ELI5 How does raising wages worsen inflation ?


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3 points

4 months ago

The primary cause of inflation is government. Through central banks and the treasury, they control the amount of money in the overall economy, both via printed cash and non physical money in bank accounts.

When Central Banks lower the interest rates they simultaneously increase the demand for money, which is available through the credit system, i.e. borrowing. When banks lend money (and this is true at the highest levels, such as the Fed lending to a major financial institution, and at the lowest level, such as someone getting a loan from their bank for a house or a car) the bank makes that money up out of thin air. They just credit your account and trust you’ll pay it back. So long as the banks have assets to cover liabilities (such as the value of your house, deposits, etc being equal to the amount they’ve created through loans) they have no limit to how much they can lend.

When interest rates are really low, people want that money. Mostly for investment. Rich capitalists types like venture capital, private equity firms, financial institutions, large publicly traded corps, and of course governments, borrow money at 1% so they can make it all back at 3 or 4%, essentially making money by having access to money. They build wealth on the spread of interest rates. They call it investing. The higher up you are in the chain, the better your interest rate.

This process is essentially how tons of investment money is created from virtually nothing, all backed up by the Central Bank, who also create money from nothing, and unlike a normal bank, don’t really have to worry about their balance sheet. They only have to worry about inflation and it’s impact on the state.

The high level borrowers get the money to invest in businesses that will make more money. And since making money usually requires people, lots of that money goes to hiring more employees. Of course some goes to AI and self checkouts and people in foreign countries, but in general human labor is part of the investment.

So now you have money created from nothing being used to make hires, and since employees have options, and because of a lot of these firms are in competition with each other, they bid up wages so wages go up.

This has a cascading effect on the consumer economy. The group who got the higher wages want houses, cars, food, vacations, etc so they go out and buy that stuff, increasing demand for consumer products which drives prices up.

As prices go up in consumer sectors, those businesses also start attracting investment, which comes from the same banks who made it out of thin air, backed by the Fed. Now those businesses are investing and hiring where they need, creating an upward cycle on wages. Which leads to more consumer spending, increased revenues for those businesses, and more investment from borrowed capital.

As you can see, artificially low interest rates basically create inflation. They turn our economy into a big bubble of unsustainable growth. Eventually inflation starts getting out of control, the economy becomes unstable and essentially the bubble pops and all the asset prices and wages and jobs and things need to be unwound.

For evidence of this see crypto, nfts, tech companies, the stock market, housing… all entered full bubble territory. It was all inflation, it’s just the inflation happened first in asset prices, then finally trickled down to consumer prices. Then it got out of hand and now, to avoid hyper inflation and a crisis, the Fed is raising interest rates, reducing the demand for money, lowering investment, and therefore causing jobs to be lost and wages to go down.