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Musings Report 2020-21 5-23-20 Understanding Inflation and Deflation
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Understanding Inflation and Deflation
Last week, we covered the relationship between the supply of money and the supply of goods and services that the money is a claim on (Why High Inflation Is Baked In).
This week, we'll look at another dynamic in the inflation-deflation conundrum.
For the better part of a decade, there's been a debate in economic circles about which force will dominate: inflation or deflation.
The debate is based on a fallacy--the assumption the the entire economy should be inflating or deflating. What's actually happened is that different parts of the economy have inflated or deflated, depending on the dynamics affecting that part of the economy.
As the Federal Reserve and other central banks lowered interest rates and created trillions out of thin air, assets that are limited in supply such as stocks, real estate, high-quality bonds, etc. have inflated enormously. The S&P 500 rose from 700 to 3,400 in a mere decade, and bungalows in the S.F. Bay Area that sold for $135,000 in 2002 were valued pre-pandemic at $1 million. That's massive inflation.
Globalization and low interest rates both fueled an enormous expansion of manufacturing capacity in the global economy, and this glut of capacity caused the prices for manufactured goods to remain stable or even deflate as supply exceeded demand for items such as low-end TVs.
But the capacity to generate services isn't quite as flexible, and so the cost of services such as healthcare, higher education, childcare, etc. have skyrocketed.
Part of this dynamic arises from what economist Michael Spence identified as tradable and untradable goods/ services: we can buy shampoo made elsewhere in the world (tradable) but we can't get a haircut from an overseas supplier (untradable).
Manufactured goods tend to be tradable, perishable goods less so. Services such as call centers are tradable, piano lessons less so (though we can now discern the potential for low-cost video-conferencing piano lessons that could be taught from anywhere in the world.)
It's important to note that this explosion of manufacturing capacity was only possible in a super-low interest rate environment maintained by central banks. If corporations had to pay 10% interest rather than 1%, the risk of losing money by expanding production capacity would have been much higher.
Cutting rates to near-zero reduced the risk and cost, and effectively incentivized global corporations to ramp up production with cheap borrowed money.
Overcapacity had already imperiled profit margins globally before the pandemic, and now with globalization collapsing, the era of deflation in manufactured goods is ending. No matter how low interest rates are held by central banks, corporations won't be adding factories at the end of long supply chains; the world is awash in commodities and manufactured goods due to the 20-year explosion of over-capacity.
Let's compare what happens when $1 trillion vanishes.
If $1 trillion vanishes from households' income, they will have $1 trillion less to spend. This is deflationary, as the supply of goods and services will remain the same but the demand for those goods and services will fall dramatically. This supply-demand imbalance leads to lower prices--deflation.
Now let's imagine that Apple's profits fall 80% in the global depression, and eventually its stock falls by 80% from over $300 to $60 per share to reflect this new reality.
An 80% decline in the value of each Apple share means about $1 trillion will have vanished: it didn't go anywhere, it just disappeared.
What effect will the disappearance of this $1 trillion have in the economy?
Since 87% of the stock market's wealth is owned by the top 10%, then this evaporation of $1 trillion will only affect the wealthiest households, as the top 10% own 87%, the top 5% own 65%, the top 1% own 40% and the top 0.1% own 20%.
The bottom 90% may be indirectly affected if their retirement pension fund was heavily invested in Apple and didn't sell at the top, but this won't affect their current consumption unless this loss causes their retirement income to be slashed.
The vast majority of the effect will be felt by the top 5% and top 1%. What will this loss of $1 trillion mean for them?
It reduces their wealth, of course, but how much it reduces their income and spending depends on "the wealth effect": the psychological impact of the decline or rise in their wealth.
It's very likely this evaporation of $1 trillion in wealth will trigger a "reverse wealth effect": the top 5% households will feel poorer, and as a result will rein in their borrowing and spending. Any reduction in spending will be deflationary if the supply of goods and services remains constant.
Now let's say $1 trillion in productive capacity evaporates: farmland is taken out of production, factories making tractor parts, oil pipelines, electrical transformers, etc. close down, supply chains collapse because it's no longer profitable to ship goods from afar, and so on, for a total of $1 trillion in lost productive capacity.
This staggering loss will shrink the supply of goods and services available. If demand stays constant--which it does for "inelastic demand" essentials such as food and replacement parts--prices will rise, and potentially by huge leaps, depending on the severity of the drop in production and availability (i.e. the supply chains).
When $1 trillion in income evaporates, the effect is deflationary.
When $1 trillion in stock market wealth evaporates, the effect is deflationary.
When $1 trillion in productive capacity evaporates, the effect is inflationary.
If we put these together, we see how the services sector could crash into massive deflation as income, borrowing and spending all drop sharply.
But at the same time, as productive capacity declines, the supply of essentials drops and prices soar in an inflationary spiral.
In conventional economics, higher prices will attract entrepreneurs to fill the scarcity, and somebody will pour capital into a new plant to manufacture tractor parts.
But will this be profitable? Perhaps not. The capital expense might be high, the expertise needed might be scarce, and the volume of parts needed might not be large enough to justify a new factory.
As for bringing farmland back into production: maybe there's a water shortage that makes this impossible. Maybe the soil is so depleted it will cost so much to restore the soil that it won't be profitable for many years--a risk few are willing to take. Maybe the crops will rot in the fields because the labor to harvest the crops is no longer cheap or plentiful. There are many contingencies that can torpedo the conventional belief that scarcities will always be magically filled.
This is the worst of all worlds for an economy addicted to "growth" of borrowing, income, wealth and production: deflation of income, borrowing and wealth and inflation in essential goods and services.
In my view, these are the dominant dynamics of the era we're entering.
Highlights of the Blog
Opting Out, American Style 5/22/20
The Pandemic Gives Us Permission To Get What We Always Wanted 5/21/20
This Sucker's Going Down: The Destruction of Demand 5/20/20
Our Fate Is Sealed, Vaccines Won't Matter: Four Long Cycles Align 5/19/20
AxisOfEasy Salon #5: Will "The Great Opt-Out" be able to scale?
Best Thing That Happened To Me This Week
Our neighbor brought over the first lychee fruits from their tree, which is a variety that matures early in the season. Yum!
From Left Field
How An Obscure British Comedy Sketch Became The World's Most Repeated TV Program
Sinkhole opens near the Pantheon, revealing 2,000-year-old Roman paving stones
Doctors keep discovering new ways the coronavirus attacks the body
Air Travel Is Going to Be Very Bad, for a Very Long Time
The real Lord of the Flies: what happened when six boys were shipwrecked for 15 months
The Coming Disruption: Scott Galloway predicts a handful of elite cyborg universities will soon monopolize higher education.
The Inevitable Coronavirus Censorship Crisis is Here
The Fallacy of Endless Growth:What economists around the world get wrong about the future.
The Coronavirus Means Curtains for Artists: The loss of revenue from live events is only the start of this particular disaster.
Silicon Valley in general, and the tech giants in particular--above all, Google, Facebook, and Amazon--have engineered a vast and ongoing transfer of wealth, on the order of tens of billions of dollars a year, from creators to distributors, from artists to Big Tech.
Abigail Zachko - impressive, young and talented guitarist
As Food Supply Chain Breaks Down, Farm-To-Door CSAs Take Off
'A Bargain With the Devil'-- Bill Comes Due for Overextended Airbnb Hosts: Entrepreneurs built mini-empires of short-term rental properties, borrowing against revenue that’s now vanishing under coronavirus lockdowns
"At the end of the day, we can endure much more than we think we can." Frida Kahlo (via GFB)
Thanks for reading--
charles |
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