Tuesday, 17 May 2022

Napkin Maths to Explain Inflation

Spending and printing money does not, and did not, stimulate the economy, David Sukoff reminds us in this guest post. It is however the root cause of inflation...

Napkin Maths to Explain Inflation

Guest post by David Sukoff

Legend has it that back in 1974 Arthur Laffer explained supply-side economics on a paper napkin and so the Laffer Curve was born. He concluded the explanation with, “and the consequences are obvious!” In that particular case, it was that when you tax something more, you get less of it. And the important converse: lower taxes increase economic growth. (Laffer’s Curve was used to demonstrate that in some cases slashing tax rates can actually increase tax revenue.)

Similarly simple demonstrations could be done to show that increasing the minimum wage reduces employment, or that free trade benefits both parties. With all the recent consternation about inflation, it is therefore long overdue that we take the 'napkin' approach to show a simple truth: that  the root cause of inflation is printing money (by which we mean, in the way things are presently managed, borrowing new money into existence to spend on things your or the government otherwise couldn't pay for).

Sure, we could write books, academic papers, hold town hall meetings and debate endlessly. For some economic issues, though, only a paper napkin is required. In order for napkin maths to be applicable, the explanation must be intuitively obvious, empirically obvious, and, of course, the maths is demonstrable on a napkin (or, the corollary to the Napkin Math Rule—a 900-word blog piece like this).

At the outset, we need to realise that inflation is, above all else, a monetary phenomenon (as Daniel Aguilar ably explains on another napkin over here). When money is printed, or borrowed into existence, prices in an economy will tend to rise.

Period. Full stop.

For the inflation napkin, we could start by drawing a historical graph of a currency's money supply -- in this case, of the American dollar. It is no coincidence that the inflection point for increased printing is March 2020. That is right around when the federal government ramped up the printing press to "stimulate" a Covid economy -- and lo and behold, inflation has begun to run rampant ever since.

The intuitive and elegant equation for the remaining space on the napkin involves a fraction. 
  • The denominator (the bottom number) is the total supply of money. 
  • The numerator (the top number) can represent almost anything. For the napkin, it’s simply X. 
  • If the denominator is increased, then the value of X, relative to the amount of money in the system, is less. It's not rocket science, just basic incontrovertible arithmetic. Napkin maths.
And it doesn't even matter what 'X' is. As an example, imagine a few people are stuck on an island where the only goods in their small economic system are coconuts -- and the total amount of money among them all is $100. On Monday coconuts are selling for $5 each. But if on Tuesday the island government then prints and distributes another $100, and nothing else happens, then the price of a coconut will become $10. As an equation, this would be 5/100=10/200. Since there are twice as many dollars in circulation, each dollar can now buy half as much as it used to. (Or, as we would more normally say it, the price of a coconut has doubled!)

What if, though, we instead increase the supply of coconuts. Let’s suppose there were originally 20 coconuts. Then, by some miracle of nature, there were 40 coconuts. If the money supply increased from $100 to $200, then coconuts would still be worth $5. Thus, the island government could 'match' the growth in the economy by printing money such that the money supply kept up with the supply of goods. If it prints additional money however, above the growth in coconuts, then prices will rise. We are still comfortably on the napkin.

The US economy is more complex than that, of course. But the logic and maths still hold. The empirical evidence on inflation supports the simple logic and math—just as it repeatedly has for Laffer.

The first so-called stimulus bill of the Covid era passed on March 27, 2020—right around the inflection point on the money supply graph. It was $2.2 trillion. The second passed on December 21, 2020 for $900 billion of so-called stimulus spending on top of the omnibus spending bill. The third so-called stimulus bill, this one dubbed the American Rescue Plan Act, passed on March 10, 2021 and was $1.9 trillion, making it a total of $5 trillion of so-called stimulus spending. This is on top of the original spending trajectory. Since we are still on the napkin, we can approximate on the money supply graph: it is currently $22 trillion, while extending the pre-inflection path would have it somewhere around $17 trillion. Thus, the money supply increased above its previous path by roughly the amount of the three so-called stimulus bills - i.e., $22T - $17T = $5T. (That's a five, followed by twelve zeroes!)

The resulting inflation has been so historically vast as to cause us to grab another napkin, or two. Given the obviousness of the relationship between money supply and inflation, one might wonder why it took so long for inflation to arrive after passage of the various bills. The Napkin Maths answer is both intuitively and empirically clear: we started seeing it much earlier, it simply manifested itself in other places. Again, more napkins would be required, but we could draw graphs of housing, stocks and shares, bitcoin, stonks, SPACs, private securities, etc. It was happening the moment the printing presses started whirring: Asset prices inflated, and consumer goods followed. It was easy for non-knowledgable commentators to miss, because, more's the pity, these things aren't measured in the official inflation figures.

Sadly, we all now are suffering for these policy blunders. The double whammy, of course, is that not only did the government print money, causing inflation, they did it in the midst of an economy-crushing pandemic. In a sense, our policymakers eviscerated the value of the dollar and at the worst possible time. The consequences were obvious: a monumental transfer of wealth to existing asset holders (increasing inequality), an insidious misallocation of capital (increasing chances of a bust), and the highest inflation in generations.

Government is now, as it is wont to do, pointing the finger in all directions—except at itself—and discussing policy solutions that not only do not address the root cause of the issue, but are almost certain to exacerbate it.

The simple fact is, they are to blame. And the further and even simpler fact is this: that spending and printing money did not, and does not stimulate the economy—instead, it is the root cause of inflation. As simple as the explanation is, the policy path is clear: stop spending, er, printing money!

* * * * 

David Sukoff

Dave Sukoff is an advisor to the investment management community and previously co-founded and ran a $500mm fixed income relative value fund. He is also the co-founder of a software company and inventor on multiple patents. Dave graduated from MIT, where he majored in finance and economics.
His post first appeared at the Foundation for Economic Education (FEE).


MarkT said...

He provides the example of a doubling in the money supply leading to a doubling of prices if supply remains equal. Simple example and easy theory to understand, but does it describe reality? On the graph he provided, US money supply has gone from $16B to $22B in the last 2 years - about a 38% increase, or 17-18% a year. If we accept the example reflects reality, why hasn't price inflation been that high?

Is it that it has been that high and conventional price indices such as CPI doesn't measure it accurately? Or is there's a big delay between the increase in money supply and the effects on prices, and we're only starting to see the impact of the past 2 years?

Anonymous said...

As he says, it is a venue simple example -- relying not only on supply remaining constant, but also ignoring something some economists call 'velocity,' (i.e., the speed with which money changes hands), and also ignoring the time it takes for the new money to find its way through the economy (and the unearned profits this causes), something Hayek once likened to watching a dollop of sugary treacle ooze out.
If you follow that link above from our friend Daniel Aguilar, he explains these other factors a little more, using a slightly larger napkin...

MarkT said...

So is the "velocity" variable basically the same thing as the lag or delay effect I referred to? To use an engineering analogy, the same as rainfall you get in an already saturated catchment, it all has to run off the hills and into the river below, but can run off either slower or faster then the average rate due to variables in the topography? If that's the case, then wouldn't you expect the price increases in the long run to still be directly proportional to the increase in money supply (less the economic growth). Is that your understanding of what he's saying, and do the statistics support that?

Peter Cresswell said...

No, the lag is what Hayek analogised as the treacle -- known formally as the Cantillon Effect. Velocity is a sort of measure of the times a monetary token changes hands. If you follow that link above from our friend Daniel Aguilar, he explains it a little more...