What Is Inflation and How Does It Work?

Takeway

• Inflation happens when there is higher demand than supply for a good or service.
• Inflation can be indirectly caused by money printing, cash handouts, overconsumption, or underproduction.

Inflation is an easy concept to grab yet apparently “ungrabbable” by most people, especially, politicians. 

Consider this:

While politicians saying such stupidities know it’s moronic, people voting for them don’t.

In this article, we will use Ray Dalio’s theory of how the economy works to understand how inflation works. 

The mechanism of inflation is not difficult to understand. Unfortunately, the abominable mainstream media does all it can to confuse you. 

Forget about them and their shenanigans.

Here’s how inflation really works. 

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The Basic Phenomenon of Inflation

Inflation is not more complicated than these eight words. 

Inflation happens when demand is superior to supply. 

That’s it. 

As you can see, the most counter-intuitive characteristic of inflation is that (like much of the rest of the economy), it has little to do with money. 

It’s a basic production (and consumption) problem, often worsened by government intervention.

Now that you know what triggers inflation, let’s have a look at why we have inflation in 2022. 

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The Causes of Inflation in 2022

There are multiple causes of inflation in 2022. 

1. Less supply
2. More demand
3. Higher transportation costs
4. Higher energy costs

These causes themselves have multiple causes. 

Let’s start with the first one. 

1. Less Supply

You have less supply when the economy makes less stuff than it used to. 

Let’s take an example. 

In 2007, the world thought the supply of oil wasn’t high enough for consumption. Prices were at an all-time high.

The subsequent development of the fracking method (as well as the discovery of immense oil reserves in Russia, Venezuela, and along the coast of Africa) made us realize that not only did we have enough oil, but that we were more likely to die due to burning too much of it than we were running out of it. 

Naturally, the price crashed after 2008. 

Did demand change? Yes.

It increased.

But the price never went as high as it was in 2007 because we found a lot of new ways to produce more of it. 

-> higher consumption does not necessarily mean inflation.

So, why is the world running out of oil and other things now? 

We’ll speak about oil in the last part, so let’s focus on goods. 

The virus is the first reason. When factories closed in China…whatever was produced there wasn’t produced anymore. Less supply = higher prices.

The second reason is that people are getting lazier (ever heard of the FIRE movement?). 

No one wants to work anymore. The virus forced a lot of people out of their jobs, or send them working from home. 

People suddenly realized that life was nicer chilling than slaving it away for someone else. So a lot of them quit their jobs and now live off their investment, savings, government checks, or with their parents. 

This is the Great Resignation (this is why almost all companies are desperate for workers at the moment). 

If people work less, factories produce less. If we produce less, prices rise. 

It’s not all though. The supply crisis was worsened by the fact that simultaneously, demand increased. 

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2. Increased Demand

Let me ask you a question? 

Have you ever been locked in your place, with nothing to do, because it was raining, or you were sick?

Now, let me ask you another question: have you ever had to work super late on a project you were super motivated and passionate about? 

Good. 

Now, third question: in which situation above did you eat the most? 

Likely situation one.

You see, human beings constantly fluctuate between two states: consuming, and producing. When you don’t produce (understand: work), you consume. When you don’t consume, you produce. 

While you can both consume and produce at the same, it’s impossible to do neither. 

When were the moments you spent the least money in your life? It’s when you were busy working – hence too busy to buy stuff.

When were the moments you spent the most money? When you were on holiday, doing nothing. 

When all of these people lost their jobs due to the virus, they went from being productive, to doing nothing. 

Add to this the trauma of a worldwide pandemic and you end up with people that not only don’t produce anything, but consume much more than they should! 

This phenomenon eludes everyone, but it is real.

When people work less, they consume more (seriously, weigh yourself at the beginning of your holidays and at the end…you’ll see). 

So, this is the first reason why demand increased. 

The second reason is money printing. 

Both the Fed and the ECB (European Central Bank) printed trillions to pay people that had lost their jobs and to bring capital to companies on the verge of collapse. 

These companies could then pay their debt and workers — but at a certain cost. 

To understand this cost, let’s take the example of a village with a butcher, a baker, and a chef. 

The butcher is making four steaks per day (sells three), the baker, four pieces of bread (sells three), and the chef, four meals per day (sells three).

Because there is overproduction (more supply than demand), prices are cheap and life is abundant. 

Suddenly, a virus hit. The chef must close his restaurant, and receives money from the government to buy steak and bread for himself. Due to the supply chain crisis, the baker and butcher only make three steaks and three pieces of bread per day. 

Since the chef is not doing anything, anymore, the baker and the butcher must eat at home by themselves. 

With three steaks and three pieces of bread produced per day for three people, the village has just enough to survive, so the baker and the butcher, because demand has increased (due to the chef doing nothing) and supply decreased, increase their prices. 

So the government gives the chef even more money to buy enough food, but since there isn’t any, prices increase even more. 

This is the phenomenon of stagflation, or hyperinflation. 

The last thing you need in case of inflation, is to enable people to consume more! 

Inflation happens because people consume too much already.

This is critical. If you want to decrease inflation, you whether need to increase production, or decrease demand, the latter being the easiest.

