How Inflation Impacts Everyone
During a discussion I had with a friend about current economic conditions and excessive money printing, he asked in a satirical manner “has anything that bad ever really happened because of inflation?”
“Have you ever heard of something called World War II?” I quipped back.
While not the direct cause, hyperinflation across Weimar Germany greatly exacerbated the anger the german population had towards the banking system, which at the time was run largely by Jewish citizens.
As the german government suffered from the repercussions of World War 1 their economy was put into worse and worse shape, and in order to meet debt payments they continuously devalued their currency and printed money at unholy rates. At the peak of the hyperinflation, Germany had 1,800 money printing machines going non-stop. Promising to get the German economy out of such a troubled state was a key element in Hitler’s campaign to become chancellor.
As the money supply within an economy grows the existing money, such as cash in consumer’s savings accounts or the money on a company’s balance sheet, becomes less valuable. As a simplistic example, if there was $100,000 in the U.S. economy and you held $1,000, you would own 1% of the economy’s wealth. If, however, the government prints another $100,000 worth of cash to make the economy’s total value $200,000, your $1,000 now represents just .5% of the economy.
This is essentially what governments do when they print vast sums of money to stimulate the economy, and as a result makes the purchasing power of each dollar less valuable. In the case of hyperinflation, when inflation rises at a rate of 50% a month or more, the $300,000 a couple spent their lives saving goes from being able to buy a house to buying a quarter loaf of bread.
The initial intention of money printing in an economy is usually a good one, but as any economist will point out you can never do just one thing in economics. If the government decides to start printing vast sums of money, causing the inflation rate to spike, an endless series of dominoes will follow.
Inflation often behaves in a very similar manner to a ripple in a pond, even a small drop can end up having a large effect on the whole pond. To better understand, let trace one of these ripples through.
As of this writing the last quoted price of steel was $205 per ton. Now suppose the price of steel rises 20% to $246 per ton. When General Motors has to purchase steel to make its semi trucks it now has to pay 20% more than it was previously paying. To make up for this it starts charging 20% more for the semi-trucks it sells to customers.
The companies that purchase the semi-trucks, which use the trucks to transport goods to retailers, are now having to pay 20% more for the semis, and naturally they deal with this by charging the retailer (let’s say Walmart for our case) 20% more for transporting goods to the store. You now walk into Walmart and find that your everyday groceries are now 20% more as Walmart has passed these price increases on to you.
In an attempt to pass the increased cost of living onto someone else you, along with your colleagues, start demanding a 20% increase from your employer in order to live in this new inflationary world. The process continues until that one drop has spread across the entire pond of the U.S. economy.
The effect spreads to financial markets with just as much impact. If the inflation rate goes to 10% per year, as it did during the 70s and 80s, bond holders who may have been receiving 4 or 5% per year in interest income will now want a higher yield since the purchasing power of their interest income is diminishing at 10% per year. During normal economic conditions (as in no negative interest rates) a bond holder will demand a yield that is higher than the inflation rate.
The result is a hike in interest rates and the borrowing cost of money which subsequently cools down the economy. As the borrowing costs on mortgages, cars, credit cards, etc. goes up consumers spend less and the economy slows, perhaps going into a recession. The higher interest rates put a curb to rising inflation as money becomes more scarce due to its higher cost.
It’s therefore been part of the government's job, specifically the Federal Reserve’s, to try and manage inflation and interest rates in a way that is in the best interest for the country.
The most notable example by far was during the 1970s when inflation started to pick up drastically. In 1976 the inflation rate was 4.6% and by 1979 inflation was at 13.2%.
In the same year that inflation was 13.2% a man named Paul Volker, who impacted the lives of every U.S. citizen at the time but today is seldom known, began his career as chairman of the Fed and dedicated his tenure to halting the rapid rise in inflation.
The ending result pushed the U.S into a deep recession and caused President Carter to lose re-election.
In the 1970s as the economy continued to boom and inflation raged, Paul Volker pushed interest rates continuously higher until in 1980 the U.S prime rate, the rate charged to the most creditworthy customers, reached 20%. The effective cost then to borrow $1.00 was $1.20 for the companies with the best credit.
These actions though were largely the result of one man’s obsession with stopping inflation and are not a predictor of what is going to happen in the near future. We don’t know how far inflation will go as a result of such a massive stimulus, but once inflation gets going it is very difficult to slow down; and the process of slowing it down quickly has proven to be very painful.