Chapter 3: Inflation

The invisible hand

We all can feel it — the invisible hand that picks our pocket and leaves us a little poorer each day, making us run a little harder for a little bit less reward. We see it in the daily rise in the price of cheese, in the inexplicable shrinking of the size of a loaf of bread, in the longer wait at the clinic, in the packed bus on our way home, in the sky-high prices of property, or in the refusal of our boss to raise our already paltry salary. We blame it on the food cartel, the greedy bakers, the lazy doctors, the “incompetent” bus drivers, the speculators in the property market, and the avarice of our bosses.

But why is it happening now? Why were prices a year ago lower than they are now? Why was a loaf of bread heavier last year compared to now? Did the baker suddenly become greedier? Did the doctor suddenly turn lazier? Did our boss suddenly become more avaricious? Probably not. They were all equally greedy, lazy, and incompetent last year as they are now. Yet something has changed! I am not insisting that the businessmen are not greedy (they must be in order to stay in business), that there is no cartel of the supermarket chains, or that the doctors are, heaven forbid, competent. Those may explain high prices, but high prices are very different from rising prices, which is what we call inflation.

We feel inflation but we can’t quite put our finger on it. Whichever way we look, we get disheartened, and our only hope is for government to step in and help us somehow.

Come election time, seasoned politicians appear on TV promising us to raise our salaries and the pensions, lower the prices of food in the supermarkets, punish the greedy “speculators”, and bring (for once!) “progress” to our weary populace.

Government financing

To understand inflation, we must start with the personal objective of every elected official. Their calculus boils down to two things:

1. To induce every person in the society to work to the best of their abilities, peacefully and lawfully exchanging their products and services with one another;
2. To get reelected.

Staying in power allows government officials to indulge in the feast of power and to enrich themselves by siphoning off a piece of the public wealth. That is one reason why governments care about total GDP and not about GDP per person, which is what each person should rightly care about. To get reelected, though, said officials need to placate an angry, hungry, bitter, and not particularly bright multitude of voters, who have thankfully forgotten the promises (and failures) from the previous election a few years back. And nothing wins people’s hearts like fresh promises of a bright future based upon high salaries, high pensions, and low taxes. So the majority of people would naturally cast their vote for the politician that promises them the most welfare, wrapped in nice-sounding euphemisms like “progress”, “fairness”, and “giving each what they truly deserve”, as everyone believes they deserve more.

Once reelected, the officials need to at least address those promises, and that requires money. Now, there are really only two ways for a government to fund its expenditures, which we shall call direct and indirect taxation.

Direct taxation

Examples of direct taxation include the usual suspects: income tax, property tax, capital gains tax, estate tax, import tax, value-added tax, excise duties, license fees, municipal fees, etc. Engaging in direct taxation is not very politically palatable, as people don’t like it when anyone reaches for their pockets. They already feel squeezed enough between low incomes and high prices to want to support even more taxation. More importantly, though, people know exactly who robs them of their money and they remember it during election times. That is why there is a limit to how much direct taxation the government can impose on people. There are other commonly quoted “official” reasons too: that over-taxation causes a grey economy and even an overall reduction in the size of the economy, so even though taxation may increase as a percentage, it may actually decrease in absolute terms. Those are valid justifications, but the key reason why governments avoid taxation is the one they don’t talk about, namely the fact that people don’t like to vote for those who tax them.

The question is then how to fund the difference between what the government collects in terms of taxes (internal revenue) and the expenditure required to fulfill outlandish election promises. That difference is called budget deficit, and almost every single country in the world is presently running a deficit. One notable exception is Singapore, where Lee Kuan Yew instituted the policy of never running a deficit (except in times of recession) — a policy observed until today¹. But such discipline is predicated on not having to fight for reelection every year, as there is a high political cost to staying frugal. Few governments can afford such a luxury. The majority have to resort to what I term indirect taxation.

Indirect taxation

To finance the budget deficit, i.e. the shortfall between taxes and expenditure, a government can borrow the money, and the way to do it is very simple: they issue government bonds, which the banking system absorbs with newly created money.

The mechanism is as follows: the secretary of the Treasury pulls out a piece of paper, writes down “I Owe You” (IOU) at the top, the number $1 billion in the middle, and a date 30 years hence at the bottom, after which he calls it a “security backed by the full faith and credit of the government”. Nobody in their right mind would buy this piece of paper if they weren’t forced to, but luckily many are indeed forced to do so. Banks must purchase government securities and deposit them as reserves with the CB if they wish to grow their loan book; pension funds are pretty much required to buy these securities by law; and life insurance companies buy them because they are practically the only long-dated securities that can match the duration of their liabilities (i.e. the date far into the future when they would need to pay their customers upon death). But the primary buyer remains the CB (either directly, if its mandate allows, or indirectly via the banking system).

