Inflation: The Tax Nobody Wants to Pay

Felix Niederer

Inflation eats away at income and wealth, just like a tax. It's the tax we never democratically decided on – but someone has to pay for it anyway.

If you have assets, you will see their purchasing power shrinking. Inflation is eating away at them. For most people, it's not a matter of life and death. But very much a question of living standards. You can still cover your basic needs. But will you be able to afford holidays next year as you did before the pandemic? Will you be able to buy a new electric car – or will your petrol car have to last for a few more years?

Inflation doesn't only affect the wealthy. It affects everyone in their own way. Those who live on a small pension may not have been able to afford fresh vegetables before. They now switch to the cheapest pasta – and may not be able to pay their rent tomorrow. Those who could hardly afford their bread in Egypt even before inflation took off may soon have to go hungry. Wheat prices are exploding – and wages are not keeping pace.

In times of inflation, everyone loses: From people with a little wealth who just thought they were prosperous. All the way to the poor, who were thought to have nothing left to lose.

Winning in times of inflation – this is mainly achieved by people who have large debts, such as a mortgage. If inflation eats away at the nominal value of the mortgage and the property retains its value, then the assets grow. However, those who win in this way should not rejoice too soon. Sometimes states skim off the profits right away. Germany has done this twice already: Starting from 1924 with the house interest tax. And then from 1952 with the burden equalisation levy.

Put it this way: Profit is not the issue in phases of inflation. For most people with assets, the goal is above all to stop the decline. Professional management can help with this – and fortunately, in the digital world, wealth management is affordable for many.

Inflation acts like an additional income and wealth tax – for us personally. But does the state really benefit from it?

Surely, if the state has debts, then at first glance inflation leads to the same result as new taxes. Because: With the loss of the value of money, the state’s debts also devalue. The more debts, and the more they lose value, the better for the state's coffers.

Many economists therefore say: Inflation is basically a tax. Someone has to pay for what the state spends. Sounds logical. However, it's a tax that is not democratically legitimised, and it leads to massive collateral damage. And it's not even fair, to use the buzzword.

The following questions arise.

Who has to pay: Everyone equally – or the rich especially heavily? When will it be paid: At the same time as government spending – or much later? And who determines how it is paid: The citizens and their elected representatives in a democratic process?

If we don't agree politically on the tax, inflation will catch up with us. The devaluation of money will then be used to pay taxes that nobody wanted to pay.

Can we therefore say: Inflation is wanted? And, if so, who wants it? Or has inflation just happened and we simply don't know exactly what to do about it yet?

But one thing is no longer a question. Do we have inflation?

Yes, we do.

How High is Inflation in August 2022?

The latest figures are from August 2022, where we can see: The cost of living in Switzerland has been rising steadily in recent months. In July 2022, consumer prices rose by 3.4 per cent year-on-year. With these values, prices in Switzerland can almost still be considered stable.

With a price increase of 3.4%, Switzerland continues to be an island of the blissful: Consumer prices in Germany rose by 8.9 per cent year-on-year in August 2022 and by 8.5 per cent in the USA. In July 2022, the inflation rate in the US was even higher, at 9.0 per cent. Since August 2021, the inflation rate had only ever risen until spring 2022. And in the UK, the inflation rate is even at 10.1%.

Annual inflation rate in Switzerland. Headline inflation includes all prices. Core inflation includes all prices except food and energy.

Will the Time of Inflation Soon Be Over Again?

The fact that prices in the USA have been falling slightly since August 2022 is seen by optimists as a ray of hope. They believe that inflation is only temporary – and will soon be over.

The optimists base this on the fact that the prices of energy and food have risen particularly sharply. These are both goods that are currently more scarce and exported less because of the war in Ukraine. But according to the optimists, prices could quickly return to normal after the war.

However, they could be wrong. After all, a shortage of supply is only one factor that can drive up prices.

How Does Inflation Actually Arise?

In textbooks, economists usually look at three main factors for inflation: Supply, demand and the money supply.

