Updated: Mar 19
In his lecture in 1978 at Kansas State University, the 1976 Nobel Prize-winning economist, Professor Milton Friedman stated the following:
“The trade unions don’t produce inflation for one simple reason: they do not own a printing press on which you can turn out green pieces of paper. The only such printing press is in Washington.[…] Inflation is made in Washington because only Washington can create money. And any other attribution of other groups to inflation is wrong. Consumers don’t produce it, producers don’t produce it, the trade unions don’t produce it, foreign sheiks don’t produce it, oil imports don’t produce it; what produces it is too much government spending and too much government creation of money and nothing else.[…] If Congress has been voting for higher and higher spending, and not voting the higher taxes to pay for it, why? Because it’s been politically profitable for them to do it.”
This quote from Professor Friedman sums up the origin of inflation. Inflation is defined as an increase in the general level of the prices of goods and services. But the real question is what leads to inflation? What makes the prices of goods and services suddenly go up? Inflation occurs when the level of the money supply outpaces the level of goods and services. The government, via the Federal Reserve, is in charge of the money supply. When there is too much money in the economy, it increases consumer demand because consumers feel richer and they, therefore, want to spend more, but the supply of goods and services cannot meet those demands, which consequently causes the price of those goods and services to go up. But when the general level of prices outpaces the level of the money supply, then we have a deflation. In this case, prices fall because consumers have less liquidity, and therefore get to spend less.
Most economists view deflation as a bad economic phenomenon because if consumers cannot spend, it reduces economic activity. Less spending means less revenues for businesses, and if there are less revenues for businesses, this will lead to unemployment because businesses will be compelled to cut their costs mainly by laying off their employees since they do not have enough cash to make payroll. When deflation even reaches an exhaustive level, some businesses are forced to declare bankruptcy and go out of business. Thus, inflation has been seen as a preferable situation to deflation. The government has always encouraged spending, either stimulating consumer spending or government spending. In either case, spending is the bottom line to get the economy rolling. The problem with inflation is that it reduces the purchasing power of consumers. Meaning that goods and services are less affordable than they were prior. This then leads us to the question: how is government’s size the real problem of inflation?
The size of government is the real problem of inflation because the bigger the government, the higher the spending. Big government needs a lot of resources to function. And the reason why government has got so big is because we; the consumers; the citizens; and the taxpayers; requested it. We started asking for more government involvement in various sectors of the economy.
We, the citizens, started asking for more government intervention to regulate different economic activities and sectors because we believe that government is far more efficient at solving problems of distributive justice. The American citizen loves capitalism but does not trust the market enough to let it work on its own, and therefore requests the visible hand of the state to supervise it through regulations. Moreover, the American citizen believes that the government can stimulate the economy as much as the market does. But regulation does not come cheap, let alone for free. In order to supervise economic activities, the government is going to ask for more money and more resources to implement these regulations. Every regulation implemented is based on the creation of a government agency. Every government agency comes with its load of burdens. The more government regulations are requested, the more government agencies are created in the process of enforcing these regulations.
Government agencies are created either by raising taxes or by government borrowing. If the government increases taxes too much, it will disincentivize taxpayers to work. What is the point to work if all of your salary is taken by the state through taxation? Hence, the government borrows from the Federal Reserve to make its spending. And the Federal Reserve loans that money to the government via money printing, which subsequently increases the money supply. In the nineteenth century, federal spending was overall less than 10% of total GDP. This means that back then, true wealth was truly created through the production of goods and services. Today, federal spending is approximately 45% of total GDP, according to the International Monetary Fund (IMF). This means that wealth is created artificially by increasing the money supply and low-interest rates. This, in turn, leads to an increase in companies' valuation, a valuation that isn’t reflected by their fundamentals. Inflation will always remain a problem so long government remains big in size. Politicians and government bureaucrats have no incentive to reduce the size of government because it enables to them to maintain their control over the economy through regulatory agencies. Inflation is politically profitable for government because it gets to spend money it did not create through real wealth production, but economically, it is a liability for those who produce wealth.