What is Inflation?
Inflation is primarily driven by monetary factors rather than supply chain disruptions. While supply chain issues and demand shocks can influence prices within certain sectors, they are not the root cause of inflation. The fundamental driver of inflation occurs when the supply of broad money (M2) exceeds the volume of goods and services produced within the economy. This imbalance results in rising prices.
Monetary policy, controlled by central banks, and fiscal policy, enacted by governments, aim to manage economic conditions and prevent overheating or excessive cooling. However, when a nation loses control over its ability to produce goods or its own monetary policy—such as is the case with the Eurozone—the challenge of controlling inflation becomes significantly more complex.
Commodities like oil play a pivotal role in the broader economy by influencing costs associated with essential goods and services, including clothing, energy, commuting, and food. Rising energy prices can drive inflation across various sectors until demand adjusts. Notably, energy commodities, especially oil, have an outsized impact on global inflation due to their linkage to the U.S. dollar and the U.S. Treasury market. These fiscal asset classes are central to global trade, with the U.S. consumption machine being funded by deficit spending in exchange for imported tangible goods.
How Did We Get Here?
The Reserve Bank of Australia (RBA), like many central banks globally, can influence the short end of the yield curve and participate in open market operations. However, it is retail banks that ultimately drive the expansion of the M2 money supply through credit creation. When the RBA keeps interest rates low, banks and investors are incentivized to chase yield, resulting in increased borrowing at short-term rates and lending at longer-term rates.
This dynamic leads to a flattening of the yield curve from the suppressed Federal Funds (FF) rate to the 10-year bond. As a result, asset bubbles emerge, with investor capital flowing into corporate bonds and equities in search of yield targets around 7%. Simultaneously, banks ramp up lending to corporate real estate and residential mortgages, further inflating property demand and prices.
Low interest rates accelerate the velocity of money, pushing more capital into stocks, bonds, and real estate, thereby increasing asset prices and supporting equity values. The wealth effect that follows drives consumption across the economy, as individuals tap into home equity to finance lifestyle choices such as home renovations, vacations, luxury purchases, or even property investment. With low rates a global phenomenon and manufacturing outsourced to low-cost economies, consumable inflation was delayed but eventually surged—like a coiled spring—when cheap Chinese imports flooded the market, pressuring domestic producers.
As employment surged in the services and gig economy, fuelled by abundant capital and easy access to credit, low unemployment and high demand for talent pushed up wages. However, wages could never rise at a pace to match escalating property prices. Meanwhile, government-sponsored capital inflows from China helped perpetuate this trend, effectively trapping middle-aged children in the family home, unable to save for their own properties. This in turn further supported demand in sectors like restaurants, gyms, and the automobile market, as personal savings took a back seat.
The Road to Rising Inflation
As global economies struggled to recover from the economic impact of lockdowns, inflation began to take hold in Western economies, exacerbated by poorly executed monetary policies. Central banks initially promised that inflation would be transitory, but this forecast proved to be inaccurate. Inflation did not subside as expected, and the reality of the situation began to unfold with stark consequences.
Inflationary pressures intensified over an 18-month period as the vast increase in the money supply started to be absorbed by the economy. A significant portion of the economy is driven by services (80%) and government spending (65%), making inflation harder to mitigate. From 2021 through 2023, Western nations experienced some of the most aggressive interest rate hikes in recent history, further squeezing household budgets. As a result, in 2024, families are facing the difficult task of managing their cost of living amidst soaring prices.
The Impact of Inflation on the Economy and the Government’s Role in Stimulus Policy
Inflation, when left unchecked, can have profound negative effects on the broader economy, even as it provides certain benefits to governments that have leveraged Keynesian economic theories. The concept of government stimulus, championed by British economist John Maynard Keynes, was initially designed to address economic stagnation. Keynes believed that economies could experience periods of inefficiency where supply and demand diverged, thus challenging the classical economic theory posited by French economist Jean-Baptiste Say. Say’s Law, which argued that “supply creates its own demand,” was effectively discredited by Keynes, who asserted that economies could falter without proper intervention.
While Keynes was correct in challenging Say’s Law, questions remain as to whether his prescribed solutions were optimal. Keynes likened money to water, believing that the velocity of money could be hindered by high interest rates or mismatched supply, thereby stalling investment and causing economic stagnation. To remedy this, Keynes advocated for a consumer-driven economy, where individuals were encouraged to spend rather than save. This policy sought to stimulate investment and bolster consumer confidence by enabling central banks to lower interest rates and inject government stimulus into the economy.
Keynesian economics, however, has been misinterpreted and misapplied by politicians and central banks over the past 80 years. What was initially intended as a tool to jump-start the economy during times of recession or depression has evolved into an ongoing justification for excessive government spending, irrespective of the prevailing economic conditions. Western governments have consistently spent more than they receive in tax revenue, often implementing schemes such as Self-Managed Superannuation Funds (SMSFs) to create a captive market for government debt. These policies effectively devalue the credit extended to the government, reducing the purchasing power of those holding such debt.
