What Even IS Inflation?

“Inflation is an increase in the quantity of money and credit. Its chief consequence is rising prices. Therefore, inflation—if we misuse the term to mean the rising prices themselves—is caused solely by printing more money. For this the government’s monetary policies are entirely responsible.”

— Henry Hazlitt, Economics in One Lesson

“Inflation is not a natural disaster or a disease that strikes a nation; it is a policy of the government, and the only way to stop it is for the government to stop inflating.”

— Murray Rothbard, What Has Government Done to Our Money?

If someone were to ask me to point out the single most destructive action a government can do short of slavery and war towards it’s own population, I would have to say Inflation.

Inflation is the main reason why you work so much and it feels like you’re not making any progress. It is an insidious form of taxation that can be levied at the discretion of the Central Bank, and it disproportionately affects the lower class.

When I studied economics, I first learned about supply and demand, and how prices adjust to equilibrate these 2 forces. Prices going up and down is a natural consequence of the market. Nothing to see here. But what in the f… is happening when all prices go up at the same time?

Productivity and Prices

Do prices tend to go up or down?

If you were born within the last 50 years, you’d be excused for thinking prices sometimes go down, but, in general, it feels like they go up all the time. But sir, let me tell you what: prices tend to go down over time.

That is because, every year, new advances in technology help us improve our collective productivity. The more productive we are, the more we can produce with the same amount of labor. This is true for most markets. Sure, there will always be unexpected events that cause either an increase in demand or a shortage of supply in the market. But these are natural phenomena, and have nothing to do with inflation.

Case Studies: Supply and Demand Shocks

Before saying how things can go wrong, we must first say how they can ever go right.

In a market economy, things are often connected in very subtle and indirect ways. What does the price of cow feed have to do with the price of pizza? Well, cows are a higher-order product in the making of pizza.

The relationships between prices are often way more obscure than this. But the important point to remember here is that fluctuations in supply and demand are always happening, and these problems contain within themselves the seeds of their solutions.

Let’s see how prices behave in 2 different scenarios.

- Case Study: Increase in demand for memory (RAM sticks)

With the advent of LLMs, one of a computer’s most common components has skyrocketed in price: memory sticks.

RAM is a way computers make operations faster. Data Centers are making a lot of calculations, and having more fast memory available can make them significantly faster. More memory means more calculations in less time.

But these memory sticks are also a component of every computer. So, because the demand for them has increased, due primarily to the surge in Data Centers that are being built, you should see them go up in price.

Because of that, you should also expect to see every computer, including personal notebooks, going up in prices.

This increase in prices affects some but not all other products; for example, you should not expect to see the price of eggs going up due to changes in RAM prices.

This signals an opportunity for entrepreneurs in the market. Companies like Micron and Samsung have already announced the building of new factories to produce more RAM.

- Case Study: Shortage in the supply of Oil

Some price fluctuations have much wider-ranging effects on the economy. Often, when there is a War in the Middle East, you’ll see the price of oil go up due to disruptions in the supply chain.

Those types of supply shocks can have a much wider effect because a commodity like oil is (in a very indirect way) a higher-order product of most other items. Almost everything is downstream of oil, due to our reliance on it for transportation and energy.

Even so, prices will change in different magnitudes. The price of gas is expected to be impacted much more than the price of silicon chips (which is much further down the chain).

The interesting thing about all this is how these circumstances are temporary.

Within a capitalist system, every time there is an increase in price, that signals to entrepreneurs that there is an opportunity to make more money if they invest in solving those issues.

The Fracking Example

People have been experimenting with new ways of drilling oil for years. The first commercial Frack was tried as early as 1949, but it was an economic failure due to the cost of making such a contraption work.

Fracking is significantly more expensive than “conventional” drilling. Throughout the early 2000s, oil prices began a steady climb. When oil sat around 20-30 a barrel in the 90s, fracking was a laboratory experiment that lost money. When prices soared toward 100-140 a barrel in 2008, the math suddenly worked. Companies could spend 5-10 million on a single well and still turn a profit.

The breakeven price for fracking in 2008 was between 70-90 per barrel. At anything less than that, the operators would lose money. Today, technology has improved so much that fracking operations can break even when oil is at 40-50 a barrel - something that would have been impossible during the initial boom.

