The Way Out of Inflation
Imagine the entire economic output of the United States is measured in apples. For the sake of simplicity, let’s say our country produced ten apples in 2021. Collectively, we had $10 to spend on those ten apples. As a result, each apple costs $1. Simple right?
Now let’s say an event comes along, say an apple pandemic. Suddenly, fewer apples are available because the trees aren’t producing as many as they did pre-pandemic. Now there are only nine apples available to consumers. A lower supply and a higher demand equate to increased prices of about $1.11 per apple.
Continuing our example, let’s say the government notices people and businesses are struggling to afford apples. They want to help, so they pass legislation offering their constituents “relief” money to help them afford the apples they need. The extra money is nice, but it doesn’t change the number of available apples. This again drives the price of apples up, as now people are more willing to spend more to get the apples they need.
Eventually, the price of apples gets so high that consumers turn to the banks to borrow money to buy apples. They offer loans to apple buyers at great rates thanks to lenient government policies. But again, the supply of apples remains unchanged. More money means the price of apples climbs.
Those in charge of the finance rates notice the cost of apples is going up too fast, so they raise the interest rates of borrowed money to slow down excess spending. How quickly they choose to raise those rates, and by how much, can have a profound effect on the amount of money people can spend on apples. But that clamping effect can hurt people and businesses. They go hungry if they can’t get the money they need to buy apples.
This overly simplified example does an excellent job of illustrating the situation we find ourselves in as a country. Inflation has become a household word and the boogieman everyone is trying to stop. Who or what’s to blame? It depends on your news source: Democrats, Republicans, OPEC, COVID, Federal Reserve (Fed), suppliers, consumers, or the person who owns your local bakery… you name it. As if these individual entities have a lever in their office that directly controls the prices of goods and services. I find the image of the corner baker maniacally laughing while raising the price of croissants, thinking, “That’ll get ‘em!” both humorous and completely inaccurate.
The reality is no one wants to raise prices, least of all the businesses that serve you. The higher the croissant price, the fewer sold alongside a cup of morning coffee. But the cost of flour, sugar, energy for the oven, and labor has gone up, so what’s the baker to do? Their sole purpose as a business is to provide value to their customers and generate a profit. When costs go up, prices go up: it’s a simple balancing act. Can anyone fault a business owner for raising prices because their costs are up?
The Fed greatly influences this cycle of higher prices and higher costs. Their primary tool for fighting inflation is raising the interest rate, making it more expensive for consumers and businesses to borrow money for houses, capital expenditures, etc. Their goal is to slow down demand by increasing costs. That’s all well and good until they push too hard, and everything ends up entirely out of reach financially for most people. It’s a precarious position in which the Fed currently finds itself.
Instead of tinkering with the demand side of the equation as so many seem to want, I think we’d be better served working on the supply side. Returning to our apple example, imagine if we went to work improving the health of the trees, doing whatever we need to do to increase the output of apples. This has the same effect as lowering demand; it creates balance. However, if consumers want ten apples and there are only nine to go around, we have a problem. We’ve been focusing on getting the economy to want nine apples by destroying their ability to afford them. Instead, let’s improve our productivity to create the ten apples needed to satisfy demand again.
Our way out of inflation is not raising rates; it’s increasing productivity. Give people the freedom to create, innovate and do things faster, easier, cheaper, and better.