Tag Archives: Finance

The End of Growth Part 4: At what point is China no longer a bubble?

I’m still reading The End of Growth by Richard Heinberg. As a reminder, Heinberg claimed (in 2011) that the world’s economic growth was essentially over, and that in the future any “growth” would be an illusion created by nations fighting over an ever shrinking economic pie. A nation may have a quarter or two of growth, or some prolonged growth as they stole more of the pie from their neighbors, but taken as a whole there was no more economic growth left for the world, largely because Heinberg also thought there was no more oil left for the world. The problem or course is how do you explain China?

It’s a lot easier to brush away claims of “growth” in the Western world, growth has been anemic (although still positive) for the last decade and a half since the Financial Crisis. And although US GDP has growth by 20% or more in that time, most Americans don’t “feel” any different, and so it’s easier for Heinberg to claim (as he does earlier in the book) that this growth is all just an illusion funded by debt. But China is different. Growing their GDP at near double digits for 3 decades straight cannot be easily ignored, and the Chinese middle classes have definitely seen massive changes in their lifestyles as almost anyone today in China can afford more and better stuff than their parents could. Houses are larger, food is more varied, technology is cheaper and easier to get to, China continues to experience massive economic growth, and that’s a difficulty for Heinberg who claims that’s impossible.

The first thing he does is punts, like anyone who doesn’t like the outcomes of China growing economically, Heinberg claims China’s growth is really just a bubble ready to collapse. I’m not about to say that China’s economy is perfect or that it doesn’t contain massive real estate speculation, but I’ve been hearing “China’s economy is a bubble that’s about to collapse” for over a decade now and I’m wondering when people will stop claiming this. A bubble is no longer a bubble is it never pops. China’s economy does experience downturns like everyone else’s, but I haven’t seen any evidence that the whole thing has or will soon collapse, as the world “bubble” would imply.

Heinberg goes on to say that China’s growth is also unsustainable because of falling exports to the West, depleting resources like coal, too many old people with too few young people, and all the other stuff that people have been claiming will implode China any day now. My question for today is: when does this end? If China continues growing at a steady clip, at what point do people update their theories to fit the facts? At what point can we conclude that China’s economy is not a bubble and has the momentum to withstand all the same shocks and stresses as a Western economy? China’s economy has more than doubled since Heinberg wrote his book, and I’m curious to know if he would accept this as disproving his theory or if he’s pushed “the end of growth” date back like so many pushed back “the end of oil.”

Now again, I’m not saying China or its economy is perfect. The Chinese Communist party is a totalitarian nightmare committing genocide in its own boarders and threatening war outside of them, the Chinese economy has vast structural problems that the government papers over, Chinese demographics are not ideal for a growing economy and there is no easy solution to any of these. But I don’t think China is going to collapse any time soon, I don’t think it’s economy is just a bubble, and I think people have been claiming the Chinese Sky is Falling for far too long without ever admitting that they are divorced from the actual facts.

Don’t put all your money into bonds

In fact, don’t put all your money into any single investment. I’m not anti-bonds, I’m pro-diversification.

As the Fed has continued to hike interest rates, I’ve been encountering a lot of chatter about buying bonds, and while I agree with some of it I’ve also seen talk saying that anyone with money in stocks is a moron and that everyone should sell everything they own and put it all into long-term government bonds. The benefits of government bonds are clear: they are a risk-free way to protect and sometimes grow your money. A bond is just a loan to the government and the government (whether the Federal government of America or the AA+ rated governments of Europe and the rest of the world) is not going to go bankrupt. Governments like Germany, America, and Japan will always pay their debts so purchasing a government bond is guaranteed to return your money to you at the end of the day. But just because they don’t have risk doesn’t mean they don’t have cost.

Everything in economics has an opportunity cost and this applies especially to bonds. There’s no guarantee that the investment you made was the best way you could have invested your money, even if you made a bit of money through it in the long run. Let me explain some of the opportunity costs you are facing when you buy bonds.

If you buy bonds today, you lock in a fixed interest rate for the length of the bond (let’s ignore I-bonds for now). That means you will receive a fixed amount of money for the length of the bond, plus you will be given back the initial amount you paid at the bond’s maturity. So if you buy a 10,000$ bond, and hold it to maturity, you will have made 10,000$ + 4% interest, it sounds like a great deal. But what other opportunities did you have with your money? Well in December the Fed will have another meeting, and it’s possible that they will once again raise interest rates. If that happens, you could buy a bond with around 4.75% interest instead of around 4%, so one of the opportunity costs you have is that if you just waited another month you could have bought a higher yield 10,000$ bond and made more money.