In short, higher prices invite competition, competition invites technological advances, which improves productivity, and productivity brings prices down.

- Tip: Valuing Cyclical Commodities Stocks

Many commodities, like oil, minerals, and others, are considered “cyclical businesses”. That means that they go through phases of expansion and contraction that are related to the rise and fall of their respective commodity prices.

If the price of Oil rises, an oil company like Occidental Petroleum would have higher profits, which would invite competition. Many competitors do not possess the expertise that Oxy has in drilling for oil; therefore, they have lower margins. Newcomers tend to have lower margins (a higher breakeven point).

When analyzing stocks in cyclical commodities, it is worth spending some time finding out their “breakeven” point. A company with a lower breakeven point is almost certainly a “better” company than an alternative with a much higher breakeven point. They can survive a bigger crunch in contraction periods and have better profit margins during expansions.

All else being equal, the lower the breakeven point, the better the opportunity.

Advances in technology are not a given; things can go badly wrong in a society leading to regressions in technology, but that is usually the exception. It usually takes major events, like wars, the burning of Alexandria’s library, or the collapse of empires, to set us back significantly in terms of technology.

If that is the case, what is happening that we see prices going up all the time?

What is Inflation

We’ve established how things can ever “go right” in an economy, and how prices are signals that tell entrepreneurs where to deploy their resources to explore inefficiencies.

Now, we shall explore how inflation is a very different phenomenon, and what impacts it brings to the market.

To understand what inflation really does, imagine a simple economy where gold coins represent all the money in circulation. The coins don’t have intrinsic value — they’re just a way to express how the market ends up pricing each product relative to the others:

What Inflation is Not

Inflation is NOT, as we saw, the rise in prices. It is the debasement of the purchasing power of money, which LEADS to rising prices. Supply and Demand effects are not inflation. This sounds like a simple confusion or simplification, but it isn’t.

How they lie to you

The Bureau of Labor Statistics (BLS) defines inflation as a process of continuously rising prices or, equivalently, a dynamic decline in the purchasing power of money. Essentially, they view inflation as the result of various economic pressures that make goods more expensive.

The most common metric is the Consumer Price Index (CPI). Here is how it works:

1. The “Market Basket”: The BLS tracks the prices of about 80,000 items that a typical urban household buys
2. Weighting: Not all items are equal. A 10% increase in rent affects your life more than a 10% increase in toothpaste, so rent is weighted more heavily.
3. The Formula:

4. Core CPI: They often report “Core” inflation, which strips out food and energy because those prices are “volatile” (though most citizens find those are the prices that really matter).

The lie here is that they are measuring ALL effects on prices as inflation (or deflation). But as we saw above, prices may go up for supply and demand reasons, and that’s got nothing to do with inflation.

Let it be clear that this conflation is no accident. The intent behind it is clear. Confusing the two is great for the government, after all, all inflation is government made, and this “confusion” allows politicians to murder rigor all day long and blame corporations for their “greed”.

- Inflation is actually much higher

As we just saw, prices tend to go down over time. So, while everything is getting cheaper in real terms, prices are going up, and they are going up by more than real prices go down.

That means that, if official Inflation was 2%, in reality, it could very well be over 3% or more!

The Cantillon Effect

Understanding why the government prints money is easy. Imagine you yourself had a money printer at your house… You could print money and buy stuff without having to earn it with actual labor. That’s just what the government is thinking. By printing money, the government can spend beyond its resources.

But inflation is even more insidious than just “all prices go up,” and government capturing that difference. In reality, new money doesn’t reach everyone at the same time. It enters the economy at a specific point — typically through the banking system — and ripples outward. The people who receive the new money first get to spend it at the old prices, while people who receive it last face already-inflated prices.

This is known as the Cantillon Effect, named after Richard Cantillon, an 18th-century economist who first observed this phenomenon.

Simulating the Cantillon Effect

The diagram above shows the broad order in which new money spreads. In the example below, you can watch that process play out in an Evenly Rotating Economy (or an Economy in Equilibrium). This is a simplification, of course. In reality, economies are always in flux, but it is a useful tool for visualizing the effect of inflation.

