The raise of inflation might have been for many the most surprising and worrying development in the past months. For many years, the narrative by central bankers and mainstream economists has been, that inflation is nothing to worry about and that it is in fact too low. And that the potential of deflation is actually way more dangerous.

The main reason for this kind of believe is, that a constant monetary growth is necessary so that people keep spending and not just ‘hoard’ money while waiting for prices to decline. A second argument is, that a deflationary economy would require wages to also decline over time, but since wages are described as ‘sticky’, this might be difficult to actually implement and therefore cause problems. This view is shared by both the Keynesian, as well as the monetarist economic philosophies, which make up the bulk of mainstream economists today. Furthermore, for some never really fundamentally explained reason, 2% — not 1.5% or 1.9%, nor 2.1% — no, exactly 2% has become the holy grail for an inflation target globally. To me this is total nonsense.

Since this a bit beside the topic, I don’t want to get too deep into this general economic discussion here, but I think it is important to grasp and understand, so I’ll elaborate my viewpoint a bit.

In general my opinion is that, contrary to modern economic theory, falling prices is a great ideal!

First, given a money with a hard supply means that the participants can reap the rewards of a growing economy.

Moreover, in today’s world we also see sectors in which the growth outpaces the inflation, leading to falling prices. But it does not seem to hinder these sectors to flourish, so that the most valuable 5 companies are all technology companies, which are mainly selling “deflationary” products.

Lastly, historical evidence clearly indicates that deflationary periods in history did not result in stagnation or dwindling economies, but in contrast led to rampant development and flourishment: For instance, during the late 18th century and all throughout the 19th century – except for the war times (in which the government tremendously increased the money supply) – America actually experienced a deflationary period in which prices were constantly falling. Therefore, to me it is no coincidence at all, that this is exactly the time-frame in which America happened to become the most prosperous nation.

Just think about the encouraging experience of waking up in the morning and going through the day knowing that the purchasing power of the money you earn and save will allow you a greater living standard in the future? I think this has a tremendous implication for general life-satisfaction, well-being and motivation for living. On the other side, today’s inflation makes people worried where they should put their savings in order to preserve their wealth. And what it really comes down to is a hidden tax!

This brings us back to 2021. Essentially, governments have two ways to spend money: Either they tax their population, or they go into debt. Taxing is the honest way, because the population immediately feels the cost of what the government does, while increasing debt is more fraudulent, because it means that the burden is pushed towards future generations who eventually are expected to pay back the debt. And in addition to paying the debt burden, there are also interest rates that need to be paid on top of it.

Furthermore, in a free market prices are determined by supply and demand. However, the price of money (expressed in interest rates), which is arguably the most important price in the economy, is not determined by the market, but by central banks. We have increasingly witnessed, that the desired interest rates are not supplied by the market. Instead, it requires central banks to rush in and buy increasing amounts of government debts in order to keep the rates at a low level.

Here is a chart that shows the expansion of central banks balance sheets over the last years. It has absolutely skyrocketed, especially due to the “help-packages” that were rolled out in response to the market interventions throughout the Covid epidemic.

Chart Source: Yardeni.com

Watching financial news, people can easily get the impression that inflation is something mystical. That it is hard to pinpoint where it actually comes from. While the economy is a complex system and there are many factors, which have an influence on it, there are some very clear basics that can be examined in order to determine whether the environment is ripe for inflation.

As can be seen in the chart, in particular the FED and the EZB did ramp-up their purchases since Covid started. If central banks purchase assets, it mainly means that they are monetizing government debts. This directly translates into an increase in the broad money supply. Hence, it is also no wonder that these are the countries where we are now witnessing increasing inflation numbers, with the U.S. CPI inflation at 6.8% and the Eurozone at 4.9%.

Central bank money printing alone does not necessarily lead to higher inflation, but it is a key ingredient. Combined with other inflationary factors, it works like fuel for a fire. Some other reasons why we are seeing these increasing inflation numbers are:

• The money is not only used to provide liquidity for banks (like the bailouts during the 2008 financial crisis), but a lot of it is going out in the form of stimulus checks directly to consumers. It therefore leads to a direct increase in gross demand.
• The low interest rates lead to the easy access of cheap money, fostering bank lending, whereby they provide debt-financed purchasing power.
• The Covid measurements have decreased overall production and massively distorted the supply chains leading to bottleneck issues and reduced supply.
• There seems to be a general trend and push for de-globalization, which is also inflationary.

