Economy boosted by consumption, not investment, portends unhappy ending.
To kick things off on the Stockhouse moderated macroeconomics group (see background article here), SH writer/editor and group moderator Robert Arber (known on Stockhouse as SH_Arber) put out a call to the participants to define inflation – what it is, what it means, and how it is manifested in the economy.
The first participants to contribute were littleguy123 and arnoldj, whose thoughts make up part I of the Inflation and money supply series, published Tuesday, June 10. In part II below, frontline_jason and StilesBC pick up the baton and run, and later in part III, self-proclaimed “indeflationist” gabrielgray weighs in. Part IV sees members moving to a discussion of money supply and inflation measurement tools.
Please add your comments at the bottom of the page, and enjoy!
[Editor’s note: Posts have been edited for punctuation, spelling, grammar and length.]
frontline_jason: To start, let it be known that I am a monetarist at heart. Since humanity became a sedentary species, countless monetary systems have had their days in the sun, only to blow up over time because at some point, someone decided to print more money and/or reduce the quality of the "collateral" backing said currency. Examples such as the Athenian issuance of bronze coin in response to a Spartan commandeering of an Athenian silver mine, and several episodes of hyperinflation in China in the 11th-15th centuries illustrate that the rules and results of the money game haven't really changed much over the ages.
Fast forward to the present, where in the past quarter century, the supply of money (at least in the OECD) has outpaced nominal GDP growth by 30% (15% just in the last 10 years). The pool of "excess liquidity" is likely to continue growing as global growth continues to moderate and central banks, in aggregate, juice the system with more money to buoy demand for stuff.
At some point (which I think will be sometime within the next couple of years), we'll have inflation comparable to the 1970s, but I would like to offer some thoughts on why the process may take a while to play out and offer a moderate view, at least relative to the doomsayers who say that the world should have ended last summer.
Taking a supply-side view of the situation, if you were to chart fixed investment relative to GDP, you would find that fixed capital formation in the developed world has outpaced GDP growth since the mid-1980s (I found this in an OECD paper). Strong capital spending puts a lid on inflation because of capacity building, and, until 2004, the rampant growth in the availability of credit (coupled with a secular downtrend in interest rates) allowed for lots of borrowing by firms to invest in capacity, effectively capping inflation and further driving down borrowing costs. This is referred to as a virtuous cycle.
The past year witnessed a marked shift in the dynamics of the game. What happened is that as a result of the excessive greed of bankers (greed, like anything, can be OK in moderation), the world has been sobered and borrowing costs have reverted to more reasonable levels. At the margin, this means less fixed investment (there is a smaller pool of projects that can cover the higher cost of funds), and suddenly the excess capacity that has capped inflation for the last 25 years is at risk of disappearing. Throw in chronic underinvestment in the commodity sector (following 25 years of declining inflation) and now there is something to talk about.
The secular winds are shifting, and what is on the horizon is a vicious cycle: Less liquidity for good firms leads to less fixed investment, which causes capacity constraints, ultimately leading to price increases which lead to higher wages to cover said increases.
Then you get high interest rates to fight inflation (monetary policy isn't as proactive as most economists like to think), which chokes lending and kills fixed investment even more (blah blah blah... an ounce of gold says you know what follows). While the initial liquidity shock MAY appear to happen overnight, it takes time for the entire system to get infected (i.e., there is a lag between liquidity and growth). On a similar vein, there is also a lag between liquidity and inflation. One parallel to the current situation is how cancer multiplies over an extended period of time and THEN kills you. Some people live years without treatment, and many more live for years without knowing that they even carry the mutated cells.
One key element worth noting is that at present, loose policy is being used to bolster the economy via consumption, NOT investment. When you invest, there is (usually) a tangible capital asset at the end of the day. Firms are not stupid. They see the global economy slowing, and will shy away from investing in new capacity given the decrease in overall demand. Sure, loose policy provides a nudge, but against a backdrop of prior overinvestment and reduced access to credit, is there still an incentive to borrow more and invest?
So, if I am a policymaker (either fiscal or monetary) and I see the main engine of my system (business investment) begin to falter, then who will pick up the slack. Two choices: The government can spend money (loose fiscal), or I can try to MAKE consumers spend more by decreasing the attractiveness of alternatives (loose money).
From a consumer's vantage point, stocks aren't exactly hot because companies are not investing as much in capacity. Holding cash sucks because rates are low (so low that consumers are losing in real terms). The only option: Spend money to feel better now! Or buy real assets (except an American house, because there are too many of those around). Unfortunately, buying a pound or two of gold or building a bunker and stocking it full of Spam isn't the first thing that springs into the average person's mind, and last I checked, this kind of thinking was "dangerous."