In this simulation, we wanna track 2 things:

1. The Flow of Money
2. The Flow of Goods

Money flows steadily between the nodes during equilibrium, and goods also flow steadily from the market towards the nodes, according to their spending.

The conditions for our example

• Every round, agents buy “goods” from every other agent, but in different quantities. This is represented by the market in the middle of the canvas. For this example, the amount of good is kept stable.
• The market always produces 200 goods per turn. Agents “fight” for those goods, the more they spend, the more goods they get.
• You can see how much of their budgets each actor spends on each other actor by clicking on the node.
• In an Evenly Rotating Economy, the flow of goods is stable. The system has reached an equilibrium. Each agent get’s the same amount of goods every round. That is called the agents baseline.

In reality, each agent is buying “economic goods” from each other agent, the market in the middle is a way to simplify the visualization of the flow of goods vs the flow of money.

Let’s print some money!

Click the button to print money and see how the system behaves:

1. First, upon printing money, the government gets a sudden burst of purchasing power. It immediately spends that money. A few things happen in rapid succession:
   1. The government acquires more goods than baseline. You can visualize that effect by tracking the green dots from the market going in the government’s direction. Those represent extra goods that the government can afford with the printed money.
   2. We keep track of the total extra goods each agent got on the bars at the bottom of the simulation.
   3. More money chasing the same amount of goods = inflation. You can track the prices going up in the top right corner.
2. The money flows out of the government into the other agents, but not in the same proportion. Banks (45%) and Large Corporations (30%) get the money first, and so, in the second round, are also beneficiaries of the large influx of money.
3. This allows them to buy more goods than baseline.
4. Workers and Local Businesses are downstream of the effects. They get fewer goods than baseline, since their supplies of money have not yet adjusted, so they have less than the equilibrium amount to buy goods.
5. The effects ripple through the system until they slowly subside. By the time the system goes back to equilibrium, the Workers and Local Businesses have been heavily shafted.

Fiat Money and the Gold Problem

We know how the government is stealing from you, and you know how it works. Was this always the case?

No. It wasn’t.

That’s because money was not an invention of some bureaucrat. It is the culmination of the cooperation between men. If you disrupt and debase money, you are debasing trust and cooperation.

It is impossible to grasp the meaning of the idea of sound money if one does not realize that it was devised as an instrument for the protection of civil liberties against encroaching inroads on the part of governments. ~ Ludwig von Mises

Why is the price of gold a mirror image of the inflation metric? To answer this, we need to understand why gold has won out as money by many different civilizations.

How Money Emerges

In a barter economy, trade is brutally inefficient.

What people naturally do to solve this problem is start accepting goods they don’t personally want, but that they know other people will accept. A wheat farmer might accept salt - not because he needs salt, but because he knows the shoemaker will.

Over time, the most marketable commodity - the one that holds its value, that everyone recognizes, that doesn’t rot or break - gets selected by the market as the medium of exchange. This is money.

Throughout history, many commodities have served as money. Cattle in ancient pastoral societies. Shells in parts of Africa and Asia. Salt along Mediterranean trade routes (the word salary comes from the Latin salarium - payment in salt). Tobacco in colonial Virginia. Giant Rai stones on the island of Yap.

But each of these had fatal flaws. Cattle die. Shells can be harvested in bulk. Salt dissolves. Tobacco rots. For something to serve as money across long periods and large populations, it needs to satisfy specific properties:

1. Durability - it must not degrade over time
2. Divisibility - it must be possible to break it into smaller units from smaller transactions
3. Portability - it must be easy to transport relative to its value
4. Scarcity - it must be hard to produce relative to the existing stock

Gold exceeds on all of those. This is how it became money.

From Gold to Paper

Gold had one practical weakness: moving it was dangerous and inconvenient.

A merchant shipping goods across the Mediterranean didn’t want to carry chests of gold coins through bandit territory. A wealthy landowner didn’t want hundreds of ounces sitting under his floorboards. The solution came from goldsmiths - the first bankers.

Goldsmiths had the vaults, the security, and the reputation. People began depositing their gold with them for safekeeping. In return, the goldsmith issues a paper receipt - a note stating that the bearer was entitled to redeem a specific weight of gold on demand. These receipts were the first bank note.

As long as everyone trusted the goldsmith, the receipt circulated just as easily as the metal itself.