This is why the common practice is to raise interest rates and limit the amount of money in the economy so that people consume less and prices can come down. 

Unfortunately, world governments have done the exact opposite. 

This is simple: the more money people have, the more they will spend. If supply ensues, no problem, everyone becomes richer. 

If supply does not follow, then inflation happens. 

I have a theory that says that taxes don’t exist to fund the state since the state is already widely funded by money printing. According to my theory, taxes, in fact, exist to prevent people from consuming too much. But that’s a whole other story. 

Let’s have a look at why our baker and butcher produced less when their pandemic hit: the supply chain crisis. 

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3. The Supply Chain Crisis

The supply chain crisis happened also due to the virus. 

Prior to the pandemic, the worldwide supply chain system (which is an utter mess) worked with the just-in-time system. The JIT system is a system where factories and companies don’t stock their pieces, but use them to assemble the final product directly upon delivery. 

The point is to decrease costs (obviously). 

The supply chain worked extremely precisely, and was really sensitive to any small variation (like dockers strikes, for example). 

When factories closed down, they both ceased to take delivery of their products, and to assemble their products to export them. Furthermore, medical supply was directed from Asia where it is mainly produced to Latin America and Africa where it is not produced. 

Containers that arrived in these countries became abandoned. Boats stopped. 

The world was off and froze for a moment. And when it was time to turn it on again…it was difficult to put back the pieces of the puzzle into place. 

Containers lacked; workers lacked; and oil was more expensive (upcoming). 

As a result, deliveries were roughly 6 weeks late. 

Imagine a supply chain that works to deliver everything the day it needs to be delivered, having to catch up on six weeks of delays, with fewer people to do so. 

What happens in that case? 

This happens. 

Boats have to wait to be unloaded, which further delays future trips.

As everything takes more time to arrive in shops, supply decreases. 

As supply decreases, price increases. 

Let’s have a look at oil. 

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4. Higher Energy Cost

Remember that time the price of oil went negative? 

That was fun. That was also crazy. 

The price went negative because factories closed, and transportation stopped. Hence we stopped burning oil. The problem is that you can’t just turn off oil wells. 

Most countries decreased their oil production to avoid a catastrophe and luckily, the economy went back to working again (and burning oil again). 

Now, whatever oil was not consumed during these 4 weeks of worldwide lockdowns meant that at some point, factories would have to restart and catch up on four weeks of delays. 

It means that they would have to consume much more oil suddenly, which they did. 

The only problem was that oil-producing countries did not increase their production to follow a spike in demand. 

Why? 

Because…money. 

Remember our equation.

Less supply + more demand = higher prices. 

Oil-producing countries voluntarily let the price of oil goes up so that they can pocket more money. 

To be honest, the needs for oil were so big that it would have been unlikely to have them pump enough oil to stabilize prices anyway. 

The same way you eat a lot after fasting, the world burned a lot of oil after burning nothing for four weeks. 

Add to this the supply chain crisis, the Evergiven stuck in the Suez canal, and you have recipe for disaster. 

(I’ll be honest, I don’t know to what extent the supply chain crisis has played a role in the transportation cost of oil, so I’ll leave it out.)

And as if it wasn’t enough…a dictator whose country produces a significant volume of oil and gas decided, in the midst of the winter, to lead a genocide against its neighboring country, creating a double crisis: wheat, and energy. 

In June 2020, my friend sent me the following meme. 

Sounds like the meme was right. 

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Ukraine

I want to speak very quickly about Ukraine.

Let’s make abstraction from the human suffering for a moment to focus on cold, hard economics.

The war in Ukraine has acted on all levels: supply, demand, supply chain, and energy. 

Not only Ukraine can no longer grow food for itself. It can no longer grow nor export food for others (Egypt, Indonesia, etc).

As a result, people that were productive up to the 24th of February became (and I hate to say this) negatively productive, meaning they now consume more than they produce.

In a world where there isn’t enough of everything, there really isn’t enough of everything now that we both lost production capacities and increased demand. 

This war did not only kill and torture hundreds of thousands. It may create a worldwide famine of the likes we haven’t seen since Staline. 

So if you think, far away, in the comfort of your couch, that Ukraine isn’t your problem and that you are not concerned, by all means…think again. 

In a globalized world, we’re all in the same boat. 

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Conclusion

Inflation has been driven by:

• Less supply due to the closing of factories (due to the virus), the shortage of workers (due to the virus), and the supply chain crisis (due to the virus). 
• More demand due to the Great Resignation and excessive money printing.
• The supply chain crisis due to the Great Resignation and the virus. 
• Higher energy costs due to insufficient supply, excessive demand, Germany, Greta Thunberg, and the supply chain crisis. 

We can expect the war in Ukraine to further drive prices even higher. 

If you want to play your part, I can now only encourage you to:

• Reduce your consumption
• Increase your productivity

Now would be the perfect time to quit your job and start a farm, or something like that. 

To quote Jeff Bezos: 

If you want to be successful in business, you have to create more than you consume. Your goal should be to create value for everyone you interact with.

Should everyone respect this mantra, the world will never lack anything ever again. 

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