The politicians in Washington are finally acknowledging that there is an inflation problem while at the same time they also don’t seem to fully grasp what inflation exactly is and how to effectively solve it. I make this observation because President Biden is pitching that the Build Back Better initiative as the solution to taming inflation and creating prosperity when in reality a massive increase in government spending is just going to make the problem much worse.
This Crisis was Decades in the Making
Inflation occurs when the money supply increases faster than the production of goods and services. The current crisis we are experiencing has its causes at the beginning of the 21st century when the Federal Reserve lowered interest rates in the aftermath of the dot com crash and created cheap money. This cheap money fueled the housing bubble that led to the 2008 crash.
The government’s response to the Great Recession was to increase government spending with the hopes that would stimulate the overall economy back to health and they were enabled by the Federal Reserve’s Quantitative Easing program which is basically money printing to buy government bonds. During the 2010s we started to see the effects of inflation when the price of assets, such as real estate and stocks, exploded while the price of consumer goods remained relatively stable.
But Covid was the straw that broke the camel’s back. Increased unemployment aid, the closing of “non-essential” businesses, and blanket government stimulus money shocked the economy because the money supply increased dramatically while production drastically contracted.
Why Isn’t the Federal Reserve Raising Interest Rates?
Overall inflation is more than 6% so far this year and that’s described as the biggest increase in 30 years. The reality is much worse than that because the standards for measuring the Consumer Price Index were changed in the late 1990s so if we use the standards prior to that, then the rate would be most likely much worse with double-digit increases. Everyone seems to understand inflation’s effects as their grocery bills have increased, the price of gas has shot up, and store shelves are empty. Everyone except for the board at the Federal Reserve, the Biden Administration, and certain members of Congress.
In theory, when inflation becomes a problem the Federal Reserve is supposed to increase interest rates to constrict the money supply but they say they won’t do so until 2023 at the earliest. If the problem is serious now then why won’t they act now? If they act later the problem will only be worse and we could have hyperinflation which would decimate the middle class.
The reason why they won’t act is because of government debt. Government deficits are mostly financed through bonds and if the Fed raises interest rates then paying back those bonds is going to cost the government more. They would need to raise taxes to make up the difference and no politician wants to make an unpopular decision even if it’s the most responsible option. It is much easier to impose the silent tax of inflation to pay the bills.
Massive New Spending Will Make Our Problems Worse
Increasing government spending is the Keynesian solution to pump more money into an economy that’s in a recession to help spark consumer spending. But when inflation is the problem to solve then this solution it’s the equivalent of using a helicopter to dump a ton of gasoline on an out-of-control wildfire heading towards a highly-populated area. Further increases in the money supply without increasing economic output are going to lead to more inflation.
The People in Charge Need to Choose Responsibility
Right now, the Federal Reserve cannot do the right thing and raise interest rates because they have monetized government debt. They keep talking about tapering the monetization by gradually buying fewer bonds but if markets react negatively to this then they’re most likely going to simply step up their purchasing again while inflation gets worse and worse.
These aren’t completed unprecedented times or problems. Paul Volcker was the Federal Reserve’s chairman at the end of the 1970s and throughout the 1980s during a similar crisis. He raised interest rates to high levels and created a recession where high unemployment was rampant. But inflation was put under control in the end prosperity followed.
But the American economy of the 1970s was stronger than the one we have today. Back then America produced goods and exported them while today every month brings a new record high trade deficit. Should the Federal Reserve do the right thing then we will experience a painful recession, but it will be less painful than the recession we’re going to have if we keep kicking the can down the road.
The only people that can lead us out of this crisis are our political leaders. Since government spending is the fuel for this fire then that fuel needs to be reduced and eliminated. We need federal budgets that have surpluses instead of deficits so that we can pay back the debt we owe. Once that house is in order, we will be in a much stronger position to take on the inflation problem with less painful consequences.
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