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Is Basic Economics Wrong? Or Is Something Else Going on With Inflation?

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We have been saying that given the extraordinary level of money printing the Fed has done since the beginning of the pandemic, a wave of price inflation is coming down the pike – perhaps even hyperinflation. But many will be quick to remind us that we raised the warning flag about inflation when the Fed launched three rounds of quantitative easing in the wake of the 2008 financial crisis. In fact, Paul Krugman has been doing victory laps again – reminding everybody that the inflation monster never did come out of its lair and promising it won’t this time either.

Basic economics tells us that increasing the supply of money without a corresponding increase in the number of goods and services in the economy should lead to rising prices. Is basic economics wrong? Or are there other things going on in the economy that suppressed or hid inflation in the aftermath of the great recession?

In a recent article published by the Mises Wire, economist Robert Murphy assesses several popular explanations for why the Fed’s monetary inflation since 2008 hasn’t generated a comparable increase in price inflation.

Government Numbers Hide Inflation

One explanation is that there has been plenty of price inflation but government numbers haven’t reflected it — that the government’s CPI measure vastly understates price inflation. This is almost certainly true. The CPI is calculated by analyzing the price of a “basket of  goods.” The makeup of that basket has a big impact on the final CPI number. The powers that be skew the number by what they include in the basket and the weight they give to each element.

But as Murphy notes, this probably doesn’t fully account for the lack of significant price inflation even with the extraordinary monetary policy in the wake of the ’08 crisis.  Significant price inflation could not have been hidden through statistical tricks.

Although the conventional measures may be significantly understating the rising cost of living since 2008, the mismatch between the extreme warnings and reality can’t be explained entirely by reference to data fudging.”

The Keynesian Explanation

The Keynesians offer an economic explanation for the lack of rising prices, arguing that increased government spending—even if financed by monetary inflation—won’t generate large increases in consumer prices so long as the economy is operating below its capacity.

In more technical terms, they argue that so long as real GDP is below potential GDP, increases in nominal spending serve to boost real output rather than prices. The intuitive idea is that the unemployed and other idle resources will absorb new spending first, before tightening labor and resource markets cause wages and other prices to begin rising.”

Keynesians such as Krugman point to the lack of price inflation after massive QE and government spending in the wake of the financial crisis and claim, “See! We were right!” But as Murphy points out, there are several problems with this explanation.

For one thing, the Keynesians didn’t merely predict a lack of significant price inflation; many of them predicted price deflation. For example, Paul Krugman in a blog post in early 2010 posted a graph of collapsing CPI inflation, warned that the disinflation could soon turn to outright deflation, and ended with, “Japan, here we come. (Japan had experienced sustained reductions in CPI.)

Five months later, Krugman admitted that the standard Keynesian tool of the Phillips curve—which models a tradeoff, at least in the short run, between unemployment and (price) inflation—hadn’t worked so well in the aftermath of the financial crisis. As Krugman acknowledged in a post entitled, “The Mysteries of Deflation (Wonkish),” coming into the Great Recession, “the inflation-adjusted Phillips curve predict[ed] not just deflation, but accelerating deflation in the face of a really prolonged economic slump” (italics in original). And since that hadn’t happened, the Keynesians too had to tinker with their model in light of reality. To generalize, in 2009 the conservative economists had predicted accelerating inflation, while the progressive economists had predicted accelerating deflation.

Another serious problem with the no-inflation-until-full-employment doctrine is that it was disproved in the so-called stagflation of the 1970s. The Keynesian mindset of the postwar era had originally led policymakers to believe that they had to choose between either high unemployment or high inflation in consumer prices. It should not have been possible for the economy to suffer through both evils at the same time.

And yet, once Richard Nixon killed the last vestiges of the gold standard in 1971, the remainder of the decade saw unusually high levels of both. For example, in May 1975 the unemployment rate was 9 percent while the twelve-month change in CPI was 9.3 percent. In light of the US experience of the 1970s, simple rules such as “the economy can’t overheat while there are still idle resources” can’t be the full story.

People Held on to Money

Another explanation is that despite the massive increase in the money supply, there was also an increased demand to hold money. Instead of spending cash, consumers saved. As Murphy points out, during times of uncertainty, “advantages of holding actual money become more important to many people, and so they adjust their portfolios to hold a greater share of their wealth in the form of money. This is what it means to say the ‘demand to hold money’ increases.”