This purchase of securities by the CB creates new money that flows in the economy as the government begins to spend it, causing what we call inflation, and we will dedicate the next section to explain how inflation works and why it is essentially a hidden, or indirect, tax on the economy. This tax is so powerful that it can replace entirely the need for income tax. As one central banker once said, the real purpose of income tax is not revenue but redistribution, since inflation can fully satisfy the funding needs of a government.

The mechanism of inflation

As governments sell bonds against newly created money, the money supply in the entire economy increases. That means that we now have

More money chasing the same amount of goods and services

But money is a commodity like any other. An increase of the supply of this commodity (without a corresponding increase of the supply of other commodities) makes its price go down — basic supply/demand principle from economics 101. That means that the prices of goods and services (i.e. their value measured in terms of money) will rise, and that is what we call inflation². In fact, the price of a commodity is based on the ratio of the total supply of money on one hand and the total supply of the commodity on the other. The more abundant a commodity is, the higher its price; the more abundant money is, the lower the price of all other commodities. The same argument naturally extends to all goods and services in the economy, and so we see that, loosely speaking,

prices = (money supply) / GDP

where “prices” in the above “equation” are a catchall for all prices of all goods and services, and GDP is the sum of all such goods and services consumed within a year. And since inflation is the change of prices, we are now equipped to see what causes inflation, assuming that GDP (the economic activity) remains the same:

Inflation is caused by an increase in the money supply

This is the most guarded secret no government will ever disclose to its dumb citizens. Inflation is a monetary phenomenon caused by an increase in the money supply due to profligate governments borrowing beyond their means, or what some call, crudely but aptly, “printing of money”³.

Inflation propagates through the economy in the following fashion:

• Government borrows money from the financial system and receives newly created money.
• Government raises the salaries of its workers — policemen, teachers, social workers, healthcare professionals at government clinics — for which it uses the new money.
• The workers feel richer now and spend the extra income on the usual stuff: necessities, shopping, entertainment, travel, etc.
• When the worker, say a policeman, spends the extra money, say on entertainment, that becomes income to the travel agency providing the service. More income to the travel agent means she gets to spend more on beauty products, which becomes additional income to the beauty parlor. And so the money circulates around at a certain speed according to people’s spending habits.
• Since there is now more money in the entire economy compared to the previous year, at any one point someone is always richer than before and is thus spending more than before, hence demand for goods and services is higher than last year, even though the supply hasn’t necessarily changed (yet)⁴.
• More demand for the same supply means that prices begin to rise, which is essentially inflation.

Forms of inflation

The above example is what we call “wage-driven” inflation. There is another effect too: since every sale is income to the seller but cost to the buyer, as prices go up many people and businesses are faced with rising costs, which forces them to increase their own selling prices. When the baker’s rent goes up, he is forced to increase the price of bread in order to remain profitable. And this is what we call “cost-driven” inflation.

You may wonder, if the baker could simply raise prices and increase his profit, why did he wait for his rent to rise? Why didn’t he do it earlier in order to maximize his profits? Well, the answer is simple: if he had raised prices earlier, he would have lost customers to other bakeries. But now that inflation is everywhere and other bakeries are forced to raise their prices too, the entire industry moves in tandem, so buyers can’t just switch from one bakery to another; they have to accept the price increase, since the cost driver is systemic.

Many people, even educated professionals, believe in their hearts that greed is the driver of price increases. But that is plain wrong. The baker is just as greedy as he has always been. If he could raise the prices without losing customers, he would have surely done it already. The price at which he sells is already the one that maximizes his profit under the existing conditions. If he is increasing the price, it is because the conditions have changed, not because he has gotten greedier. If it was that simple to get rich by simply being greedy, most of us would be gazillionaires already.

Shrinkflation

Another manifestation of inflation is its cousin the shrinkflation. Whereas inflation means paying more for the same product, shrinkflation refers to paying the same for less product. For example, a chips manufacturer faced with increased production costs may choose to either raise the price of a packet of chips or reduce the chip content per packet. In many cases, the latter is better received by customers, as they are less likely to spot a decrease in the package size than an increase in the price. But shrinkflation is essentially the same as inflation: paying more money for less product and fewer services.

