A couple of last night's headlines

"More rate hikes" are in the works "until inflation eases". I'm leaving out words, but I got the key concept.

The concept is that inflation is caused by an overheated economy, and if we have inflation we have to cool things off. There is too much economic activity, and we need less. The economy is growing too fast, and we need it to grow slower.

The policy is based on a metaphor about temperature. The metaphor gives us a story we can understand. But that doesn't mean that the policy is right.

 

Milton Friedman used to talk about "the quantity of money relative to output". He said there is too much money, compared to the size of the economy: Too much money per dollar's worth of GDP. I like this story because it is based on economic quantities, not on the metaphor of temperature. 

I'm not saying that one of these stories is right and the other is wrong. I bring them up because I want to compare the two inflation stories. In the one story, there is too much economic activity. In the other, there is too much money.

I think Friedman would say that you can't have "too much economic activity" unless there is enough money to support all that activity: Thus, the inflation that is caused by too much activity can only happen because there is too much money. I pretty much agree with that story. So does the Federal Reserve. 

The news reports mention interest rate increases because interest rate increases will sooner or later reduce the growth of the money supply, and will reduce the growth of economic activity, and will reduce inflation. The Fed accepts this story. It is the accepted story.

The trouble with that story is, it is only a story about inflation. It is not a story about the whole economy. The only thing I've mentioned, above, is inflation. Inflation, and how we deal with it.

Hey! Inflation is a big problem. Everybody knows. If you don't know, you can tell from the amount of news coverage of inflation in recent months.

But inflation is a result. It is a result of economic activity, the quantity of money, and the rate of interest, along with other factors that we have not talked about here and which don't make the news. Inflation is a result, and we need to deal with all of its causes or our solution will eventually fail.

The last time inflation was as bad as it is now was 40 years ago or more. I keep hearing it in the news, and the "years ago" number keeps growing. They make it sound like everything was great in the years when inflation was less. But everything wasn't great in those years, and you know it. 

This is what happens, according to the accepted story: When inflation goes away, everything is okay. So when we get inflation to go away again, everything will be okay again. That is what the news reports boil down to, and apparently that is what we think.

I think we know better.

Let's go back to the inflation story and see what is left out. Back to the story of economic quantities, not the temperature metaphor. Here is the story:

• You can't have "too much economic activity" unless there is enough money to support all that activity.
• The inflation that is caused by too much economic activity can only happen because there is too much money.
• The Federal Reserve responds to inflation by increasing the rate of interest in order to reduce the growth of the money supply.
  

So, how do interest rates come into the story?

The Federal Reserve understands that borrowing money creates new money and increases the quantity of money. If we borrow less, we will increase the quantity of money less. If they make borrowing more expensive, we will borrow less. And the Fed can raise interest rates to make borrowing more expensive. So that is what the Fed does: They raise interest rates to make borrowing more expensive, so that we borrow less, to slow the creation of new money and reduce the growth of the money supply, in order to reduce the expansion of economic activity and fight inflation.

As borrowing gets more expensive over time, more and more people reduce their borrowing. So the quantity of money increases less. Over time, this reduces the growth of economic activity -- lowering the economic "temperature" -- and it reduces the resulting inflation. So the Fed keeps increasing interest rates "until inflation eases substantially," as the headline says. That is the story of making inflation go away.

The part of the story that never gets told is what happens when inflation comes down and stays down for 40 years. What happens? People increase their borrowing for 40 years. Maybe longer. As long as we don't get the inflation, people keep borrowing more and our debt keeps increasing. That's the short version, but that's the story.

So now, I have a question: What happens when we borrow money? Not the inflation part. We covered that. What else happens when we borrow money?

We increase our debt.

When we increase our debt, we increase the debt service payments we will be making out of our income. This leaves less income to spend on other things.

As a rule, our debt increases faster than our income. Household debt increases faster than household income, private sector debt increases faster than private sector income, and all-sector debt increases faster than all-sector income. As a rule, debt increases faster than income.

To simplify the picture of what happens, assume that debt is always increasing faster than income. That means that the cost of debt service is always increasing as a portion of our income. To get an idea of how much debt service cost increases for household debt, I looked at the TDSP dataset at FRED. That's "Household Debt Service Payments as a Percent of Disposable Personal Income".

I had Excel put a straight-line trend from 1980 (start-of-data) to the high point at 2007 (just before the financial crisis). The trend line rises by 1.95 percentage points, almost two percentage points of Disposable Personal Income.

That worked out to a 0.0723% increase per year during the 27-year period. Doesn't sound like much, but it does accumulate to almost 2% over the 27 years.

When the amount we pay for debt service increases, we have less income left over for other expenses. Between 1980 and 2007, we lost 2% of our income to debt service. If we were a business, that 2% change might mean we had to take the money out of our profits and pay it to our creditors.

That loss of profit could put us out of business. Financial costs arising from the growth of debt could put us out of business. Two percentage points of profit is a lot to lose.

 

Okay. When debt increases, the cost of debt service increases. It takes more of our income to pay our bills. We have less of our income left for other things, like current spending. Until there is a problem like there was in 2008, we may find ourselves borrowing more to meet current expenses, simply because our existing debt service payments consume so much of our income.

I'm not blaming anyone for this. I'm just pointing out that it happens: We end up borrowing more and increasing our debt, because money is tight because so much of our income goes to service our existing debts.

If only a few people get into trouble this way at any one time, we can point the finger and hold them in contempt, and get away with it. But if it happens to too many of us all at the same time, you get what they call "a financial crisis".

You can't fix inflation by focusing only on inflation. You have to also pay attention to the growth of debt, and the increase in debt service cost. And if you are aware of the problem, you can interpret inflation as the economy's attempt to compensate for high levels of debt and debt service costs. You can come up with a better story to explain inflation.

I know it's not as simple as I'm trying to make it sound here. But the problem is not just inflation. And the evidence that the problem is not just inflation is simple: The policymakers' solution to the inflation problem is to make borrowing money more expensive. Their solution to inflation is to make sure there is inflation in the cost of borrowing. It makes no sense.

The Federal Reserve raises interest rates to fight inflation. They raise interest rates, to get people to borrow less, to fight inflation.

Instead of doing that, or in addition to doing that, what we need is to take some of the so-called "excess" money that is already in the economy, and use that "excess" money to pay down existing debt.

No, it doesn't help if we borrow money today, creating even more debt, so that we can use that money to pay down debt. No. On the other hand, it doesn't help if the Federal Reserve increases interest rates so much and so often that they create a recession. Maybe we need to do both: raise interest rates some to slow the growth of borrowing, and create new policies that encourage people to pay down existing debt faster.

Hey, I can't keep going over these thoughts until they sound as clean and clear as I want them to sound. So I'm just going to post this thing and be done with it.