Why do we have inflation and why do governments under-report it

Many of us feel the official inflation rate is out of sync with reality. If you do your shopping, pay your rent, go to the hospital, its easy to see something doesn’t add up. Many of us actually do not understand why there’s inflation and what its implications are. It used to mean price increase but the world changed dramatically in the last decades and inflation has evolved into other variations. In this blog post I’ll try to explain what inflation is in the XXI century, why do we have it, why do governments artificially suppress it, how can we measure it and how can we protect ourselves against it.


What is inflation?

Inflation is the generally perceived as price increase of goods and services .. but a more correct way to describe it is – the depreciating in the purchase power of a currency. Since the creation of the FED in 1913 and most notably since 1971, inflation has picked up relentlessly. But inflation is not only reflected in prices: Corporations today offer less quality / less quantity in order to increase profits – which essentially means higher inflation to consumers.

Why do we have/need inflation? 

First and foremost we need inflation (i.e. money supply expansion) to cope with population growth. Imagine we were only 10 people in the world with a combined $10 .. we’d have $1 per capita. If population grows to 20, we’d have only $0,50 each and deflation would kick in. If you think prices will be lower tomorrow, you delay consumption and if you delay consumption the economy crashes. So in today’s world which evolves around consumption and population growth .. we need money supply expansion to keep pace with population growth. It’s only when money supply grows faster than population growth (which is the case since the FED was created in 1913) that we get inflation.

Why are Governments increasing money supply faster than population growth?

Because they want to stay in power. As such they’re forced to over-promise their citizens with ever growing social welfare plans and pensions. In order to pay for these promises they go deep into debt which needs to be repaid with cheaper/devalued currency. You can’t really blame them as they’re simply trying to maintain social stability. Either we as a society accept to change the rules of the game (lower social spending, lower pensions, less government, etc) or we can’t blame governments for underreporting inflation. Perhaps a better alternative would be to shrink Governments and give them less power, but that’s a different topic altogether.


But why do Governments underreport inflation?

1. First and foremost to artificially boost economic growth (or GDP). It’s my belief that the US economy has been contracting since 2007, along with every other developed world country. Real inflation has probably been around 8-10% annually. Considering the GDP numbers they report are real growth numbers (already discounting for inflation), if they were to report real inflation .. they’d need to admit that the developed world is not growing but is actually shrinking 2-3% a year. (tax revenues are probably a better proxy for growth).

2. Paint a rosier picture about real wage growth numbers. Median US household income was ~57k in 1999 and ~53k today (adjusted for inflation). Now imagine instead of using 1% official inflation numbers, they’d use a more realistic 5%. That alone would bring real household income to 27k today (instead of 53k). People feel it in their day-to-day lives that something doesn’t add up but if the official numbers say otherwise .. they they must be right and I must be wrong. Imagine if people were to find out that their purchase power is >50% lower today than 16 years ago. There would be a revolution tomorrow!

3. Less social spending. Many of the government expenses are linked to the official inflation numbers. Pensions, salary increases, benefits, etc. If governments around the world were to report real inflation numbers, they’d be bankrupt now.

4. More tax collected. By underreporting inflation, the tax brackets are artificially set at a low level, which generates more revenue to governments. In the Netherlands for example everything you earn above 56k you pay 52% income tax. Next year they’ll probably report 1% inflation, which means  the threshold will move to 56,560 EUR. If they were to report a more realistic number of 5% inflation .. the threshold would move to 58,800 EUR, meaning less taxes to the Dutch government.

5. Suppress price of gold / silver. If real inflation was properly captured by the CPI (inflation index), Gold would be much much higher, which would challenge fiat currencies and consequently the establishment. Many people argue Gold price is being manipulated. Not that I doubt that, but even if they’re not outright manipulating it (via the futures paper market) .. they may well be doing it by underreporting CPI inflation. As we know the main gold price drivers are: 1) direction of USD 2) real interest rates. By suppressing inflation they inflate the real interest rate, which favours paper yield-generating assets.


