Risk Over Reward

Thinking About Investing

Economic Fundamentals: Inflation (part 1)

by Alpha and Vega, an Investor and a Trader
March 14th, 2010

In this issue:
1) What is Inflation?
2) An Introduction to Inflation
3) What Causes Inflation?
4) Synthesis

Dear Friends, Colleagues, and Investors,

This is the second essay in the "economic fundamentals" series and tackles
inflation. The greatest economists disagree about the nature of inflation. I will
not attempt to settle the debate here, but rather to explore the dominant
perspectives. My premise is that most of the perspectives on inflation are not
mutually exclusive, but rather represent different interpretations of a chaotic
reality. By applying many different lenses to the current economic climate we
will gain a more thorough understanding than with any single lens. A big part of
our job as investors is to find the intellectual tool that best fits the job. To that
end, I’ve structured this essay as a debate with many voices. Most of the ideas
here come from the great economists Hayek, Keynes, and Friedman, but I am
also indebted to the more modern economists John Hussman and Paul
Krugman. Those of you with a strong background in economics might want to
skip to section #3.

You may view this week's newsletter in PDF format here:

What is inflation?
Inflation is a persistent and widespread increase in prices. If a currency is
suddenly devalued causing all prices to double, this is not inflation. Inflation
requires a dynamic of persistent price increases over time. Once inflation takes
hold, it is naturally self-sustaining. If consumers expect that prices will continue
rising, they will make their purchases as soon as possible to avoid the higher
future prices; this causes the velocity of money to rise and increases the
immediate demand for goods, fulfilling the prophecy of higher prices. The
additional demand causes corporate revenues to rise and workers demand
raises; the higher wages similarly lead to higher demand and higher prices and
further wage hikes.

An Introduction to Inflation
At its core, inflation is simply a question of supply and demand. Prices of
goods are set where supply meets demand. If demand for goods increases
faster than supply, prices will rise. One trigger for inflation is a supply shock.
For example, in the Gulf War, the world’s oil supply was decreased while
demand was unchanged. This caused oil prices to rise until demand was
reduced to meet the new lower supply. The rise in oil prices led to higher prices
for all the many products that are directly and indirectly made from oil including
fertilizer, gasoline, and steel. Supply shock inflation is less frequent and
generally less lasting than demand driven inflation.

More commonly, inflation is driven by an increase in aggregate demand.

Aggregate demand is a measure of the total demand for goods and services
throughout the economy. It can increase for many reasons. If the Federal
Reserve prints new money, more money will now be chasing the same quantity
of goods. Financial innovation (e.g. ATM machines, complex derivatives) may
increase the velocity of money, which is very similar to the printing of new
money. An increase in general optimism or “animal spirits” may cause
businesses to spend more on investment and consumers to increase
consumption. Finally, an increase in government spending may compete with
private demand for goods and push prices higher.

Milton Friedman claimed that “inflation is always and everywhere a monetary

phenomenon.” Friedman was deliberately oversimplifying, but he believed that
most inflation is caused when the money supply increases faster than the supply
of goods.

For much of human history, the money supply increased when new precious
metals were mined. More recently, central banks introduced fiat money (i.e.
paper currency) and controlled its supply. Friedman argued that modern
inflation was usually caused when the central bank increased the money supply
too quickly. This can happen with the literal printing of money, with open market
operations whereby the Federal Reserve purchases government debt from
banks, or from a reduction in reserve ratios or interest rates. Complicating this
view are the numerous examples of money printing that did not result in inflation
(i.e. Japan), how to measure the money supply, and savings versus investment,
and productive versus unproductive spending. I’ll revisit all of these issues.

What causes inflation?

John Hussman argues that it’s not new money that primarily causes inflation,
but unproductive government spending. This is a critical and uncommon view.
If the new money is used to pay down debt (either private or public), the
deleveraging does not necessarily cause inflation. I’ll illustrate this concept with
an example: The government borrows $100 from private citizens and spends
that money purchasing asphalt to build roads. Let’s say the citizens were
previously keeping the $100 under their mattress in cash. The citizens feel
equally wealthy as before (they still have $100 saved), but there is an extra
$100 of demand for goods because of the government borrowing. Now the
Federal Reserve prints $100 and uses it to buy the government’s debt from the
private citizens. Once again the citizens have $100 in cash, but demand neither
increases nor decreases. In other words, the increase in demand (and possible
inflation) was caused by the government spending, not the Federal Reserve’s
money printing.