So, through the magic of television (and leverage), I will find something to buy, eat/use, and throw it out to make me feel better. There's only one catch, which is that spending now means giving up something in the future, and, to take the situation to the extreme, if one were to borrow to consume, all that is left at the end of the process is a liability that somehow has to be repaid (i.e., interest, which requires more money printing).
So, to conclude, printing money is a funny game. I guess the key point is that if the money goes towards investment, it's a good thing because assets are always good to have. Borrowing to spend, on the other hand, is a practice that should be outlawed simply because the endgame is buyer's remorse plus a liability.
StilesBC: I'm humbled to join a discussion of such critical thinkers. Sadly, this is a rare occurrence. You guys have hit the nail on the head with how complicit our media has been in making the general public as clueless as possible to any matter of real importance pertaining to the economy (or in society in general, for that matter.) They have been very successful at that. Considering they are owned by the same people that have as much interest in things going like they have been the last 30 years, this should be no surprise (see: chart).
A perfect illustration of this is what is now labeled as "America's Oil Crisis." I have CNBC on in the background at my workplace on mute. Every once in a while I see them having an “expert panel” on about why they think the price of oil is so high and what should be done about it. Usually it's just a bunch of guys placing the blame on one boogeyman or the other.
But hardly does one ever hear about basic supply and demand. When oil was $40, it was because of the Iraq War, $50 was the “Terror premium,” $70 was because of Hurricane Katrina, $100 was because the $USD was falling, at $130 it's the Evil Speculators. But rarely addressed is the much researched, yet inconvenient fact, that our rapid rate of growth has surpassed our ability to fuel it. The analysts' suggestions of “what to do about it” is another topic for discussion altogether.
But this ties in well to previous discussions on inflation (and what it is). Often repeated is that the rise of oil prices are going to “cause inflation” or in Fedspeak, will increase “inflation expectations” for the future.
Rising prices are not going to cause inflation. As mentioned earlier, monetary inflation causes prices to rise (among other factors). And that seemingly trivial difference is having far-reaching effects throughout our economies. People are taught the Keynesian definition that Rob posted earlier that inflation is a “rise in the general price level.” So when they see the price of oil rising to $135 they are programmed to view that as the problem. When in reality the problem was something else entirely, and the effect of that problem is a rising price of oil.
I hate to be in such agreement with the previous posters, but I do concur that the asset deflation being experienced in the western world is not going to abate. This deflation will permeate through the rest of the economy in all the classic ways. Banks will eventually go insolvent once they run out of ways to obfuscate their balance sheets. Any of the “progress” seen of late in the financial sector amounts to nothing more than delaying the write-offs in a Hail Mary hope that residential real estate prices miraculously recover.
State governments will start going belly up and be forced to slash spending programs and jobs or raise taxes. The rising level of unemployment and the reverse wealth-effect from asset prices no longer rising will crush the consumer. Prices of anything that aren’t absolutely necessary (food, energy, money) will nosedive. Global supply and demand fundamentals for those necessities will determine prices, rather than just the rest of the world.
The topic of interest rates is a little more complicated. I enjoyed arnoldj's perspective (see Inflation and money supply, part I: Treasuries crowd bonds) that the Treasury is going to be forced to increase issuance in the near future, putting upward pressure on rates. However, over the long term I still believe that in order for Treasury rates to rise substantially, there would need to be credit issuance from more than just the government. And the downward pressure on rates for perceived “quality” debt will outmatch government issuance.
If people are not spending, and are even attempting to pay back debt, businesses are not expanding, and banks are not willing to lend, where is excess capital to go? Treasuries, gold, physical notes are the obvious answers. Oil seems to be a choice that many are making. Anything without the same risk as equities, real estate or corporate debt.
How it all ends is anybody's guess. With Congress changing the rules of the game on a weekly basis and socializing the markets, who knows how long this could be dragged on for. Japan's deflation has lasted 18 years and counting. They attempted the same bailouts of irresponsible lenders, tried supporting asset prices, and the result was a crippling debt of 3x their annual GDP. In trying to figure out what will happen, I think the best idea is to maintain an open mind. The options are inflate or default, as mentioned earlier. No doubt we'll be hearing all sorts of wacky ideas coming from the mouths of politicians in an election year.
This group discussion was conducted with members of the Stockhouse community.
Next: gabrielgray was last to the party but no less prolific for it – he contributes to part III of the series, “Indeflationists unite,” coming soon.
