Recently here on Mises Wire, Sammy Cartagena wrote a brilliant article demonstrating that Two Percent Inflation Is a Lot Worse Than You Think. In it, he demonstrates that the manageable 2 percent inflation year over year we all have gotten used to is a whole lot less manageable than we tend to think. But in it, he also cited explaining that “over 23 percent of all dollars in existence were created in 2020 alone.” From that he explains that while future inflation is important, he is focused on past inflation for the sake of his article, which is where these two articles diverge because this will be questioning future inflation. Anyone paying attention has seen that there has obviously been inflation this past year whether through price increases or more subtle ways to sneak inflation into the economy. However, when we look at the massive spending bills and the aforementioned fact that over 23% of dollars have just recently been ushered into existence, it leaves many asking why has there not been proportionally drastic inflation?
The major piece that is holding back even more inflation than we’ve already seen is a public expectation of a return to normal. The economy is exceedingly complicated and there are countless causal factors effecting this so I cannot say this is the only reason, but we can turn to The Mystery of Banking where we see Murray Rothbard go as far as claiming that “Public expectation of future price levels” is far and away the most important determinant of the demand for money. Rothbard goes on to cite his intellectual predecessor – Ludwig von Mises – to explain just how strongly expectations played a role in the German hyperinflation in 1923:
The German hyperinflation had begun during World War I, when the Germans, like most of the warring nations, inflated their money supply to pay for the war effort and found themselves forced to go off the gold standard and to make their paper currency irredeemable. The money supply in warring countries would double or triple. But in what Mises saw to be Phase I of a typical inflation, prices did not rise nearly proportionately to the money supply. If M in a country triples, why would prices go up by much less? Because of the psychology of the average of the average German, who thought to himself as follows: “I know that prices are much higher now than they were in the good old days before 1914. But that’s because of wartime, and because all goods are scarce due to diversion of resources to the war effort. When the war is over, things will get back to normal, and prices will fall back to 1914 levels.” In other words, the German public originally had strong deflationary expectations. Much of the new money was therefore added to cash balances and the Germans’ demand for money rose. In short, while M increased a great deal, the demand for money also rose and thereby offset some of the inflationary impact on prices.
As Rothbard explains, prices not rising in proportion to a radical increase in the money supply is not only understandable, it is actually to be expected. Sure, this current situation is not a wartime economy, however, as far as Rothbard’s explanation of the psychology of the average person goes, it is not all too different from the expectations during the war. Today the psychology of the average American leads to him thinking to himself “I know that prices are much higher now than they were in the good old days before 2020. But that’s because of the pandemic, and because all goods are scarce due to the unemployment from people who had to stay home during this dangerous time. When the pandemic is over, things will get back to normal, and prices will fall back to 2019 levels.” The problem with this expectation is that it cannot last forever. As Rothbard explains
Slowly, but surely, the public began to realize: “We have been waiting for a return to the good old days and a fall of prices back to 1914. But prices have been steadily increasing. So it looks as if there will be no return to the good old days. Prices will not fall; in fact, they will probably keep going up.” As this psychology takes hold, the public’s thinking in Phase I changes into that of Phase II: “Prices will keep going up, instead of going down. Therefore, I know in my heart that prices will be higher next year.” The public’s deflationary expectations have been superseded by inflationary ones.
Rothbard explains that these new expectations will intensify the inflation rather than holding it back. Rothbard also claims that there is no way of knowing when these expectations will finally shift because so many cultural, technological, geographical, and other factors affect any given population. As a result, we unfortunately can’t say when modern Americans will realize that prices are not headed back to their pre-pandemic levels and start having intensifying expectations. But however long it does take, the last point that we have to remember from Rothbard is his claim that “When expectations tip decisively over from deflationary, or steady, to inflationary, the economy enters a danger zone. The crucial question is how the government and its monetary authorities are going to react to the new situation.” While it is too late to not have created all that new money supply, when the day does come that we enter that danger zone, it is not too late for us to react appropriately and avoid that final phase III of hyperinflation but rather allow for a healthy deflationary bust allowing the economy to recover as it so desperately needs.