A high money supply is a condition for inflation. Inflation can only occur if the money supply is large enough – whenever the quantity of goods in the economy as a whole is matched by an excessively large money supply. This condition is fulfilled: The money supply has been massively expanded. There will be more on how this can happen later in the article.

If we observe a high money supply, then the next factor we consider is supply. If supply becomes scarce, then the aggregate demand for goods exceeds the aggregate supply of goods. Then, if the supply cannot grow suddenly (scarcity), but there is enough money in the system (money supply), prices will rise and inflation sets in.

Why Does Inflation Continue to Rise?

When they go shopping, workers feel that their lives are becoming more expensive so they demand higher wages. If they get what they demand, they can continue to afford as much consumption as before. Demand remains too high.

If the companies then pay higher wages, their profits will fall. Therefore, if possible, they raise prices. Consumers, most of whom are also workers, notice this and then they demand higher wages.

Everyone – workers as well as entrepreneurs – notice that all goods and services are becoming more and more expensive. That is why they no longer wait to go shopping. They immediately buy things that they might otherwise have waited a few months for. Because: In a few months, these goods will be more expensive. That increases demand. But the supply has not increased. Which is why prices are rising.

Whatever dynamics we look at in inflation: We see a spiral of negotiations in which prices are rocked upwards. Nobody wants to lose, but the negotiations cost a lot of time in which more useful things could be done – and that is why everyone loses in the end.

Why Didn't Inflation Start Earlier?

When the money supply increases, inflation can occur – we've just seen that. But then why didn't inflation arise long ago? After all, the central banks of the western world have not only been expanding the money supply since yesterday – but for more than a decade.

How Much Has the Money Supply Grown in the US?

The USA started a programme called Quantitative Easing after the financial crisis of 2008. On 25 November 2008, the Federal Reserve announced that it would buy up to $600 billion of mortgage-backed securities (MBS). The first programme, QE1, was limited in time. But it was extended, in 2010 with QE2 and also in 2012 with QE3. After that, it was always continued. And in March 2020, around the outbreak of the pandemic, it was topped up as QE4.

In the 14 years since the programme began, the balance sheet of the Federal Reserve System has ballooned from $925 billion to almost $9'000 billion – almost tenfold.

The Fed's balance sheet: From $925 billion in September 2008 to $8'851 billion in August 2022. Source: Federal Reserve Board.

Which Countries Have Increased the Money Supply?

It's not only the USA that has increased the money supply.

Since 2010, Europe has been plunging into a debt crisis. The European Central Bank started a similar programme. It initially began in a limited way, then expanded, with the words with which Mario Draghi went down in history for in July 2012: «Whatever it takes.» The result: Here, too, almost a tenfold increase in total assets to almost 8'800 billion euros by May 2022.

Switzerland joined its big neighbours, but only increased its balance sheet fivefold in the same period, from around CHF200 billion to CHF1'000 billion.

Japan started the expansion much earlier. The speculation bubble on the Japanese stock and real estate market burst at the beginning of the 1990s. Until 1999, they tried one interest rate cut after another. Then the interest rate reached zero – and Japan started buying bonds on a grand scale.

How Does a Central Bank Increase the Money Supply?

Everyone likes to talk about printing money. But of course it's not about banknotes. These are the instruments involved:

1. Lowering the base interest rates. This is how a central bank lowers the yields on short-term loans. For example, for savings deposits or money market funds. The result: Loans from commercial banks become cheaper for everyone. This money can then be used to take over companies or buy real estate. The money supply increases because the loans in the commercial banking system increase. In the balance sheet of the central bank, this first measure is almost invisible (only in the context of the reserves that the commercial banks have to hold. At the ECB currently 1 per cent, at the SNB 2.5 per cent).