So when you go to the clinic next time and notice that the waiting time has increased dramatically, it is because the government does not wish to pass the increased costs to the population and so they must contend with fewer doctors and nurses, resulting in longer waiting times and less attention per patient.

Shrinkflation is just another face of inflation and its root cause is exactly the same. Remember this next time when a silver-tongued politician tries to blame the degrading quality of public services on someone or something else: climate change, war in the Middle East, or some other far-fetched explanation that only serves to conceal the one and only culprit: money printing.

Asset inflation

The earlier illustration on how money propagates through the economy may seem to suggest that the government workers are the beneficiaries of inflation. There is no such thing. As people and businesses are faced with higher costs, they initially try to resist increasing their own prices for fear of losing clients. During that time, they work as hard as ever but earn less. They are essentially paying an indirect “inflation tax”. At some point, they can no longer sustain their margins and are forced to raise their prices, in turn increasing the costs for the next person on the supply chain. How much inflation tax one pays hinges upon their ability to pass the cost increase to their customers. A plumber is his own master and can quickly raise his prices when his travel cost increases, for example, but a salaried employee may have to wait for years before he is in a position to request a salary increase. Walmart is in good shape to pass any cost increase to their captive shoppers, whereas a cinema operator may have a hard time raising prices on people who are already squeezed by rising prices elsewhere. One can forgo watching a movie, but one must still buy one’s groceries.

That is why the inflation tax hits different people and businesses differently. Assets are immune to how much money is being printed, so those deriving income from assets are more immune to inflation than those who are on a fixed income, like retired folks and salaried employees.

The asset owners are generally the wealthier class of society, and so they are less impacted by inflation. Borrowing the example above, a salaried worker may be squeezed between a tough boss’s refusal to raise his salary and higher prices at Walmart this year, but the Walmart family (who own the majority of Walmart shares) are profiting handsomely from those higher prices since Walmart’s margins have remained the same⁵.

So as the government prints money and the money seeps through the economy, it tends to consolidate at the top of the social pyramid, enriching the wealthiest class, namely the asset owners, via increased dividend income and higher valuations of stocks and property⁶. It is good to be rich when a socialist government is in power, isn’t it?

Inflation as a transfer

In the long run, the effect of any monetary policy is nil. Prices have doubled, wages have doubled, the amount of money in the economy has doubled. Temporary dislocations have been ironed out. Everything measured in money is basically multiplied by 2 and everything is back to normal. Nobody is better or worse off, as their doubled income is ultimately spent on twice as expensive items. The economy is back to where it started, except that the road to get there was littered with pain and stress for those who bore the heaviest burden of the inflation tax.

Observe that money printing does not create or destroy value in and of itself: it only shifts value from one person to another. When a barber raises the price of a haircut from $4 to $6, this is an extra $2 of cost to the client (bad for the client) but is also a gain of $2 of income for the barber (good for the barber). So on a net basis, inflation is neither bad nor good; it is simply a zero-sum transfer of value from one group of people — donors — to another group — beneficiaries. Generally, inflation transfers value:

• From the working people to the government, in the form of an indirect tax that they cannot observe and blame on the real thief.
• From the savers to the borrowers, in the form of a loss of value of their savings. One example is pension funds, who are the biggest victims of inflation.
• From the poor to the rich, as the values of assets increase. Remember that the poor own cash, which loses value during inflation, while the rich own hard assets like property, land, gold, or shares in operating businesses, all of which are relatively immune to money printing.
• From people on fixed income (like retired people and salaried workers) to rentiers (landlords) and self-employed people (like the barber), who are at more liberty to increase their rents or the prices they charge for their services.
• From the private economy to the public administration, as the later are the direct beneficiary of government spending while the private economy must foot the bill in this zero-sum transfer.

Not only does inflation shift value, but it does so from the more productive to the less productive parts of the economy, punishing the least deserving of punishment and rewarding the least deserving of reward. It causes stress to people, misallocation of capital, difficulty in business planning, and many other distortions that ultimately impact the quality of life and even cause social unrest and revolutions in the extreme.

But for all its negatives, inflation remains the favorite tool of governments, because it allows them to tax the population surreptitiously without the population knowing they are being robbed. This is why you would often hear government officials pointing their fingers at the “greedy” traders for “price gouging”, the “unpatriotic” hoarders of gold for selling the local currency instead of saving it, the “lazy” doctors who prefer to leave understaffed government clinics in favor of better paid private practices, or the “cheating” employees who underdeclare their incomes and pension contributions, which governments like to blame for the perennial insolvency of pension funds.

