitz recognize that by giving new money to the poorest, US government support has likely contributed to inflation. However, he says this is temporary because (clip 1:52 - 1:59).

“The fiscal support is coming to an end and I am firmly off the believe that it is the fiscal support that’s made the most difference”

10 Unemployment

Okay, now, let’s put a different spin on the demand-pull inflation channel.

Are there any non-monetary ways that overall demand might outpace overall supply?

Yes, the theory of inflation that is most popular in universities is related to the Philips curve.

The Philips curve plots the relationship between unemployment and inflation. The idea behind this is that if unemployment is low the economy is running close to or at its full capacity. This means that workers have a lot of money to spend and that not much more can be produced.

So, while wages are likely to rise with labour in such high demand… aggregate supply cannot keep up and thus we will see demand-pull inflation.

If this is true, we should now see signs of an overheating economy, labour shortages … trucker shortages and what not.

But, do we? Let’s have a look at the evidence…

Both in Europe and the United States, the unemployment rate shot up at the start of the pandemic and then came back almost to the low rates that we saw before the pandemic… when there really wasn’t a lot of inflation.

So, that is not particularly alarming.

However, unemployment rates might not tell the full story here because they only include people who are actively looking for a job. It could be that very well be that workers don’t feel like returning to the workforce, or… more likely that they have retired early.

Like 2.4 million people apparently did in the US…

So then, we should see a drop in the percentage of the population who work. And indeed, the labour force participation rate in the United States dropped and has not recovered by nearly as much as a the unemployment rate. In Europe however, this is less obviously the case. And indeed it did not have many extra early retirements…..

perhaps because those lazy Europeans already retired much earlier than Americans anyway?

And yet, there are plenty of reports of labour shortages in both Europe and the United States. But, these could very well be temporary due to massive shift in fortunes of sectors. In other words, while highly skilled pilots are still unemployed by the thousands, there is now a shortage of medical workers in many countries.

And so, indeed in the USA, wages are rising. However, in line with expectations that there is a large labour force left, average wages in core European countries such as France and the Netherlands are not rising that fast.

The European exception is of course UEs home country of the United Kingdom, where wages are skyrocketing ….

But, you know, they decided to kick out most of their European work force in the middle of a pandemic.

Again, the teams disagree both about how serious labour shortages really are and how long they will last.

On the side of team transitory, people like Stiglitz argue that the tight labour market is a good thing. But, that is will likely come to an end as fiscal stimulus measures come to an end.

Now, hitting back for team permanent, Larry Summers beliefs about the numbers from the last few months (clip 0:10-0:18)

“Look, it’s more evidence that we have got a problem that the risk to the economy is that it is overheating”

and while he does admit that (clip 1:56-1:57 & 2:15-2:38)

“we have transient inflation. But it is an elementary fallacy to confuse the fact that we have some transient inflation with the false proposition that all the inflation is transient and we have nothing to be concerned about. If you look at things that are longer lasting.. labour shortages pervasive”

But, why would they be pervasive?

Well, here again I think professor Goodhart and dr. Pradhan make the most convincing case with their ageing hypothesis. If their theory proves correct, we might see permanent more pressure on the labour mark.

So, here we have it. The two views are clear. There are labour shortages. But, there is disagreement on how severe they are and how lasting they will be. And perhaps even if they are a bad thing at all.

11 Demand Shifts

So, that was that. The teams clearly agree about the role of supply chains. However, there is broad disagreement about whether there AGGREGATE supply is really too low or whether AGGREGATE demand is too high.

This is not surprising since the data isn’t strongly supporting either position.

After all, we have seen that there are labour shortages in many sectors. But, unemployment is still not shockingly low, especially not in Europe. Also, aggregate real consumption in Europe is still below its pre-lockdown trend the USA and is just about on trend in the USA. This is not what we would have expected to see if the ‘money printing story’ hypothesis was true. Furthermore, industry is producing quite a bit less than they potentially could in both Europe. and the United States

Yet, there is clearly a lot of inflation.

But, what if there is another explanation?

What if this inflation story is not about total demand and total supply. What if it is about massive shifts in demand from services to goods?

For example, in the USA you can see that real expenditures on services are still quite far below their pre-Covid levels while real expenditures on goods have shot up quite far above it.

How can such a shift cause inflation you might ask?

Well, it could be that for the categories where there are massive shortages such as cars prices go through the roof. At the same time, service jobs cannot adjust prices downward that quickly because they mostly rely on contract workers with a fixed income. In economics This last phenomenon is known as ‘sticky prices.’

As you can see in this graph by Jonathan Nitzan, there might be some truth to this story. Clearly price of cars, which shot up way more than other prices declined marginally. This dragged the average upwards.

If this is true, we should see and end to inflation when we see an end to pandemic…. whenever that is.

12 Inflation Expectations

Okay so, now we have talked about the aggregate supply channel, the aggregate demand channels, and we haven even about a shift in demand from service to goods.

However, when it comes to inflation there is one other factor that economists study closely… inflation expectations.

You see, what happened in the 1970s is that economists,

armed with the logic of total supply and total demand,

were totally caught off guard when Western economies were hit by inflation that couldn’t fully be explained by rising oil prices, or labour shortages or not even by money printing, . So, they had to come up with a new theory, and that was the theory of inflation expectations which goes like this:

At the end of each year….. you … as a worker.. might expect that get a raise that compensates for inflation. Similarly, expecting inflation next year, businesses, will want to increase their prices at the start of the year, by at least some amount to compensate for that inflation.

What will happen if people act these expectations?

Exactly, prices will actually go up. and there will actually be inflation.

This perverse dynamic is what many members of team permanent fear for. Sure, they recognize that a large part of inflation today is supply driven. However, they fear that:

“If these (previous) factors lead to higher inflation expectations and an increase in wages, inflation could accelerate on a more durable basis. (source)”

Not surprisingly, team transitory begs to differ. They believe that the central bank, having presided over low inflation for decades now, has built up enough credibility to break the expectations cycle and convince people they will act if inflation becomes to high.

Or as Treasury secretary Janet Yellen puts it 1:29:

“measures of inflation expectations still look quite well contained”

And also in Europe, inflation expectations are currently at around 2.3% for this year and expected fall back below 2% for the years after.

13 Exchange Rates

Now before we conclude, we have to talk about the relation between exchange rates and inflation.

However, to be honest, most team members don’t talk about this.

The reason for that is that they are from Europe and the US, whose currencies are so dominant that they often import and export in their own currency.

On top of that, this relationship is rather tricky to study. On the one hand if your currency depreciates, your imports will get more expensive and this will translate into higher prices. However, on the other hand, if there is excessive inflation in your country then the value of your currency will also drop. So, it is not clear which causes which.

That being said, the exchange rate channel of inflation is a major major factor for smaller currency areas such as Turkey, Lebanon and Brazil. Countries with much higher inflation than in Europe and the States.

Therefore, to be honest, I think this topic deserves a video of its own.