That’s not the only opportunity cost though, what if you suddenly have to make a big purchase? You could sell that 10,000$ 4% bond you purchased, it’s still worth somewhere close to 10,000$ if you bought it recently, but if you sell it after the Fed has raised interest rates you will find the price you can get for it is much lower than what you may have expected. That’s because your bond is paying a lower interest rate than what people can get buying new bonds, why spend 10,000$ to buy a 4% bond when you can spend 10,000$ to buy a 4.75% bond. So if you buy a lot of bonds then have to sell them after an interest rate hike, you’ll have lost out compared to if you had bought after the interest rate hike or if you had not bought at all.

Another scenario is that the Fed doesn’t hike interest rates but the markets recover. Say the inflation report comes out and shows inflation slowing substantially, in that case the Fed would have less reason to raise rates and the markets would have more reason to rally as people expect better times ahead. You’ve still got your 4% bond but markets on average rise 7% each year, so in an average year the stock market can be expected to give greater returns than buying a bond. In this case you haven’t lost any money but you’ve incurred an opportunity cost by buying bonds instead of stocks, you could have had greater returns buying stocks.

I’m not saying don’t buy bonds, bonds can be a good way to mitigate risk and ensure consistent returns. But I am seeing some people act like current trends will last forever, that the market will stay down forever and thus bonds are the only way to get any kind of return. I’m just saying that every action has an opportunity cost, and while buying bonds are low risk they are still a bet that interest rates won’t go much higher and the market won’t gain too much. Otherwise, you might have been better off putting your money elsewhere.

People are always fighting the last war

We live in a time of high inflation and rock bottom unemployment, but I remember less than a decade ago reading the prognosticators of economics talk about how low inflation and high unemployment (or underemployment) were the inevitable future of our economy. It was said with as much certainty as could be mustered that the Financial Crisis had fundamentally changed the nature of our economic reality, no more could we expect governments to bail us out (they all had too much debt), instead we were going to keep suffering for a long while for the profligate lending of the banks. Of course that wasn’t true, and neither is it true that inflation and low employment are a certainty for the rest of time.

What’s crazy to me is that both predictions were made with the same data. Our population is aging, globalization inevitably moves certain jobs overseas and forces American workers and companies to compete with those in foreign nations. Our government has high debt, real wage growth is anemic or negative, and the job of fixing all this has landed solely on the head of the Federal Reserve since the rest of the government can’t or won’t do so. This describes 2012 as much as 2022, and yet this evidence is used just as confidently by the takemongers of 2012 who predicted an eternal low-growth as the takemongers of 2022 predicting eternal inflation. It reminds me of all the sci-fi books and movies from the 70s and 80s predicting a far future of the 21st or 22nd century in which the Soviet Union still existed, people routinely project their current reality onto the future without any further thought. If pressed they’ll then use any evidence at all to defend their predictions, even if the same evidence could be used for an entirely different conclusion.

The 2010s were a period of low growth, low inflation, and high unemployment/underemployment. The 2020s have so far been a period of higher growth, high inflation, and very low unemployment. Both decades have challenges, and many of the challenges are the same. But I see no reason to believe that the trends of today will last forever.

How do bonds work

Seriously. I don’t get it. People are telling me “buy bonds, the market will explode” but when I went onto my brokerage I couldn’t understand a damn thing about what I was looking at. If anyone understands bonds, feel free to tell me what I should be doing.

Note: this post was made almost entirely in jest, I understand how bonds work but was miffed at how poor the front-end for buying them was at my brokerage. I’ll have a better post on bonds up later.

Are passive ETFs creating market inefficiencies?

Yesterday I wrote about how the YOLO memesters might be creating market inefficiencies, today I thought I’d look at the other side of the coin with the more mature, more upscale passive ETFs.

For those who don’t know, a passive ETF is just a pile of money that you can buy into like a stock. When you hold a stock of $VTI for example, you own a tiny percentage of that big pile of money. The money in turn isn’t just a bunch of cash, it’s invested into the stock market according to the ETF’s prospectus, from which the ETF is not allowed to deviate from by law. $VTI’s prospectus says for example that it will seek to track the performance of the whole US stock market by investing in a representative sample of companies in that market. In this way, $VTI isn’t making a decision on the worth or value of any individual stock, it is merely buying every stock and assuming the market will do the hard work. Since the value of the total US stock market grows at an average rate of between 5% and 10% every year (with some down years like 2022), this means that $VTI is expected to grow at that pace as well and an investor in $VTI can make 5% to 10% returns without any of the stress or hassle of picking their own stocks. The only things $VTI asks for in return is a tiny amount of money in the form of it’s expense ratio, just 3¢ for every 100$ of investor’s money is taken for expenses, which seems to be a reasonable deal for everyone involved.