This was an elegant market innovation. The gold stayed safe in the vault, while paper was used to make transactions easier.

The notes were always backed by gold in the vault!

Then the goldsmiths noticed something. Depositors almost never all came to withdraw their gold at the same time. On any given day, maybe 10% of receipts would be redeemed. The rest just circulated as paper. So the goldsmiths started doing something fateful: they issued more receipts than they had gold. They lent out paper claims on gold that didn’t exist.

This was the birth of fractional reserve banking. It was, in a strict sense, fraud - the goldsmith was issuing property titles for property he didn’t hold. But it was profitable fraud, and it worked as long as too many depositors didn’t show up on the same day. When they did, the goldsmith went bankrupt. These were the first bank runs.

- Case Study: John Law and the Mississippi Bubble (1716–1720)

The first large-scale experiment in central banking and fiat money took place in France, and it ended exactly the way Austrian theory would predict.

John Law was a Scottish gambler and self-taught economist who fled to the continent after killing a man in a duel in London. He spent years studying banking in Amsterdam and eventually pitched an idea to Philippe d’Orléans, the Regent of France: let him create a bank that would accept gold deposits and issue paper notes in return. The notes would be more convenient than metal, and the bank could lend out the gold for profit.

The Regent, facing a French treasury bankrupted by Louis XIV’s wars, agreed. In 1716, Law established the Banque Générale, which was bought by the Crown in 1718 and renamed the Banque Royale — making it France’s first central bank. Law also founded the Mississippi Company, a joint-stock venture that absorbed all French colonial trading companies and, eventually, the entire French tax collection apparatus.

Law’s genius — and his fatal error — was the same move the goldsmiths had discovered: he issued far more paper notes than the bank held in gold. The notes flooded the economy. Share prices in the Mississippi Company soared from 500 livres to 10,000 livres. The word millionaire was coined to describe the beneficiaries. For a brief, intoxicating moment, John Law was the richest man in Europe and the most powerful financial figure France had ever seen.

By January 1720, it all came crashing down, inflation was running at 23% per month. Depositors rushed to convert their paper back into gold, but the gold wasn’t there — it had never been there, not in sufficient quantity. The bank restricted redemptions, then suspended them. Share prices collapsed from 10,000 livres back to 500. Food prices soared by 60%.

Law was dismissed from his position as Controller-General of Finances and fled France. He spent his remaining years gambling in Rome, Copenhagen, and Venice, never regaining his former wealth. He died in poverty in 1729 and was buried in the church of San Moisè in Venice.

It didn’t take long for governments to see what the goldsmiths had stumbled onto. If a private banker could issue more receipts than he had gold and get away with it most of the time, imagine what a sovereign state could do - one that could compel acceptance of its notes by law and imprison anyone who refuse them.

Law’s failure didn’t discouraged governments from trying again - it just taught them to be more cautios about it. The Bank of England had already been chartered in 1694, two decades before Law’s scheme, and it survived precisely because it moved more slowly. The pattern repeated across Europe and eventually in America.

Central banks were the formalization of this principle. The gold standard, as practiced by most nations through the 19th and early 20th centuries, was never a pure 1-to-1 backing. It was always a managed ratio, with governments holding a fraction of the gold that would be needed if everyone showed up to redeem their notes at once. The entire arrangement rested on confidence - the belief that not everyone would show up at once.

Wars were the turning points. Governments have always suspended gold convertibility during wartime, because fighting wars is expensive and gold reserves are finite. Britain suspended convertibility during the Napoleonic Wars. Most of Europe did the same during World War I. Each time, promising to restore convertibility after the war. It was always restored at a worse ratio, effectively devaluing the currency against gold.

The most brazen act came from the United States. In 1933, President Franklin Roosevelt signed Executive Order 6102, making it illegal for American citizens to own gold - they were required to sell their gold to the Federal Reserve at 20.67/ounce, after which the government revalued gold to 35/ounce, pocketing a 70% profit at the expense of every citizen who had just been forced to hand over their savings. After World War II, the Bretton Woods agreement made the dollar the world’s reserve currency, still nominally backed by gold, but only foreign central banks could redeem - ordinary citizens had been locked out for over a decade. Then, on August 15, 1971, Richard Nixon closed even that last window, announcing that the United States would no longer redeem dollars for gold at any price. The last thread connecting paper to metal was cut, and every major currency in the world followed suit.

