Why are we seeing a lot of inflation?


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We’re certainly seeing a lot more inflation than we were used to over the last 30 years. Sure, the cost of a Coke in a vending machine has been slowly creeping up, but today it seems like the price of everything has been going up overnight. Food and fuel costs have been rising especially quickly. Where $8 would buy you a nice lunch just a little while ago, now it is more like $13 for the same meal. Today we’re going to talk about where all of this inflation is coming from and what you as an investor should be doing to protect yourself.

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What causes inflation?

People often say that “inflation is too much money chasing too few goods.” But what does that mean? In a free market society, businesses charge as much as they can for a product and consumers pay as little as they can. Because there is competition, the most a business can charge is actually the minimum the product can sell for when you take expenses into account. Theoretically a business could charge whatever it wants, but if another business charges less, they’ll lose the sale and be left with lots of unsold inventory. Because they need to sell inventory to pay their costs, businesses will lower their prices until their items sell. This means the price of an item will be whatever the cost to produce, market, and sell the item was (plus any taxes) plus a small additional amount to make it worth it for the vendor to sell the item.

Really what you’re doing when you work a job and buy things is trading your labor for the items you want. Because items take a certain amount of time and effort to produce, generally it will take a certain amount of your labor doing a given thing to get that item. this amount will stay relatively constant over time. For example, a person working at a fast food restaurant will generally earn enough per hour to buy a meal and a half at that restaurant or an equivalent restaurant. A person performing a rare and valuable service like performing brain surgery might earn enough per hour to buy 1000 meals. This was just as true in the 1960s and is true today.

If you track the amount of labor needed to get a given something, generally this will remain about the same unless that something becomes more rare or it becomes easier to make that thing, meaning less time is spent producing it. A person at a fast food restaurant will need to work about 40 minutes to get a meal unless a new way to make that meal is invented where twice as many can be made for the same amount of labor. A brain surgeon will make 1000 meals per hour until a robot is invented where anyone with a college degree and some training can perform the surgery, at which time the pay for performing that service would drop to about 10 meals per hour or something.

To make it easy to trade what you do for what you want, money was invented. These are little IOUs you receive that you can trade to someone else for something you want. Ideally the value of those IOUs would be fixed where you would be able to trade those you got working a fast food place for a meal and a half at any point in the future. Unfortunately the value of those IOUs is no longer pegged to anything tangible and more of them are printed than labor is performed, so their value tends to decline with time.

Think of it this way: Let’s say that you lived in a world where the only thing you could buy is hamburger meals. You work a job and they agree to give you two hamburger meals each hour that you work. On average, everyone also makes two hamburger meals per hour, so it all works out where the meals produced equal the meals consumed. You can expect there to be two meals per hour available for you when you want to trade in your voucher.

Because most workers don’t want to eat that many meals, they are given vouchers to get their meals later. A worker knows that if he works for ten years and saved some of his vouchers, he will have enough vouchers to get meals for another five years. He is storing the value of his work up for later. Let’s say that these magical meals last forever (as it seems some fast food meals would) so things are still in balance where there is one meal available for each voucher. Another way to think of it is that people are constantly storing up their vouchers, so the meals they don’t eat now are left for those who had stored up their vouchers in the past.

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Now let’s say that the managers decided to give their workers an extra voucher per hour. The workers don’t produce any more, but they have an extra voucher per hour. There is now an imbalance where there are more vouchers than there are meals available. If people were to store the extra vouchers, having the additional vouchers wouldn’t make any difference since there would still be enough meals to meet the demand with the number of vouchers that are used. If people decided to use their extra vouchers, however, there would now be an issue since there would be more vouchers than meals.

The people collecting the vouchers would obviously desire to get as many vouchers as they could. Normally this is one per meal since that is the rate that sells all of the meals that are being produced. If a place decided to take two vouchers per meal, for example, people would go elsewhere and they wouldn’t sell all of their meals. As long as there is sufficient competition, prices are kept in check. But now if there are more vouchers than meals, places could ask for more and still sell all of their meals because there would be more vouchers than meals available. The amount of work per meal is the same, but the number of vouchers received and exchanged have both increased. That’s inflation.

The people who saved up their vouchers for meals later have lost meals, but those who are using them as they go really see no difference. They still get the same amount of stuff for the amount of time they work.

With inflation, the people hurt are those who have cash since they are not able to buy as much with that cash as they were when they received it. People who are working just see their wages increase. Inflation is caused by money being created and distributed without sufficient work being provided to earn that money. In the US, it is because the government is printing more money than it takes in and distributing it to buy things and giving it out to people who are not working. The effect is offset somewhat by the fact that the government issues bonds to borrow that money from the future, but because the government never pays down that debt, the amount of IOUs continues to exceed the amount of work provided, so dollars never become more valuable again.

What is causing this inflation?

OK, so that’s what causes inflation in general, but what about the inflation the US is seeing right now? Well, there are two causes, one temporary that really isn’t inflation, and one permanent. The second is more important than the first.