This first measure doesn't have an immediate effect on interest rates for long-term investments. This also requires:

2. Massive bond purchases. Here the central bank buys bonds, often those of its own government, within the framework of so-called open market actions. In contrast to the first measure, this expansion can be seen very clearly in the central bank's balance sheet. Through these bond purchases, the National Bank monetises the debts of the state: That is, an excess of debt is replaced by an excess of money, quasi one evil by another. Since it is frowned upon that the National Bank buys new issues of government bonds directly from the Treasury, it instead buys them on the secondary market from third parties. But this again gives them an appetite to subscribe to the state's next new issues. The state thus receives new money that it can spend again (on more personnel, infrastructure, stimulus checks and helicopter money). In addition, the central bank drives up the price of bonds with its purchases. This pushes down the yield. So the central bank also lowers interest rates at the long-term end.

(Read more about the seemingly paradoxical connection between the price and interest rate of bonds in our article: Bonds in Inflation: Safe is Suddenly No Longer Safe).

Can You Fight Any Crisis With More Money?

In recent decades, central banks have always increased the money supply in times of crisis. To save themselves, they have then taken the following actions:

1. By buying up bad loans. At the beginning of the first round of American quantitative easing in 2008, the main aim was to stabilise the market after the fall of Lehman Brothers. The loans were already on the market as mortgages, some of them with extremely questionable credit ratings; these mortgages were called subprime. The excessive money supply had already been created in the commercial banking system. The FED only prevented it from disappearing again – from credit collapsing and liquidity drying up.

2. By encouraging new credit. In March 2020, at the start of the pandemic, many citizens and politicians had hoped that the European Central Bank would help with more money. But after the sovereign debt crisis, the ECB already had many years of Mario Draghi's «Whatever it takes». As a result, there were hardly any bonds left in the market for it to buy; as it had already bought them all. In a memorable speech, Christine Lagarde said there was nothing she could do – the responsibility for a stimulus lay with the states: «I don't think that anybody should expect any central bank to be the line of first response. It's fiscal first and foremost.» The states have acted. They have relaxed the debt ceiling. They have taken out new loans. And they made possible what had been forbidden for decades: That in the EU the Community would guarantee loans – no longer just the individual countries. This allowed aid money to flow – and the ECB received new government bonds that it could buy for its balance sheet.

Two examples, two central banks, two different crises. And yet, in the end, the same recipe. More money solves every crisis. However, anyone who sticks to the textbook should not do that. For that, as we've seen above, says: A larger money supply calls for the danger of inflation.

In the first case, the Federal Reserve Board didn't put out a fire. In the second case, the European Central Bank deliberately poured oil on the fire.

But is the textbook perhaps wrong? After all: The danger of inflation has been around for decades. But inflation didn't materialise for a very long time – until recently.

Why Is Inflation Only Coming Now?

The official statistics say that inflation has only just begun. Before, it was moderate, and a bit of price increase is considered price stability – two per cent is considered normal (more on how normal that really is below).

In Germany, inflation only cracked the two per cent mark in April 2021. In the USA, it came in March 2021: For the first time in a long time, there was a 2 before the decimal point, at 2.6 per cent.

But the official inflation statistics only measure consumer prices – not asset prices. The market values of assets such as real estate and shares, however, have risen consistently since the beginning of quantitative easing. Such a state of rising asset prices coupled with stable consumer prices is now called asset inflation.

Hasn't Asset Inflation Been Here for a Long Time?

Since the end of the financial crisis, (almost) all asset classes have risen, from stocks to real estate to bonds. On 25 November 2008, the money glut started with QE1. Since then, in the 10 years from 1 December 2008 to 1 December 2018:

  • Bonds by 23 per cent (US Treasury Index from 1'766 to 2'171)
  • Real estate by 41 per cent (Case Shiller Index from 150 to 212)
  • Equities by 242 per cent (S&P500 from 731 to 2'506).

In other words: Everything has gone up. Even asset classes that are normally considered inversely correlated have risen at the same time. Only commodities have not really performed in this decade (but then even more so during the Ukraine crisis). The GSCI, with a lot of fluctuation, has only managed to gain 10 per cent.

Shares gained particularly strongly. Because nominal interest rates on bonds were low. And so the word among the professionals on Wall Street was: There is no alternative to shares. They even coined their own acronym for it: TINA – There Is No Alternative. Stock prices knew one direction above all: Upwards.