And the best part is that instead of directing their ire at the government that actually caused the inflation, people fall for the lies because they appear to correspond to what they see. They see the price of bread going up and blame the greedy baker. They see the price of milk going up and blame the greedy dairy farmer. They insist on (and vote for) welfare, subsidies, and price controls — exactly the kind of policies that cause inflation in the first place. That is the reason socialist policies sell so well while being so punishing to the very people they purport to try to help.

Inflation and debt

There is another sinister reason why governments resort to inflation: because it reduces the value of outstanding debt. That may sound counterintuitive — how is it that borrowing more and adding to existing debt could possibly result in a reduction of this debt?

Well here is the thing. We saw that inflation causes money to lose value and to ultimately multiply both incomes and prices. If the same amount of apples are produced but the price of apples has doubled, the monetary value of those apples has also doubled. So while the economy does not really increase in real terms, it increases in nominal terms. Income taxes are collected on nominal income, and so the government’s revenue has doubled, but the debt has only increased by the interest rate at which it was issued, which is generally much lower than the rate of inflation. And herein lies the one conclusion you should take away from this essay even if you don’t remember anything else:

Debt shrinks when the rate of inflation exceeds its interest rate.

The above is obviously just as true for savings as it is for debt: if your savings are earning an interest rate lower than the rate of inflation, you are losing real value. If the price of apples rises by 20% while your savings earn 5%, each year your savings are worth 15% less in terms of apples. Inflation destroys savings, and likewise it destroys debt. Inflation is your enemy when you have savings and your best friend when you have debts.

I witnessed that in my home country in 1996, when the hyperinflation caused by an irresponsible and incompetent socialist government wiped out the value of money, and everyone who had a mortgage practically walked away with a free apartment. At the beginning of 1996, my father’s mortgage was 70% of the value of our home, but by the time the currency value had been decimated 1,000 times (correct, that is 3 zeros), the value of the mortgage had plunged to the price of a kiddie bicycle. The lesson you should take away is this: if you can borrow at an interest rate below the rate of inflation, just do it⁷. But please don’t jump up and run to your neighborhood loan shark to sign up for a loan at some punitive interest rate (like 1% per day!) and blame it on my advice that you are now miserably buried in debt.

Here is another even starker conclusion:

• owning savings under inflation leaves you poorer each year;
• owning hard assets, like property, allows you to retain the real value of your wealth (while the nominal value grows along with other prices), but it leaves you neither better nor worse off;
• borrowing against your assets, however, allows you to build wealth, as the real value of the assets remains the same and the value of debt shrinks.

In other words, what makes you wealthier are not the assets themselves, but the loans against them, or put bluntly:

Debt makes you richer!

I would have laughed at anyone who told me that before I had a grasp on how our financial system works. Now I only wish I knew the truth sooner.

The above lessons explain why governments, who otherwise fear inflation for its potency to cause social unrest, actually like it when it comes to existing debt. They have effectively created a system where borrowers get rich and savers remain poor. And since the governments themselves are habitually on the borrowing side, they will always exert influence on the CB to tilt monetary policy in their favor. As long as you remain on their side (i.e. as a borrower and not a saver), you will benefit. And that is the case as long as interest rates are lower than the rate of inflation, which is exactly how governments like it too.

We know that the CB is supposed to be independent of the government and manage the price stability in the economy, so we would expect it to push against government’s largess, and sometimes the CB does in fact push back by refusing to purchase the newly government bonds issues, leading to an oversupply of them in the market and a drop in their price — effectively an increase in their yield (the interest rates that the government must pay). Governments don’t like such increase in cost, and they are often quite vocal about it⁸. In many cases, they get their way. Below is a fun chart showing that no matter the color of the sitting president’s party, the senate, or the congress, and no matter what any of them may have promised, the one sure thing is that they would raise more debt and increase the debt ceiling when it gets in their way (or suspend it outright):

I often hear the argument that “debt will have to be repaid”, so I would like to address this fallacy. The conversation follows a similar pattern:

• Q: But governments can’t issue debt forever, as sooner or later this debt would have to be repaid, wouldn’t it?
• A: No, debt does not have to be repaid, and in practice it never is. Old debt is rolled over by taking on new debt, and additional debt is piled on top of it.
• Q: But then debt would grow exponentially?
• A: That is exactly what debt does — it grows exponentially, along with the money in the system.
• Q: But that can’t go on forever, can it?
• A: Yes, of course it can go on forever, because the CB can always issue more money to buy the maturing debt. There is no limit to how much money can exist. The only cost to that is inflation, which hurts people because it is a tax on them. But as long as this tax is not excessive, people will bear with it.
• Q: But that means sooner or later we will have hyper-inflation, no?
• A: Not necessarily. Remember there is a time component: everything happens over time. As long as the growth of money does not exceed the growth of real GDP, debt will remain a constant percentage of the economy and there will be no inflation. Any excess growth would generate inflation, which is indirect taxation on top of the direct taxation.

