The real reason inflation is high
The consumer price index rose 3.8 per cent across the year to October, triggering a fresh round of debate about the cause, but one huge factor is almost never discussed.
Our economy is drowning in dollars as new home loans and government borrowing supercharge the money supply faster than the economy can absorb it.
In just 10 years to the end of September what economists call M3, the sum of all cash and deposits at banks, soared from $1.8 trillion to $3.3 trillion.
Yes, the Australian economy has grown since 2015 – mainly as a result of a nearly 16 per cent increase in the population – but nothing else relevant has grown anywhere nearly as fast.
And what did all that new money do?
Most of it went straight into the housing market where, lo and behold, prices have soared.
Strikingly, capital city dwelling prices have increased about 80 per cent since 2015, according to a series kept by SQM Research – almost precisely the same as the increase in the money supply.
Houses and apartments haven’t become more expensive so much as the buying power of the currency, and unfortunately all the wages and salaries denominated in it, has collapsed.
In terms of things the financial system can’t create out of thin air, the big returns in property have been illusory. When valued in ounces of gold, long considered by many the only timeless, universal currency, Australian property has lost significant value.
It’s fashionable to complain about how expensive things have become since the Covid pandemic, as if inflation were some unfortunate act of God, but it’s a choice.
Governments around the world have pumped in trillions of new units of currency into their economies while banks have created credit like there’s no tomorrow. The value of owner-occupier and housing investment loans outstanding in Australia, for instance, has increased by $1 trillion since 2015 to $2.5 trillion, according to Reserve Bank statistics. The more than $300bn handed out to households and businesses during Covid lockdowns were all freshly created dollars.
The official inflation figures based on CPI are artificially low, excluding asset prices which is where inflation typically shows up first. New money doesn’t increase prices uniformly at the same time, a too often forgotten insight of French economist Richard Cantillon in the early 18th century.
“The increase of money will first be felt in the channels where it enters; and so gradually it will spread to other channels and raise the price of goods and products in the whole state,” he wrote in his classic 1734 essay on monetary policy.
What’s known as the Cantillon effect describes how those who receive the new money first, such as the recipients of new loans, benefit the most as they are able to spend the money before it seeps into the rest of the economy and increases the overall price level.
Cantillon’s belief in an inextricable link between money and prices was popularised last century by American economist Milton Friedman, who famously argued “inflation is always and everywhere a monetary phenomenon”.
But central bankers and politicians junked this idea in the 1980s in favour of so-called neo-Keynesian economic models that ascribe inflation to excessive aggregate demand. Inflation arises when unemployment is too low and the economy overheats, they argue, or when workers and employers trigger a wage-price spiral.
It turns out Friedman’s and Cantillon’s ideas have at least as much to offer. The past few years have illustrated how shockingly useless these new theories have become.
In May 2021 the brightest minds at Treasury and the Reserve Bank, using the latest economic models, forecast inflation would never exceed 2.25 per cent across the next three years.
As readers know, within 12 months it had jumped to 6.6 per cent before peaking at 7.8 per cent in late 2023.
It wasn’t only Australian economists with mud on their faces. US Treasury secretary Janet Yellen later was mocked routinely for claiming inflation would be small – and later transitory – in early 2021.
All these forecasts from the first half of 2021 were made well after governments had pumped Covid stimulus into their economies. Indeed, they were made after inflation had already begun to rise rapidly and they occurred well before Russia invaded Ukraine in early 2022 (an event that politicians, laughably, would blame later for high inflation). It should be obvious now that the increase in the quantity of money was having a significant impact on prices.
In economics I was taught good money should be three things: a store of value, a medium of exchange and a unit of account. Modern currencies are obviously no longer stores of value. That’s why highly leveraged purchases of things governments and banks can’t reproduce, such as land, tend to be winning investment strategies. Accelerating money creation almost guarantees their appreciation in nominal terms.
Tightening the screws on lending is one way to limit this phenomenon, but don’t hold your breath. M3 increased 7.3 per cent in the past 12 months alone.
The Australian Prudential Regulation Authority rolled out new mortgage rules last week – only a fifth of new loans can be to borrowers with a debt of greater than six times their income from February – that were akin to imposing a 300km/h road speed limit.
“These new limits won’t be binding on most banks so will have little impact on the aggregate flow of credit to either owner-occupiers or investors,” chairman John Lonsdale said.
The Australian dollar tap isn’t about to be turned off anytime soon.
Adam Creighton is chief economist at the Institute of Public Affairs.
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