- Money vs Currency

Money is a store of value that emerges from the market. It is durable, divisible, portable, and — above all — scarce. Gold is money. It has been money for five thousand years, not because governments said so, but because the market selected it through the process we described above.

Currency is a medium of exchange. It is useful for buying your coffee and paying your rent. The dollar, the euro, the yen — these are currencies. They are accepted because governments compel their acceptance through legal tender laws. But being accepted and being valuable are two very different things. A currency can be accepted today and worthless tomorrow. Ask anyone who lived through hyperinflation in Weimar Germany, Zimbabwe, or Venezuela.

The Stock-to-Flow Ratio

With gold, there is still an expansion of the total stock.

All the gold ever mined in human history - every ounce pulled from every mine on every continent since the Egyptians first panned the Nile - still exists. About 205,000 tonnes of it.

Annual gold production adds roughly 3,000 to 3,500 tonnes per year. That’s about 1.5% of the existing stock.

This ratio - existing stock divided by annual production - is called the stock-to-flow ratio. Gold is approximately 60-to-1, meaning it would take 60 years of current production to double the supply that already exists. No other commodity comes close. Silver sits around 20-to-1. Copper, oil, and agricultural commodities are all under 1-to-1, because they get consumed.

This is what makes gold hard money. No miner, no government, no cartel can meaningfully inflate the supply of gold. The physical constraints of geology enforce a discipline that no politician ever would.

Now compare this to fiat currency. In 2020 alone, the Federal Reserve increased the M2 money supply by roughly 25%. In a single year, they did to the dollar what it would take gold miners seventeen years to do to the gold supply. And they did it by pressing a button.

Gold Doesn’t Go Up. The Dollar Goes Down.

This is the answer to the question we posed earlier: why is the price of gold a mirror of inflation?

It isn’t that gold is becoming more valuable. Gold today buys roughly the same amount of goods it bought a century ago (probably more seeing that goods have become cheaper).

What changed is the dollar. In 1971, when Nixon severed the last link between the dollar and gold, an ounce cost $35. Today it cost over $5,000.

Look at the charts at the top of this page. The Purchasing Power chart and the Gold Price chart are telling the same story from opposite ends. One shows the dollar falling. The other shows gold “rising”. They are (close to) mirror images because gold is the reference point - gold is the ruler, and the dollar is the thing being measured. It keeps shrinking.

This is why gold is a defense against inflation. Not becaus it’s a “good investment,” and not because it “goes up.” It’s because gold is money - real, market-selected, physically scarce money - and holding it means opting out of the government’s debasement scheme. When you hold gold, you are storing your labor in something that cannot be printed, cannot be debased, and cannot be inflated away at the whim of a central banker.

The gold standard did not collapse. Governments abolished it in order to pave the way for inflation. The whole grim apparatus of oppression and coercion - policemen, customs guards, penal courts, prisons, in some countries even executioners - had to be put into action in order to destroy the gold standard.

– Ludwig von Mises, The Theory of Money and Credit

Stocks: Owning What Cannot Be Printed

Gold is not the only shield. There is another asset class that protects against inflation, though for a very different reason: productive businesses.

When you buy a stock, you are buying partial ownership of a company - its machinery, its brand, its contracts, its future earnings. Unlike the dollar, a business can reprice. When inflation erodes the purchasing power of the currency, a company’s revenuew rise in nominal terms because it sells its goods and services at higher prices. Its costs may rise too, but a well-run business with pricing power can pass those costs through to customers and keep its real margins intact.

This is one of the reasons why, over the long run, the stock market has outpaced inflation. Because stocks are holding a claim on real productive assets rather than on paper. You are trading depreciating currency for ownership of something that generates value.

To make that less abstract, look at the index chart below. It does not compare the raw dollar prices of Gold and the S&P 500 on a single axis. It rebases both lines to the date under your cursor. That is why the lines move when you hover: the chart is resetting both assets to 1x at that moment, so you can compare which one appreciated more from that starting point forward.

Of course, not all stocks are created equal. Understanding which businesses can weather inflation - and which ones get crushed by it - is an entirely different discussion.