It is true that a vicious spiral of unchecked monetary expansion, coupled with loss of trust in the currency can lead, and has lead at times, to hyper inflation and a breakdown of the financial system. Hyper-inflation is a distinct possibility, but it is not necessarily the only outcome of the monetary bull running on the loose. What it takes to get back on track is a tough government, usually a dictatorship or a military, that has the staying power to force the population to swallow the bitter pill once so that public finances can be put in order. Democracies are generally poorly equipped to stop the vicious cycle, as the one-person-one-vote principle of democracies tends to elect the most spendthrift governments, and since they reckon they may not stay in power for long, they go for the easiest band-aid solution — more debt now and more inflation down the road.

Interest rates

What is the effect of interest rates on inflation? Interest rates are one more lever of monetary policy at the hands of the CB, just like the money supply. Again, as a tool of monetary policy, changing interest rates neither creates nor destroys value, but rather transfer value from one class of economic participants to another. For one, interest rates have a negating effect on inflation — high interest rates reduce the effect of inflation. Furthermore, they impacts asset inflation differently from the inflation of goods and services, as the value of assets is derived from future cash flows, and those future cash flows get discounted more when interest rates are high.

Governments have three main reasons to like low interest rates.

First of all, interest rates are the cost they must pay to borrow. That is why the policy of governments will always be to keep interest rates as low as possible, generating inflation, and feeding the asset inflation in the process.

Second, low interest rates make the local currency less desirable versus international currencies, leading to its devaluation, which benefits exporters at the expense of importers. Governments will always support exporters with any tools at their disposal — tariffs, subsidies, and of course weak currency and low interest rates, as that creates employment and adds to the GDP.

Finally, the low interest rates create asset inflation which boosts the value of real estate and pushes up the stock market, benefiting primarily the wealthy. And as most decision makers in government are themselves wealthy asset owners, low interest rates work just fine for them. Yet again, governments may claim that their policies are all in the name of the poor, but they actually benefit the wealthy disproportionately, and that should not come as a surprise to anyone who has been around long enough.

Footnotes

1. See “From Third World to First: The Singapore Story: 1965-2000”, pp 232. ↩︎
2. Economists reserve the term inflation for the “increase in money supply”, whereas the pedestrian definition is “the increase in prices all around us”. The two are obviously related, the latter being a consequence of the former as we have just seen. For the avoidance of doubt, we will stick with the latter meaning of the word. ↩︎
3. Technically money is not printed, as it is in electronic form, and also the government doesn’t create it directly but rather it forces the CB to create it to purchase new government bonds. ↩︎
4. While economic agents may respond to increase demand by increasing supply, part of their response will inevitably be higher prices. If a barber’s clients increase by one, he can accommodate and simply shave one more customer, but if too many customers queue up, he would need to raise his prices. ↩︎
5. Not only has the dividend income increased for Walmart shareholders, but the asset value, i.e. the share price, is close to its all time high. ↩︎
6. As of today, April 29, 2025, the market capitalization of Hermes International, a top end luxury goods seller, is in excess of the market capitalization of Louis Vuitton Moet Hennessy, the seller of mid-tier luxury goods. Similarly, the market capitalization of Ferrari is much higher than that of Volkswagen. Such comparisons would have been ludicrous in less inflationary times. ↩︎
7. I sat down to calculated the rate of inflation in Bulgaria for the period 2021-2025, as measured by the official minimal salary, and it came to 11.5%, way above the “reported” inflation of 4.5% over the same period and still further above the current mortgage rate of 2.6%. ↩︎
8. For example, US president D. Trump is trying to depose the head of the FED for refusing to lower interest rates. Another example is when Turkish president T. Erdogan installed his son-in-law as the head of the Turkish CB and has instructed him to keep interest rates low and to continue to purchase government bonds, which has naturally resulted in runaway inflation and a massive collapse of the value of the Turkish lira. ↩︎