Since consumers were saving instead of spending, the newly minted dollars didn’t circulate in the economy and push up prices.

After the fact, because we didn’t observe an unusual drop in the purchasing power of the US dollar from 2008 onward, we can confidently say that the demand to hold US dollars increased to offset the increase in US dollars orchestrated by the Federal Reserve. This is necessarily true.”

But as Murphy points out, this doesn’t tell us anything about what will happen during this latest round of money printing. We can only evaluate this in hindsight. People may be more incentivized to spend this time around. (And in fact, with multiple rounds of stimulus checks flowing into people’s bank accounts, they are.)

It’s also important to consider that at some point, those saved dollars will be spent. It’s possible that the inflation created in 2008 won’t show up in prices until years later.

There were also policies in place to incentivize banks to hold more cash in reserve (excess reserves). In October 2008 the Fed implemented a policy of paying interest on bank reserves parked at the Fed. From an individual commercial bank’s perspective, the interest payment offered an incentive to refrain from making new loans to customers. By 2014, excess reserves had skyrocketed to $2.7 trillion. So, while the Fed was printing money, the banks weren’t injecting all of it into the economy.

Inflation Showed Up in Asset Prices Instead of Consumer Prices

This is a pretty compelling argument. While consumer prices didn’t skyrocket, the stock market certainly did. Real estate prices spiked. When even saw big increases in the price of art. As Murphy points out, “The benefit of this type of explanation is that it underscores the arbitrariness of the conventional public discussions about money and prices.”

Why should the particular metric of the Consumer Price Index, as tabulated by the Bureau of Labor Statistics with its controversial techniques of ‘hedonic’ adjustments, be the default measure of ‘inflation?’ Indeed, academic economists have long argued that on a theoretical level, rising asset prices can be indicative of ‘easy money’ just as surely as rising consumer prices.”

The Markets Wrongly Assessed the Efficacy of Monetary Policy

Peter Schiff has said repeatedly that Krugman and other Keynesians were correct about CPI after ’08, but they were right for the wrong reasons.

It’s just because the world was wrong in their assessment of the efficacy of US fiscal policy and monetary policy, and the ability of the Fed to actually do what it was bluffing it could do, which was normalize interest rates and shrink its balance sheet back down to pre-financial crisis levels. And on anticipation of normalization of interest rates, shrinking the balance sheet, and the fact that then Europe embarked on the same failed QE policy, only later than we did, the idea was we would be tightening while the rest of the world was still easing; we were the first into the crisis but we were going to be the first out, and that created a lot of demand for the dollar. And that helped support the US economy, the US bond market, and it temporarily kept a lid on consumer prices and made it appear the Krugman was right.”

Peter insists Krugman was not right. Ultimately, he’ll be proved wrong.

We are going to get all the effects of all that inflation. It’s just going to happen later than people like I believed. It’s going to be happening, I think, now.”


The fact is, the economy is extremely complex and interconnected. It’s nearly impossible to pinpoint any one element and emphatically say, this caused that. We can turn to economic theory and say, “absent other factors, x causes y.” In the case of inflation, we can say, “absent other factors, an increase in the money supply will cause prices to increase.” But many other factors can obscure the impact or hide it completely.

It’s important to understand that just because we didn’t see hyperinflation after the ’08 crisis doesn’t mean we won’t see it this time around. The situation is vastly different. We’re seeing much more of the printed money going directly into the hands of consumers than we did during the Great Recession. This increases the likelihood that the inflation will show up in consumer prices.

As Murphy points out, the inflation doomsayers may well be vindicated.

During the housing bubble years in the early and mid-2000s, a growing number of alarmists warned that home prices were rising to absurd levels and that Americans should prepare for a giant crash in real estate and stocks. While the bubble was still inflating, the conventional wisdom dismissed these warnings as baseless fearmongering. It was only after the crash that most people recognized that the doomsayers had been correct.

Likewise, it is possible that the US dollar will crash against other currencies, interest rates on US Treasurys will spike, and official CPI inflation will rise well above the Fed’s target of 2 percent. If this happens, those early critics of the Fed’s QE policies could plausibly claim, “We were right about the impact, just not about the timing.”

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