The temporary cause is a reduction in the amount of energy being produced. On inauguration day, President Biden went into the White House and reversed several executive orders created by President Trump that increased the production of oil and natural gas. He ended the ability to drill on a lot of Federal land. He cancelled the Key Stone Pipeline that would have resulted in a lot of oil being produced in Canada and sent to refineries in the US.

As a result, there is a lot less oil and natural gas being pumped out of the ground and being processed into forms that can be used. Because demand for both remains at least as high as it was, the price of gasoline, natural gas for heating, and things like fertilizer produced by natural gas and plastics produced from oil have increased. Because oil is needed to fuel trucks, trains, and planes used for transportation of goods and natural gas is used to heat businesses and in their production of products, increases in the cost of these products has increased the cost of getting goods to market. This has caused the price of things to go up. Even if a good is not oil or made from oil, because the price of transportation has increased, the price of everything has increased.

This is not real inflation because it can be corrected. There is plenty of oil and natural gas still in the ground, so the supply could be increased again. In fact, this type of inflation is somewhat helpful in that because prices are higher in the shortage, those who don’t need oil and gas as much use less, leaving more for those who really need it like those bringing critical goods to market. If prices remained low, we could actually run out of supply and not get the goods to market people need, resulting in big issues.

Pumping more oil and gas is one solution, but it isn’t the only one. If other forms of energy were produced that could be used in the same ways, prices would also decrease for energy overall. For example, if we built a large number of nuclear plants and changed over to electric cars, trucks, and electric trains and started heating using electric heat pumps instead of natural gas, that would reduce prices. One thing that the Biden administration could do to help this along is reduce the regulations on building nuclear plants or give out low interest loans to encourage them to be built. There are currently plenty of incentives to build renewable energy such as installing solar panels, so this will likely pick up if energy prices remain high.

The bad news about this form of inflation is that it does not mean that wages will go up to meet it. There is actually less of a needed good being produced then there was before, which means those working and producing things will need to work more to acquire it or shift more of their income to paying for it. The businesses are not bringing in more money that they could put towards towards wages. They are charging more, but that money is going to pay for fuel, heating, and shipping. We’ll just need to pay more for energy, certain goods, and shipping and cut spending elsewhere until the issue is solved.

The other issue is real inflation and can be solved. The government has passed multi-trillion dollar aid packages and is giving out money to people who are not working. This is like the managers giving out extra vouchers to employees or even people who are not working. You now have vouchers for meals where people did not produce meals in return. People who earned vouchers are competing for the same meals with those who did not.

This type of inflation will cause the value of existing vouchers to be reduced. But the businesses now can raise prices, taking in more of these vouchers, and then raise pay for their workers. They need to pay more for labor, but that labor is worth more per hour than it was, so it all washes. It may take a little time for workers to demand and receive the needed wages, but through actions like changing jobs or making successful pleas for increased salaries, wages will increase and the balance of labor expended for goods received will equal out again.

How can you protect yourself?

So, now that you understand why inflation is happening, how can you protect yourself from the effects? Well, the first thing is to cut out unneeded spending until your wages increase. You are not being paid enough for the labor you are expending, so you’re losing labor if you keep spending like you have been. If you have luxuries you buy that you could do without, cut back a bit. If you have big purchases coming up where the cost of the good is out of balance with the amount of work you used to do to afford that item that you could delay, do so. If you work extra to buy the things you can’t afford with your current salary, you’re expending more labor that you will need to in the future to get that item.

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Now if you can borrow the money at a good interest rate, that is a different story. In that case you’ll be able to pay back the money with less labor than it would take you right now since you’ll be paid more in the future but the loan amount would be fixed. Note that this would not work if you use variable interest like a credit card or an adjustable rate home loan, but if you can lock in your rate through a home loan or a line of credit, that might make sense. Be sure that the interest rate you’re paying is low enough to come out ahead after inflation, however. This will get more difficult with time since lenders watch interest rates too and factor them in when making terms for loans. Note that home mortgage rates have increased by more than 2% over the last couple of months.

A second thing to do is to invest. While the value of cash sitting in your sock drawer will decline with inflation, the value of stocks and real estate will not. If the government prints more money and hands it out to people, the companies you own can just charge more for their goods and things balance out. The government also tends to give money to people who spend it right away, rather than save and invest it, so you may even see the amount your companies earn increase faster than inflation.

A share of stock or a piece of real estate is also an asset that has a value relative to the amount paid for labor. As the value of dollars decreases, the price of a stock or piece of land will increase. The dividends or rents you receive will increase as well. Really, if your money is in assets rather than in cash or bank accounts, inflation will not affect you. The only exception is that you may be paying out capital gains taxes when you really didn’t have a gain. Vladimir Lenin mused that the way to destroy those who have assets is to have high inflation and high capital gains taxes. Pretty much the only way to protect yourself there is to wait to sell until capital gains rates are low enough if you are able. Otherwise with time you’ll reach the socialist’s goal of everyone having the same amount. Unfortunately, that amount will be nothing.

Have a burning investing question you’d like answered?  Please send to smallivy@smallivy.com or leave in a comment.

Disclaimer: This blog is not meant to give financial planning or tax advice.  It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA.  All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

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