Inflation is the decline of purchasing power of a given currency over time. A quantitative estimate of the rate at which the decline in purchasing power occurs can be reflected in the increase of an average price level of a basket of selected goods and services in an economy over some period of time. The rise in the general level of prices, often expressed a a percentage means that a unit of currency effectively buys less than it did in prior periods.
Inflation can be contrasted with deflation, which occurs when the purchasing power of money increases and prices decline.
- Inflation is the rate at which the the value of a currency is falling and consequently the general level of prices for goods and services is rising.
- Inflation is sometimes classified into three types: Demand-Pull inflation, Cost-Push inflation, and Built-In inflation.
- Most commonly used inflation indexes are the Consumer Price Index (CPI) and the Wholesale Price Index (WPI).
- Inflation can be viewed positively or negatively depending on the individual viewpoint and rate of change.
- Those with tangible assets, like property or stocked commodities, may like to see some inflation as that raises the value of their assets.
- People holding cash may not like inflation, as it erodes the value of their cash holdings.
- Ideally, an optimum level of inflation is required to promote spending to a certain extent instead of saving, thereby nurturing economic growth.
Ray Dalio, HOW THE ECONOMIC MACHINE WORKS:
In an economy without credit: the only way to increase your spending is to produce more. But in an economy with credit, you can also increase your spending by borrowing. As a result, an economy with credit has more spending and allows incomes to rise faster than productivity over the short run, but not over the long run. Now, don’t get me wrong, credit isn’t necessarily something bad that just causes cycles.
It’s bad when it finances over-consumption that can’t be paid back. However, it’s good when it efficiently allocates resources and produces income so you can pay back the debt. For example, if you borrow money to buy a big TV, it doesn’t generate income for you to pay back the debt. But, if you borrow money to buy a tractor — and that tractor let’s you harvest more crops and earn more money — then, you can pay back your debt and improve your living standards. In an economy with credit, we can follow the transactions and see how credit creates growth.
Let me give you an example: Suppose you earn $100,000 a year and have no debt. You are creditworthy enough to borrow $10,000 dollars - say on a credit card - so you can spend $110,000 dollars even though you only earn $100,000 dollars. Since your spending is another person’s income, someone is earning $110,000 dollars. The person earning $110,000 dollars with no debt can borrow $11,000 dollars, so he can spend $121,000 dollars even though he has only earned $110,000 dollars. His spending is another person’s income and by following the transactions we can begin to see how this process works in a self-reinforcing pattern.
But remember, borrowing creates cycles and if the cycle goes up, it eventually needs to come down. This leads us into the Short Term Debt Cycle. As economic activity increases, we see an expansion - the first phase of the short term debt cycle. Spending continues to increase and prices start to rise. This happens because the increase in spending is fueled by credit - which can be created instantly out of thin air. When the amount of spending and incomes grow faster than the production of goods: prices rise. When prices rise, we call this inflation.
The Central Bank doesn’t want too much inflation because it causes problems. Seeing prices rise, it raises interest rates. With higher interest rates, fewer people can afford to borrow money. And the cost of existing debts rises. Think about this as the monthly payments on your credit card going up. Because people borrow less and have higher debt repayments, they have less money leftover to spend, so spending slows and since one person’s spending is another person’s income, incomes drop and so on and so forth.
When people spend less, prices go down. We call this deflation. Economic activity decreases and we have a recession. If the recession becomes too severe and inflation is no longer a problem, the central bank will lower interest rates to cause everything to pick up again. With low interest rates, debt repayments are reduced and borrowing and spending pick up and we see another expansion.
As you can see, the economy works like a machine. In the short term debt cycle, spending is constrained only by the willingness of lenders and borrowers to provide and receive credit. When credit is easily available, there’s an economic expansion. When credit isn’t easily available, there’s a recession. And note that this cycle is controlled primarily by the central bank. The short term debt cycle typically lasts 5 - 8 years and happens over and over again for decades. But notice that the bottom and top of each cycle finish with more growth than the previous cycle and with more debt.
