- A Word On Inflation

I can’t think of a concept that is more broadly (almost completely) misunderstood than inflation. Its enemies despise though its effect isn’t all negative. Its proponents fully embrace it despite its very obvious risks. And the talking heads that appear on my TV can’t seem to agree whether they see it or don’t. So I thought I’d clear up some of this apparently total confusion for at least a few of you. First the good news.


Why (some small amount of) inflation is good.

For all intents and purposes IBM created the PC industry out of whole cloth. Bill Gates tagged along, as did Steve Jobs and a handful of others. But whoever was personally responsible, the emergence of the PC was a profoundly creative act. It created an industry, which in it’s turn created much commerce, which in turn created a generous amount of wealth. But all that creativity could have easily been for naught.

In order for economically creative events like that to take place you need a dynamic and growing economy. But if Bill Gates et al. and their fellow entrepreneurs have to spend all their time groping around in the darkness for capital to fund their creative endeavors, it places an obstacle in the way of economic growth. The tools for central bankers to manage the availability of capital are very imprecise. And over the years it’s been determined that the least harmful practice is to have just enough money around so that there is a little extra in case someone wants to invent the ipod or something.

There are other more technical reasons I can go into, but I think that gets’ the basic point across. If you want to optimize your economy for growth, you need to set the level of capital available as 101% of what’s necessary.

Now the bad news.

Why (too much) inflation is bad.

Increase the capital supply much faster than the supply of ‘stuff’ and you set up a situation where everyone has money, but no one has stuff. Supply - demand curves being what they are, this will cause prices to rise even if nothing else changes. This is the real threat of inflation. But there are other more pernicious effects. For instance, those rising prices reduce the ‘purchasing power’ of savings and lower the living standard of the population. If you worked hard in a low inflation environment and managed to save a million dollars across your lifetime, what’s that matter when inflation makes a big mac cost $100,000. The numbers don’t adjust to your benefit. More to the point, it benefits people who have borrowed money and punishes those who lent it. This is particularly troublesome when the people who control inflation are also the people who owe all the money.

So how do I know what inflation is right now?

The traditional view of ‘inflation’ has in the past referred only to a rise in wages and prices. And when you hear someone on TV saying that there are no signs of inflation lately, this is always what they mean. But this is like saying that there is no sign of a gunshot wound even though we know for certain that the bullet has left the rifle and is on its way. The more contemporary view (since Milton Friedman anyway) is that rising wages and prices are a symptom of inflation not a cause of it. The real cause of inflation is an increase in the supply of money. Eventually it will find it’s way to consumers, and that will causes rising prices.

This newer definition explains ‘asset inflation’ which we saw in dot.com stocks and in real estate. The older definition says that those aren’t manifestations of inflation at all, but are caused by ‘animal spirits’. The new definition is most widely embraced by market participants who have their careers on the line. But economic departments haven’t embraced the new definition even if they do arguably understand it. This is why you see such heated arguments between Steve Leisman (an Economist) and Tea Party hero Rick Santelli (A trader) every morning on squawk box.

As regular readers have probably figured, I prefer the Friedman view as well.


What can I do about it?

If you believe inflation is imminent, there are 3 ways you can protect yourself. The first is to buy hard assets. The prices of real estate, commodities and even something like baseball cards or Harley Davidson motorcycles all have their prices positively affected by inflation. It will also affect the prices of the gasoline you buy, the food you eat and the electricity you use… so you had better hope the price of one rises faster than the price of the other. Still… it will be better to keep your money there than to leave it in the bank.

The second thing you can do is to buy currencies where you think the inflation would be lower. Currency exchange rates are directly and immediately affected by inflation rates. Typically the value of the high inflation currency falls and the price of the low inflation currency rises. But in today’s market there probably aren’t any currencies where inflation will be any lower where there aren’t other risks involved. (If you’re interested in this idea then you should google the phrase ‘competitive devaluation’ to learn more.) The short story is that in this environment I wouldn’t recommend this strategy for anyone who isn’t a pro.

The third thing you can do is to make sure you are a borrower and not a lender. If inflation skyrockets your mortgage won’t change a bit. If you have a 500K mortgage and it takes 100K to buy a Big Mac, then you can pay your mortgage off for the price of a decent meal. If however, you own bonds and are therefore a lender, their value is going to collapse because the coupon payments you get won’t be changing either.

How likely is any of this? Well… right now the largest debtor in the world is the US Treasury. That’s not going to change any time soon. Inflation helps debtors and hurts lenders, so you can decide for yourself.

But if interest rates begin to go up then the amount of money required to service our massive debt will also rise, and that makes the federal deficit math look apocalyptic REALLY quickly. What’s more, rising interest rates would slow economic growth and negatively affect the one economic number our politicians really do care about …. unemployment. Higher rates, slower growth, higher unemployment.

Under those conditions, more inflation is how I’d bet, even if wages and prices don’t demonstrate a rise anytime soon.