What are the other non-price variations of inflation?

Less quantity: Companies are finding creative and subtle ways to offer offer less quantities to disguise inflation, in ways that consumers don’t notice. People wouldn’t accept price increases of 5-10% a year but they do accept 19 tea bags (instead of 20 the year before, meaning 5% inflation) or smaller sizes for the same price.

Less Quality: A more subtle way to boost profits and hide inflation is to offer less quality. Chocolates have less cocoa, more water is added to foods (wines, meat, milk, etc), we use less good ingredients in food production. Not to mention the introduction of genetically modified foods (GMO), which cause cancer in the long term. How is this captured in the inflation rate? It’s not!

Battery spams / malfunctions: iPhones and MacBooks for example have short battery spams. After 1 year usage, the battery of both your computer and iPhone stars eroding much faster. This is certainly not a coincidence. There are very smart people at Apple designing batteries that will speed up battery deterioration faster than they otherwise should. If you buy an iPhone every 2 years instead of every 4 years .. that’s 100% inflation right there!

Geological inflation: It’s getting harder and harder to pull minerals / metals out of the ground. The low hanging fruit has been picked .. now it requires more expensive technology and labour force to extract these metals (they’re getting lower grade, getting harder to find, deeper and more expensive to mine). We are exhausting the planet Earth’s capacity to regenerate natural resources, thereby reducing the incremental marginal benefits.

Technological improvements: Farmers use better and better techniques to produce food, generating higher yield from same amount of land. But if we manage to do things cheaper, why are prices to the consumer not cheaper then? Why do companies keep all these productivity gains?  Assuming their productivity is 2% higher each year and price to consumer remains the same as last year .. is inflation really 0% or rather 2%? Some food for thought…


What is the real rate of inflation today?

No one really knows. There are strong inflationary forces but also some deflationary ones.

Basic needs that take 70-80% of your income (rents, food, healthcare, insurance premiums) have been growing at 8-10% a year. In contrast, the price of “nice-to-have” items such as plasma TVs, cars, computers, etc are shrinking (though by constantly introducing new models every year, corporations induce consumers to rush and buy items more often than they really need .. leading indirectly to higher inflation).

The advent of the internet and the sharing economy exert powerful deflationary forces in the economy. It led to the disintermediation of banks, hotels, taxis, housing, insurance, travelling, trading, essentially removing the middle man. Estimates suggest corporations are capturing 90% of the value of this disintermediation (hence the higher than normal stock market valuations), with consumers benefiting only the remaining 10%. That also explains why structural unemployment shot up, as a lot of gate-keeper jobs have been permanently removed from the system. Globalisation also makes our non-essential products cheaper by moving production to ever cheaper countries.


How can we protect ourselves against inflation?

Make sure your savings grow faster than inflation. It’s not an easy task with banks paying 0% on your savings account (and soon to start charging when negative rates kick in) . Stocks and real estate were a good option in 2009-2014 period but it’s way too late & risky now. My favourite investment is education in yourself (expanding the mind & knowledge should yield results much faster than inflation, regardless of the economic environment). Precious metals are also an interesting option in the long term if you’re prepared to see them losing value in the short-term before the inevitable rise. Investing in small companies directly could also be a good investment though risky in these turbulent times. The worst you can do is to keep it in the bank, unless you intend to invest when there’s blood on the street (easier said than done). Also make sure the bank where you keep your savings is financially sound. In the next crisis I suspect few will survive. If you have >100k in cash, then you should be concerned as another Cyprus-style depositors theft is likely to occur. Governments chose this path of financial repression as the only politically acceptable path out of the gigantic debt levels we’ve accumulated. The other paths of inflation and / or default were not politically feasible and the population would rebel.


Follow me on Twitter @ricardo_afonso_


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