Why Have Consumer Prices Not Risen for a Long Time?

The money supply is getting bigger and bigger. With rising share prices and real estate prices, private assets are growing. How can it be that consumer prices didn't rise for a long time?

Let's go back to the textbook.

A large money supply only ensures that inflation can happen – it doesn't mean that inflation will actually happen. For prices to rise, too little supply must still meet too much demand.

The demand was great. New money and high wealth have driven it. At the same time, however, supply has also grown – and has been doing so for much longer, not just since 2008. There are two main reasons for this:

1. Technology is making great leaps. With software, automation, robots and artificial intelligence, productivity has increased. This has allowed a greater quantity of goods and services to be created at the same cost. There has been no price pressure. This is also because robots and algorithms often do the work that was previously done by humans.

2. Globalisation brings cheap labour. Since the opening of communist China to capitalism, the country has become the workbench of the world. And what is not produced in China comes from Vietnam, Indonesia, Bangladesh and many other countries. There has always been a new country whose labour force serves an increasingly global economy. Thus, wages have risen in individual countries – but globally they have actually fallen in real terms.

This has slowed down consumer prices for a long time. Only asset prices have risen. But shouldn't at least rents rise when real estate prices rise?

But Why Is Inflation Starting Now?

In May 2022, the world looked like this: Unemployment is low. Almost everyone who wants one has a job. Neither wheat nor oil are coming from war zones. And because of new lockdowns, there are fewer bicycles and smartphones from China. These would be the ingredients for a supply inflation that would subside by itself.

More problematic is that the economy is booming – and therefore there is full employment. Most of us won't like to hear this. But full employment is the enemy of price stability. As long as for every job there is someone else who would like to do it, there is no inflation. But if workers become scarce and can change jobs with a wave of their hands, and perhaps earn 20 per cent more after changing, then inflation is unstoppable.

If inflation is not only due to problems in the supply chain, but at least partly due to the economy running hot, then only a recession can stop it again.

How Do You End Inflation?

Simple answer: With hard measures. The central bank can end inflation by raising interest rates and reducing its balance sheet. Unlike expanding the money supply, this is actually easy to do.

In regards to this, the legendary British economist John Maynard Keynes said: «You can lead a horse to water, but it has to drink itself.» Only if private households and entrepreneurs want the credit, can the commercial banking system create money. And only when states issue it, can the central banks print it.

A central bank, on the other hand, can brake hard all by itself, without outside help. And: Braking hard is easier than accelerating. However, like a chauffeur who has to brake, it will probably do so cautiously – more slowly than it could.

Starting from the FED governor Alan Greenspan, the following pattern can be observed: The central bank will keep raising interest rates in very small steps until something breaks a little. If the recession is then there, it may start lowering again right away.

If the central bank is too cautious, however, it can prolong the suffering. And that is usually the complicated answer to the question of how to end inflation. In the 1970s, the US experienced two recessions and four years of sluggish growth but galloping inflation – the combination of stagnation and inflation we know today as stagflation.

This phase only came to an end in 1979 when the President of the Fed Paul Volcker raised the key interest rates – and adopted a whole package of further tough measures. We know this package today as the Volcker Shock. And a shock it was indeed: Mortgage rates rose to 18 per cent.

Is Inflation Desirable Today?

The mandate to central banks is clear. Almost all central banks in the world have price stability in their mandate. For some of them, the mandate also explicitly includes creating the conditions for full employment – for example, at the US Federal Reserve.

In order to achieve full employment again after the financial crisis of 2008, the Federal Reserve Board has since aimed for an inflation target of 2 per cent. Inflation has become a goal that can be stated publicly – and that should even be achieved.

Since then, the presidents of the Fed, from Ben Bernanke to Janet Yellen to Jerome Powell, have even regretted in public appearances that they had fallen short of this inflation target. In plain language, they have said: We should actually print even more money than we are already doing. And we can do that safely.

Is It Possible To Control Inflation?

