Why is inflation bad and what causes it?

Most of us are painfully aware of inflation. Webster’s dictionary says, “inflation is a continuing increase in the general price level.” It is usually measured by using the Consumer Price Index (CPI), which is calculated and disseminated by the U.S. Bureau of Labor Statistics. If you would like to see monthly and annual data from 1913 to 2024, you can go their website.

 I’m not going to reproduce the whole thing here, but I’ll use some of the data as we go along. The base is set at 1982-84 = 100. We will also be interested in wage data, which is gathered and published by the Federal Reserve.

The CPI for January 2017 was 242.839 and the average wage was $26. By January 2021, the CPI stood at 261.582 and the average wage rate was $29.93. So the CPI increased by 7.72% and wages increased 15.12%.

From January 2021 to January 2024, the CPI rose from 261.582 to 308.417, an increase of 17%, compared with an average wage rate which rose from $29.93 to $34.68, an increase of 15.8%. So wage earners lost ground. And that’s only three years.

That’s only the beginning

Generally Accepted Accounting Principles (GAAP) require use of historical cost. This is also required by the U.S. Securities and Exchange Commission (SEC) and IRS. What is historical cost? It means that when a company acquires a fixed asset, such as a building or a piece of equipment, it must show the asset’s cost as the number of dollars actually paid for it at the time it was bought.

Companies then spread this cost over the number of years the asset is used: as an expense called depreciation. But since it took fewer dollars to buy the asset when it was acquired than it would today, the depreciation figure shown on the income statement significantly understates the true expense and it, therefore, causes an overstatement of net income.

Why is this bad?

When investors make decisions about which companies to buy into, they carefully study the financial statements of each company under consideration.

Inflation affects the financial statements of different companies differently. The overstatement of profits is greatest when the assets include large investments in buildings or equipment that were acquired long ago

In addition to income, investors are very interested in the rate at which income is growing.  If you are trying to find the growth rate for a company’s income, you look at results over a period of time.

But remember income for, say, 2022 was calculated and shown on the financial statements in 2022 dollars and the 2023 number is shown in 2023 dollars. This causes growth rates to be overstated. The overstatement is greater during high inflation and it affects all companies.

So, we can see that, first, inflation causes net income figures that appear financial statements to be overstated. The amount of the overstatement varies greatly from company to company. Second, inflation also exaggerates income growth rates.

Since investors rely on financial statements, and since comparisons between companies becomes very difficult, and growth rates are overstated, capital can be mis-allocated. The “best” companies don’t necessarily attract the capital, and this causes economic efficiency to be suboptimized and investor returns to be lower.

Another serious problem, is what happens to the amount of income tax a corporation pays.  When historical cost is used (and the IRS requires it) profits are overstated. Therefore, the amount of income tax the companies have to pay is higher than it should be.

What causes inflation?

Politicians often say something like, “Inflation is caused by evil corporations raising their prices.” But if that were true, consumers would have to lower their standard of living by consuming less. Companies would face lower demand, so they would have to lower their prices again.

What allows inflation is an expansion of the money supply; more money chasing the same goods. That can happen in either of two ways: the Fed can increase the money supply faster than the economy is growing, or buyers can (temporally) expand their money supply by borrowing.

Private debt in the U.S. has grown from $14.56 trillion at the beginning of 2021 to $17.05 trillion at the end of 2023. That’s an increase of 17.1%, so, private debt has increased by $2.49 trillion. Just that increase amounts to $2.49 trillion divided by 340 million people is $7,324 per person. So, a family of four has $29,296 more debt than it had three years ago. The $17.05 trillion is made up of $12.61 trillion of housing debt and $4.89 trillion non-housing debt (including credit cards).

Meanwhile, federal deficits over the last three years have amounted to $5.85 trillion. This means our collective federal debt went from $26.477 trillion to $34 trillion — an increase of $7.524 trillion or 28.42%.

What does that mean on a per capita basis?  $7.524T/340 million people = $22,129 per person; $88,517 for a family of four.  

No kidding — this is really true.

But what else is bad about all the new debt?  The current interest rate on federal debt is 3.2%.  This year interest on federal debt will be approximately $838.4 billion. On a per capita basis that amounts to $3,244. So, a family of four will be burdened with $12,976 of annual interest payments.

The Heritage Foundation says, “Interest on the federal debt is now so immense that it’s consuming 40% of all personal income taxes.” And I have ignored what has happened with states’ public debt.

Obviously, we can’t keep this up forever.  If we continue down this path, only bankruptcy can result.  And nobody knows what the effects of that would be.  Inflation is bad and it is caused by expansion of the money supply. Don’t think of inflation as increasing prices. It is really devaluation of the dollar. That means we have to spend more of it to get the same goods.

Willis Greer holds bachelor’s and master’s degrees from Cornell University and a PhD in managerial accounting from the University of Michigan. He has served on several faculties including the University of Iowa and Dartmouth’s Amos Tuck School. He lives in Rollins.