In a hypothetical world without money, based on barter, inflation cannot exist. The price increase of a good would automatically imply the reduction of the price of the good with which it is exchanged. It is because of that Milton Friedman considered that, in the long term, sustained inflation was always a monetary phenomenon, a phenomenon that took several years to crystallize and was the consequence of an increase in the quantity of money in circulation in an economy above its real economic growth, this being a difficult factor to modify because it depends on the physical and human capital available in a country, together with the technology used to combine them appropriately.
Now, it is good to remember that, when the production of a country is below its potential level, the increase in the amount of money does not have to produce inflation and the same thing happens if the economic agents decide to hoard the incremental money supply instead of spending it.
Starting in the 1980s, the world began a process of disinflation, a process that continues to this day. This dynamic has generated a profound debate among economists about the general increase in prices in an economy, which is understood as inflation. Many of them predicted at the time that inflation was dead and would no longer be a problemsince the central banks understood the nature of the problem itself and would not repeat the mistakes of the distant past.
As a result of the extraordinary monetary measures introduced during the pandemic, a small group of economists began to consider that the trend of recent years was going to change and that we were on the verge of a new era of inflation. Have these economists been right?
Will this inflation be transitory, as the main monetary authorities argue?
We are currently seeing unprecedented price records since the Great Financial Crisis, as a result of the recovery of demand repressed by the pandemic, after having avoided a shock of demand thanks to the deployment of an unprecedented arsenal of monetary and fiscal measures, combined with a shock of supply due to the disruption of production chains by desynchronizing the confinements of the different countries and partially destroying the smallest and, therefore, vulnerable productive fabric.
Will this inflation be transitory, as the main monetary authorities argue? Central banks find themselves mired in a major dilemma. East dilemma occurs whenever the economy hits a shock of offer, as is the present scenario. In fact, many central banks are opposed to undertaking monetary restrictions in the face of inflation originating from a shock of offer.
This was the case in 2008, when Bernanke it did not raise interest rates as a result of the increase in oil prices, just the opposite of what, erroneously as was later confirmed, the ECB did. At the present time, the problem is different because there is already an unprecedented monetary injection carried out previously and there is no talk of implementing restrictive monetary measures, but of beginning to neutralize the expansion that has been deployed.
Unweaving the monetary safety net, once demand has recovered, and, therefore, counteracting the inflation that we are seeing, would imply lower economic growth and less job creation, raising the risk of leading the main economies into a recession . Failure to do so would entail the threat of giving inflation a more structural character, because the longer central banks take to act, the more likely it is to enter into a price-wage spiral that entails more negative long-term consequences.
The question that people may ask is: Why is inflation so bad? If we were in a world where everything was linked to this variable, shouldn’t we care? In that case, we would not be impoverishing ourselves, right?
The reality is that not everything is tied to inflation. In practice, the salary increase depends on each agreement and, therefore, there is no obligation to apply the CPI automatically, unless that agreement establishes a salary review clause. So, the loss of purchasing power will be a reality for a large mass of wage earners.
Unweaving the monetary safety net, once demand has recovered, and, therefore, counteracting the inflation that we are seeing, would imply lower economic growth and less job creation
Even if everything were linked to inflation, it would still be a very negative phenomenon. In a market economy, prices are its beacon, and thus that of the global economy as a whole. All the necessary information is synthesized in them, sending clear information with an associated incentive. As Hayek said, “the market solves the enormous problem of the allocation of scarce resources by concentrating the information on the uses of all the affected goods in an economy in a single reference, the market price”.
In general, politicians and consumers do not usually have a good understanding of the price mechanism. For example, after a natural disaster it is common to see price increases in some goods (generators, saws, wood, etc.), the most demanded by the circumstances at a given time. But consumer complaints are not long in coming, leading politicians to consider establishing price controls. This occurred, for example, at the beginning of the pandemic with the price of masks.
But, in essence, the meaning is much simpler. That increase is a beacon with an incentive, “today we need to produce more of this good at the expense of others.” Over time, the price incentive will cause more resources to be allocated to producing that good, sacrificing others, and will end up satisfying the needs of the consumer, causing prices to end up falling. This would not occur if minimum prices were established.
When inflation soars, it is more difficult for economic agents to discern whether the price increase is a consequence of greater real demand in the economy or whether it is a monetary phenomenon not supported by real demand. From there, the allocation of resources in the economy begins to work worse.
So, inflationis the “great danger” because implies a dysfunctional economy and a general impoverishment of the population. Although there are also great beneficiaries, the indebted agents, among them a very important one… the States.
With the central banks in a complicated situation due to all that has been said, in view of the contemporary data that we are learning, it should not take long for them to start withdrawing the extraordinary stimulus measures implemented, regardless of the risk, not very likely today. today, to precipitate a new recession. The opposite would imply allowing structural inflation with interest rates below economic rationality, a scenario that, in the long term, would be much worse. This second option would be the symptom of a sick economy.
We hope that the gradual withdrawal of these measures will not take long and will be adequately absorbed by the economy and make it impossible to enter an inflationary spiral..
**Pedro Mas Ciordia is CEO of Santander Private Banking Management.