Why? Because people push it — they have an inclination to borrow and spend more instead of paying back debt. It’s human nature. Because of this, over long periods of time, debts rise faster than incomes creating the Long Term Debt Cycle. Despite people becoming more indebted, lenders even more freely extend credit. Why? Because everybody thinks things are going great! People are just focusing on what’s been happening lately. And what has been happening lately? Incomes have been rising! Asset values are going up! The stock market roars! It’s a boom! It pays to buy goods, services, and financial assets with borrowed money! When people do a lot of that, we call it a bubble. So even though debts have been growing, incomes have been growing nearly as fast to offset them. Let’s call the ratio of debt-to-income the debt burden. So long as incomes continue to rise, the debt burden stays manageable. At the same time asset values soar.
People borrow huge amounts of money to buy assets as investments causing their prices to rise even higher. People feel wealthy. So even with the accumulation of lots of debt, rising incomes and asset values help borrowers remain creditworthy for a long time. But this obviously can not continue forever. And it doesn’t. Over decades, debt burdens slowly increase creating larger and larger debt repayments. At some point, debt repayments start growing faster than incomes forcing people to cut back on their spending. And since one person’s spending is another person’s income, incomes begin to go down which makes people less creditworthy causing borrowing to go down. Debt repayments continue to rise which makes spending drop even further and the cycle reverses itself. This is the long term debt peak. Debt burdens have simply become too big.
For the United States, Europe and much of the rest of the world this happened in 2008. It happened for the same reason it happened in Japan in 1989 and in the United States back in 1929. Now the economy begins Deleveraging. In a deleveraging; people cut spending, incomes fall, credit disappears, assets prices drop, banks get squeezed, the stock market crashes, social tensions rise and the whole thing starts to feed on itself the other way. As incomes fall and debt repayments rise, borrowers get squeezed. No longer creditworthy, credit dries up and borrowers can no longer borrow enough money to make their debt repayments. Scrambling to fill this hole, borrowers are forced to sell assets. The rush to sell assets floods the market. This is when the stock market collapses, the real estate market tanks and banks get into trouble. As asset prices drop, the value of the collateral borrowers can put up drops. This makes borrowers even less creditworthy. People feel poor. Credit rapidly disappears. Less spending › less income › less wealth › less credit › less borrowing and so on. It’s a vicious cycle. This appears similar to a recession but the difference here is that interest rates can’t be lowered to save the day. In a recession, lowering interest rates works to stimulate the borrowing. However, in a deleveraging, lowering interest rates doesn’t work because interest rates are already low and soon hit 0% - so the stimulation ends. Interest rates in the United States hit 0% during the deleveraging of the 1930s and again in 2008.
The difference between a recession and a deleveraging is that in a deleveraging borrowers’ debt burdens have simply gotten too big and can’t be relieved by lowering interest rates. Lenders realize that debts have become too large to ever be fully paid back. Borrowers have lost their ability to repay and their collateral has lost value. They feel crippled by the debt - they don’t even want more! Lenders stop lending. Borrowers stop borrowing. Think of the economy as being not-creditworthy, just like an individual. So what do you do about a deleveraging? The problem is debt burdens are too high and they must come down. There are four ways this can happen:
- people, businesses, and governments cut their spending.
- debts are reduced through defaults and restructurings.
- wealth is redistributed from the ‘haves’ to the ‘have nots’. and finally,
- the central bank prints new money.
These 4 ways have happened in every deleveraging in modern history.
Usually, spending is cut first. As we just saw, people, businesses, banks and even governments tighten their belts and cut their spending so that they can pay down their debt. This is often referred to as austerity. When borrowers stop taking on new debts, and start paying down old debts, you might expect the debt burden to decrease. But the opposite happens! Because spending is cut - and one man’s spending is another man’s income - it causes incomes to fall. They fall faster than debts are repaid and the debt burden actually gets worse. As we’ve seen, this cut in spending is deflationary and painful. Businesses are forced to cut costs which means less jobs and higher unemployment. This leads to the next step: debts must be reduced!
Many borrowers find themselves unable to repay their loans — and a borrower’s debts are a lender’s assets. When borrowers don’t repay the bank, people get nervous that the bank won’t be able to repay them so they rush to withdraw their money from the bank. Banks get squeezed and people, businesses and banks default on their debts. This severe economic contraction is a depression. A big part of a depression is people discovering much of what they thought was their wealth isn’t really there.