Hussman concludes that we should focus on demand, not the money supply.
Government borrowing may increase aggregate demand and money printing
may not. This is a complex framework since it matters greatly who buys the
government debt and under what circumstances. In my example, citizens
purchased the debt with cash that was otherwise hidden under a mattress. If
instead it was banks purchasing the government debt under normal economic
conditions, the government debt would likely displace private borrowing and
would not increase aggregate demand.

To continue the discussion of the effects of government spending, let’s turn to

Keynes. Classical economics argued that investment must equal savings.
When the government borrows money, classical economists argued that the
government would “crowd out” private borrowers since they’re drawing on the
same pool of savings. The mechanism for this crowding out is higher interest
rates. Keynes disagreed. Keynes argued that investment was more dependent
on long-term profit potential and “animal spirits” than the supply of savings.
Keynes recognized that the link between savings and investment was tenuous
at times. Savings may sit useless with a bank that is too scared to make new
loans or it may be multiplied many times through the fractional reserve banking
system. During recessions, demand for investment drops below the supply of
savings and therefore the government doesn’t crowd out much borrowing with
its spending. Keynes argued that the government’s spending may be
unproductive, but it’s still better than nothing. He said that it might be prudent
for the government to deliberately break a window and then hire someone to
repair it, as long as the repairmen would otherwise be unemployed.

What about the relationship between inflation and unemployment? One of the
biggest misconceptions in modern economics is based on the Phillips Curve.
The mistaken view is that the there is a direct trade off between inflation and
unemployment, and that by increasing inflation we decrease unemployment.
The flip side of this is the argument that as long as unemployment is high we
are unlikely to get inflation. First of all, the historical data does not support
either claim. While there is certainly a relationship, it is not at all direct. Rather,
the Phillips Curve shows the relationship between the employment level, and
real wage increases. When unemployment is low, wages will increase faster
than the general price level. If most prices are falling by 5%, wages may only
fall 2%. Wages are a key component in the general inflation level, but there are
many other factors to consider.

Hayek explained that it’s not inflation that causes unemployment to decrease,
but rather the unexpected increase in inflation. This is because an unexpected
increase in inflation causes revenues to increase unexpectedly and produces
greater profits. Over the long run, these profits are not real because they must
be spent on more expensive capital and material inputs. In the short run
however, they lead to an increase in aggregate demand and thus make
businesses and consumers feel wealthier. As soon as inflation expectations
match inflation, the higher interest rates eliminate the excess profits.

Synthesis
We’re faced with a handful of very different sources of inflation. To summarize:
Inflation may be caused by…
an increase in the base money supply
an increase in total money (taking into account the velocity of
money)
an increase in total money + debt (taking into account leverage)
an increase in aggregate demand
an increase in unproductive demand for goods
an increase in inflation expectations
a decrease in economic slack (e.g. unemployment)

None of these are mutually exclusive, but by emphasizing one element over
another, we may come to a very different conclusion about the current risk of
inflation. In the last few years, the base money supply has more than doubled
and government debt and spending have dramatically increased, but other
sectors of the economy have been deleveraging and the velocity of money has
collapsed. Inflation expectations remain moderate, and there is plenty of slack
in the form of unemployment and excess manufacturing capacity.

Ultimately, we know that inflation’s root is higher demand relative to supply, so I

think it makes sense to bring everything back to that. Every view discussed
above is right at least some of the time, but it’s right because under particular
conditions it will lead to a sustained increase in aggregate demand. Our job is
to judge how aggregate demand will react to a change in leverage, inflation
expectations, unemployment, and all of the other factors discussed above. To
accomplish this we need a thorough understanding of how the potential
inflationary inputs act on aggregate demand. Hopefully this discussion has
been a small step toward that understanding.

Your "animal spirited" trader,

Vega

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