Everyone wanted a little inflation in recent years. What no one really wants, however, is a situation like Goethe's. «I can’t get rid of the spirits I have called» as he laments his sorcerer's apprentice in the 1797 ballad, while the ghosts flood the house.

This is exactly what can happen with inflation.

There are several historical examples of inflation getting out of hand. The most spectacular case in Central Europe is the hyperinflation of the Weimar Republic. Inflation began with the First World War in 1914, slowly at first, then faster and faster – until the decline in value in 1923 took on absurd characteristics.

One hundred trillion marks. That sounds like a lot of money. In mid-November 1923, however, you could buy just four loaves of rye bread in Germany for that. Inflation only came to an end when a new currency was introduced on the 15th of November: The Rentenmark. With it, 100 trillion Reichsmarks became 1 Rentenmark.

We don't have to look back 100 years for more examples. There has been hyperinflation time and again. Recent examples include Venezuela (2019), Zimbabwe (2008) and Yugoslavia (1994) – where the old currencies collapsed and had to be replaced by new ones.

To curb inflation, many countries resort to currency reform even when they don't yet have hyperinflation. Argentina and Turkey have both experienced decades of inflation of 10 to 30 per cent annually, and both have introduced new currencies.

However, the success of these currency reforms was very ephemeral. Inflation quickly returned to the old levels. The people in the country had become accustomed to inflation. Confidence in their own currency remained low. And those who could, changed their money into hard currencies as quickly as possible, preferably into US dollars or euros.

Who Can Afford Tough Measures?

One of the few cases in which a central bank restored confidence on a lasting basis was at the end of the seventies in the USA – with the Volcker Shock. The dollar regained its former strength and remained the world's reserve currency.

The price: Mortgage rates of 18 per cent. In 1979, the Fed raised key interest rates sharply to 17.6 per cent. By 1981 they had risen even further – to 22.36 per cent.

But if this is the solution, the question is: Could the USA still pay the interest on its debt after such a rate hike?

At the end of 2021, there was over $28'000 billion outstanding federal debt. At 20 per cent interest, that means an assumed interest burden of $5'600 billion – almost as much as the government spent in 2021 in the first place ($6'800 billion).

Stop all government services, lay off all government employees – just to pay off debt instead? It's unlikely that democratically elected politicians would want to resort to such means.

A solution like that of the Weimar Republic seems more conceivable: The state was the main beneficiary of hyperinflation. Its debts amounted to 154 billion marks in 1923. When the new currency, the Rentenmark, was introduced on 15 November 1923, it was just 15.4 pfennigs. The state thus eliminated its own debts. From landlords whose mortgage debts expired worthless, the state recovered the capital gain within the framework of the house interest tax.

In the Weimar Republic, it was mainly the costs of the First World War that were on the state's books as debts. In the last 20 years, quite different measures have led to more debt – from bank bailouts to wage replacement for all those who could not work because of the Covid-19 pandemic. But no matter what the state spends the money on, at some point someone has to pay.

Can't We Just Keep Printing Money?

In the long run, inflation is always a monetary problem. That is the credo of monetarism, a school of economists based around Nobel Prize winner Milton Friedman. Other economists prefer to put long-term considerations in the background. «In the long run we're all dead», John Maynard Keynes sneered. Keynes was nominated three times for the Nobel Prize. He never received it – and yet today an entire school of economists is named after him: Keynesianism.

In recent decades, the credo of the monetarists was considered taboo in monetary and economic policy. The ideas of the Keynesians were in vogue. Especially in the latest version: The Modern Monetary Theory. On the subject of money printing, it says: Yes, we can!

In 2020, the US economist Stephanie Kelton even made this the subject of an entire book: «The Deficit Myth: Modern Monetary Theory and the Birth of the People's Economy». In it, she explains why every state that is master of its own currency can basically print as much money as it wants. And that is why the state can also spend as much money as it sees fit – and everyone votes on it democratically.