For me, it has actually been rather surprising how long it has taken for inflation to finally also show in the Consumer Price Inflation Indexes (CPI).

Whether the CPI is actually giving a somewhat reliable inflation number is another highly debated topic. What can be said is that the way of calculating has gone through various changes over the years. Prior to 1980, it used to be a fixed basket of goods which price was measured over time. Nowadays the calculation is much more complex. For instance, so called hedonic adjustments try to adjust for technological improvements of products. In addition, if a product increases a lot in price, it is presumed that consumers will shift to buy a cheaper substitute product. Thus, many argue that these changes have made it possible for government institutions to understate the real level of inflation. ShadowStats tracks the CPI in the old fashioned methodology and comes up with U.S. inflation numbers approaching 15%.

Chart Source: ShadowStats.com

Moreover, the CPI does’t include real rents or investment items. These are for most people important parts of their budget and have gone up way more than the CPI over recent years.

If inflation keeps rising then one thing to watch out for are price controls. When prices are starting to rise, people have the misinformed suspicion that it is because of price gouging by greedy sellers who take advantage of the distressed situation. Even though history provides sufficient evidence that price controls have the adverse effects of making the situation even more dreadful, politicians nonetheless often feel tempted to impose controls to gain popularity from their constituency.

A currently unfolding case study is Turkey, where the inflation level has crossed 30% in December. There are news that governors across the country are expected to impose price controls. And there are already videos on YouTube in which police officers go into supermarkets telling the operators to lower the prices.

I would not be surprised to also see arguments for price controls in developed countries if the inflation trend continues in the coming year.

Finally, inflation is a very individually dependent phenomena. Every person has a very different basket and therefore it is hard to pinpoint a general number. The real inflation that each person experiences will always be very unique to the location, the circumstances in life and the spending habits.

What to make out of it?

The key problem is that governments and central banks around the world have put themselves in a corner where it is almost impossible to get out. In my opinion from just observing and playing around with the numbers, they have passed the trigger-point of no return out of the debt spiral. Here is some basic math:

• The total global debt (including government, household, corporate and bank debt) is now at about 300 trillion USD.
• This debt is supported by a global GDP which is slightly less than 100 trillion USD. This is the underlying economy that can potentially be taxed or employed to service the overall debt.
• Since debt is more than three times as much as GDP, this means that in order for every 1% growth in debt, the GDP would need to grow at least 3% just to keep up with it.
• Considering the rate at which debt is rising at the moment this would require an enormous spike in GDP. Unless there is some major technological breakthrough, leading to a massive global productivity improvement, I think it is impossible.

Additionally, in order to fight inflation governments and central banks would need to let interest rates rise. However, this would make the burden of debt rising even faster since the increased interest rates would require to add additional debt even faster. Additionally, a rise in interest rates would trigger great economic distress, crashing stock-markets and housing prices and probably lead to a severe recession, hence a decrease in GDP.

I am pretty sure that central banks are pretty aware of the position they are in… they just can’t admit it. Admitting it would lead to a financial crisis right away.

The way out

The way for governments to get out of this debt spiral is actually inflation itself.

In other words, “Inflate or die!”

And therefore I think that while central banks will deny it, and will keep paying lip service that they are going to fight inflation and keep it at a “manageable level”, the real goal is to debase the money over the next decade, or even longer, through a persistently high inflation. High inflation is good for everyone who has debt, because it means that the value of the outstanding debt is being decreased. It is bad for all those who save money, their savings are constantly being devalued.

If this is the case, then what can investors do to preserve their wealth? I think the first important implication is not to hold bonds or large amounts of cash. If you invest in 10-year bonds with a coupon of 1.5% while inflation is at 5% or more, you are guaranteed to loose money. Basically, those who hold these assets will be the ones finally paying for fiscally irresponsible governments. The only reason for holding some cash or bonds is to use them as liquid ‘dry powder’ for investment opportunities, to take advantage of sudden market developments and fluctuations.

Assets that might work well against a long inflationary period are scarce assets, which cannot easily be increased. Such assets would include:

• Bitcoin
• Gold
• Other industrial commodities such as silver, copper, nickel etc.
• Real estate
• To some extend stocks, particularly the ones involved in the production or transportation of scarce resources (e.g gold miners, pipeline operators, oil producers, uranium producers etc.)