Many individuals attribute economic hardship to rising interest rates, echoing the sentiments of economists like J. Chalmers, who argue that high interest rates slow down economic activity. However, the primary issue is not the absolute level of interest rates, but the rate of change. Predictability is a fundamental requirement for healthy economies, and stable currency plays a key role in maintaining that predictability. If currency is not stable, there must at least be a widespread agreement on a consistent rate of devaluation, typically around 2% annually, to maintain confidence in its value.
Historically, the natural rate of interest has hovered around 6.5%, prior to the establishment of the Federal Reserve in 1912. Higher interest rates lead to a stronger currency with increased purchasing power, helping to keep asset prices in check and aligning economic growth with actual production. In contrast, low interest rates tend to encourage capital flow into non-productive assets, thereby expanding the money supply without a corresponding increase in goods and services. This imbalance fuels inflation.
While higher interest rates may slow consumption and growth, they also foster sustainable and progressive economic development. With higher rates, consumers can save without the pressure of taking on excessive risk to beat inflation. Though debt servicing costs may rise, asset prices generally decline, improving the ratio of savings and earnings to asset values.
Moreover, elevated interest rates can limit excessive government intervention in the economy, fostering a larger, more vibrant private sector. A healthy balance between the public and private sectors contributes to greater domestic economic independence and increases revenue from exports. Under such conditions, government debt as a percentage of tax receipts rises, ensuring that governments are using tax revenues and debt more efficiently allocating funds to projects with a positive return on investment rather than borrowing against future tax receipts for projects with questionable economic returns
The Impact of Shareholder Primacy and Government Expansion on the Economy
As businesses globally increasingly prioritize shareholder returns over the interests of consumers, the long-term stability of the commercial ecosystem is jeopardized. When short-term financial metrics such as share prices and quarterly results overshadow the pursuit of long-term value creation, the market inevitably faces a crisis. This approach, when aggregated across industries, leads to a collapse as the pursuit of immediate financial gains undermines the sustainability of the broader economy.
Similarly, the expansion of government, which has absorbed a growing number of private-sector workers displaced by globalization and technological advancements, cannot indefinitely perpetuate the illusion of economic health. Eventually, the accumulation of debt and misallocation of tax revenue leads to a decline in productivity, consumption, and rising inflation. As private sector income tax revenues diminish, alternative taxation measures are introduced, enabling the government to recover lost funds to sustain its expanding bureaucratic apparatus and central economic planning.
US Public Debt and Its Broader Implications
In the private sector, cost-cutting and technological innovation are crucial for survival. However, when these strategies are implemented across the entire economy, they diminish the demand for goods and services, further exacerbating economic contraction. As the government expands, it competes directly with the shrinking private sector workforce. The government holds a distinct advantage in this competition—it makes the rules, essentially creating a scenario where private sector competition is continually disadvantaged.
The rise of artificial intelligence (AI) compounds this issue. In the late 1990s, the internet emerged as a powerful tool, though its potential was not fully realized at the time. Today, AI is seen as the next frontier, with widespread hype surrounding its potential to drive productivity and GDP growth. While AI may contribute to efficiency, there is a real risk that, like outsourcing and offshoring, it could ultimately prove disruptive. If AI replaces up to 50% of the remaining private sector labor force, the government may be forced to continue its expansion, funding more public sector jobs through taxpayer debt. For instance, in August 2024, the Albanese government in Australia created 47,000 jobs, all funded by government debt. While additional government employment may increase tax revenues, the question remains: from whom will these taxes be collected?
The scenario described here may sound extreme, but the evidence suggests it is increasingly plausible. As inflation rises and government borrowing capacity wanes, the ability to sustain such economic models diminishes. The chart of U.S. public debt, currently accumulating at a rate of $82 billion every two days, illustrates the unsustainable trajectory. This situation cannot be rectified simply by changing political leadership—it will likely require a large-scale credit event that could trigger a global economic downturn.
The Australian Economy: Productivity Concerns and the Risk of a Corporate Real Estate Collapse
Turning to Australia, the issue of stagnating productivity remains a key concern. While construction and development companies are pivoting to new strategies, such as focusing on residential build-to-rent projects, these efforts may not shield them from the looming corporate real estate collapse. It is worth noting that despite significant investments in construction jobs, Australia has built fewer free-standing houses today than it did in 1995.
While demand for goods and services may persist, if the means to fulfill that demand are lacking, or if broader economic issues prevent fulfillment, this imbalance could lead to serious economic misadventures. As the global economy faces structural challenges, businesses must prepare for the possibility of further disruption and adapt to the shifting economic landscape