An obstacle that even Kelton herself admits: Wage inflation. But that was not yet in sight in 2020. And that is why Kelton was able to conclude: As long as there are still people without jobs, the people with jobs cannot demand better wages. And without wage pressure there is no inflation – no matter how large the money supply becomes.

However: In July 2022, the unemployment rate in the US was just 3.5 per cent. Many economists say that it can't get any lower. That is full employment. Because a part of the workforce is always between jobs. This unemployment due to job search is considered the base, most economists estimate it at around 4 per cent. And you don't just have to ask the economists if there is full employment in the US. Many workers actually have two jobs. If only because the wage from one full-time job is not enough to live on.

And the Modern Monetary Theory doesn't solve another problem: Not all states are masters of their own currency. The countries of the Eurozone have surrendered their sovereignty to the European Central Bank. From it, the 19 states receive a uniform monetary policy – but continue to make 19 different budgets.

To sum up: If a country is not master of its own currency, it cannot print unlimited amounts of money. And at the latest when full employment is reached, even a sovereign country must stop printing money. Otherwise, what seems to work in the short term will go wrong in the long term.

Who Will Pay For It?

For a long-term perspective, we'd better switch to Milton Friedman. In doing so, many things become clear. The state may be able to spend more than it takes in the short term. But in the long run, it must either raise taxes or print money.

Whether on the left or the right, printing money is easiest for politicians. In a legendary speech from 1978, Friedman said the following in response to the question of who pays for excessive government spending:

«Do you suppose the tooth fairy does? You pay it and I pay it, and one of the ways we pay it is by the tax which we call inflation. Inflation is from this point of view a form of taxation.»

-Milton Friedman, Nobel Laureate in Economics

If the deficit is paid for with taxes, then the state retains its policy space. We have all got used to the fact that income tax is progressive. This means that those who earn more pay disproportionately more taxes. This may be politically desirable, because with a higher income one can afford higher tax rates. The state could tax large fortunes with special taxes.

If, on the other hand, the state accepts inflation in order to pay off its debts, then this hits everyone. It hits the wealthy and eats away at their assets. But it also hits those who live on the edge of the subsistence level – and otherwise pay no taxes at all.

What Other Taxes Are There?

Taxes in the narrower sense and inflation as a tax – these are only two of the ways to finance government spending. The US economist Carmen Reinhart, Vice President and Chief Economist of the World Bank, names four other methods:

  • Capping interest rates on government debt.
  • Nationalising banks. And preventing other banks from entering the market.
  • National banks must buy the bonds of their own state or hold them as reserves.
  • Control of capital movements.

The first method is currently used in western countries. All of the others are not. But they are popular worldwide in countries where inflation threatens to get out of hand. These measures are part of what Reinhart and, before her, the US economists Edward S. Shaw and Ronald McKinnon called financial repression – an arsenal of measures with which states can divert money from private individuals into their pockets.

How Can You Protect Your Assets?

Few people have increased their wealth during inflation. One of which is the German Hugo Stinnes, who managed to become really rich. During the hyperinflation of the Weimar Republic, he borrowed in Reichsmarks and invested in hard currencies. A risky strategy – that worked out for him. There is no guarantee that it can be repeated today. Especially because at present almost all hard currencies are entering the inflation phase at the same time.

For most of us, it means: Avert damage. So in times of high inflation, don't specifically look for more yield. But perhaps stay a little further away from the vehicles that governments use to finance their debt – bonds.

Why bonds in inflation are problematic is explained in this article: Bonds in Inflation: Safe is Suddenly No Longer Safe. Read about how real assets can better protect your portfolio and how to increase their proportion in your portfolio at True Wealth – Inflation: Protecting Wealth With Real Assets.

Disclaimer: We have taken great care with the content of this article. Nevertheless, we cannot exclude the possibility of errors. The validity of the content is limited to the time of publication.

About the author

Felix Niederer

Founder and CEO of True Wealth. After graduating from the Swiss Federal Institute of Technology (ETH) as a physicist, Felix first spent several years in Swiss industry and then four years with a major reinsurance company in portfolio management and risk modeling.


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