$VTI and other ETFs like it are easy, low-risk investment vehicles, so it’s no wonder they have exploded in popularity. Not only that, but studies have demonstrated that passively managed ETFs almost always outperform their actively managed peers. But is this “$VTI and chill” mindset of investors creating market inefficiencies of its own? Remember that passive ETFs invest in the whole market, regardless of if an underlying stock is any good or not. Not all ETFs are as broad as $VTI of course, some seek to track a certain market segment or a certain type of stock, but all passive ETFs share a commitment to obeying their prospectus and investing in valid companies without precondition. This means that they cannot participate in price discovery which is seen by some as the primary purpose of markets, including stock markets. If company A is growing, profitable, and well run, then it should be rewarded with having a higher value than it’s competitor, company B which is shrinking, unprofitable, and poorly run. We would expect that the stock market would perform price discovery on these two companies, investors would buy stock in the A and sell the stock in company B, raising and lowering their stock prices in turn. This then rewards company A for its success, and lets it use its high stock price as a tool to further expand the company, hopefully rewarding investors in the process and creating a virtuous cycle of success breeding success.

But passive ETFs don’t participate in price discovery, they don’t sell bad companies and buy good ones. Passive ETFs buy a representative sample of companies according to their prospectus, and they keep their expense ratios as low as possible in part by not doing the kind of deep dive on their investments that you would expect from an active investor. If company A and B are both worth 5% of the total stock in a passive ETF’s market, then it will hold 5% of its total value in both A and B. And if every investor in the market was a passive ETF, then there would be no way for the price of A and B to move relative to each other, because there would be no sell pressure on one relative to the other. Indeed some have claimed that the rise of passive ETFs is making the market less efficient, and tipping the scales towards large companies that will get bought up by the most popular ETFs simply because they are large and thus make up such a large portion of the market. If this is the case, then the erudite bogleheads are doing as much damage as the memesters.

Are stocks-as-memes creating market inefficiencies?

Stocks have long been the investment vehicle of choice for people with small amounts of excess cash.  Bonds are confusing, bank interest doesn’t pay much, and property requires high amounts of cash that most people don’t have.  But stocks are easy to understand, potentially give jackpots, and require such a small amount of upfront investment that almost anyone can afford them.  In ages past stocks were still usually bought through a specialized broker, and while the shoe shine boys in New York giving out stock tips may have been seen as a signal of a price crash, most people not living in major cities didn’t have access to a broker who could help them buy.  The brokers were therefore a barrier to entry that prohibited a lot of people from owning stocks who otherwise might have.  These days buying a stock can be as easy as installing the app, so quite literally anyone can own one at the push of a button.  This has democratized the market, but may have led to some unexpected consequences.

It seems that these days, stocks have become more than an investment opportunity.  Some stocks can be a badge of honor, a feeling of belonging, or a source of self-actualization.  You may invest in nuclear power because you want to help fight climate change, you may invest in Manchester United because you love the club, you may invest in GameStop because you believe you’re destroying the short sellers and want to be part of something greater.  None of these feelings have anything to do with the stock’s financial value.  They aren’t a dividend, they aren’t growth, they are a feeling you have when you own the stock and those feelings are often irrational.  In some ways these feelings call into question our understanding of stocks and investors generally.  

Now let’s be clear, there has always been emotions in the stock market.  Some people have always bought a company simply because they “liked” it with no better reason why, and “panics” can be just that: mindless rushes to cash out based on fear without thought.  But when a stock’s price is almost entirely based on feeling rather than actual value, to some extend it forces us to re-evaluate the market as a whole.  Last year, GameStop’s stock rose exponentially for no good reason whatsoever, and while some have considered it nothing more than a bubble, the price remains irrationally elevated even today.  There is no way a stock with no growth, no earnings, and no path to profit should be trading so high, and yet it is. If you took a company that was identical to GameStop in every way, but called it something different, it would  have but a small fraction of GameStop’s market cap.  That’s because GameStop isn’t just a company, GameStop truly is a meme. It seems insane, but there truly is a group of people for whom ownership of GME stock is bringing them no financial value whatsoever, but who continue to hold it out of emotional value.  You wouldn’t think such a group would be big enough to move the market, but last year showed them to be plenty large, and I believe there are still enough of them hanging around, holding the stock, and even buying more to ensure continued upward pressure on the stock’s price. 

If a market is anything, it is a mechanism of price discovery. The stock market should be a mechanism to discover the correct price of companies, and our research assumes that this in turn allows profitable and growing companies to prosper while unprofitable and shrinking companies fail. We know market actors can be irrational, but the average of all market actors, the “wisdom of the crowds” so to speak should have some logical underpinning if the market is to find the correct price of these companies. Stocks becoming a form of self-expression more than an investment vehicle could introduce inefficiencies to this market, and I’ll still trying to come to grips with what the consequences could be. We might imagine a future in which board members will seek out a CEO based not on the value they can add to the company but by whether or not they, like Ryan Cohen, have a ready-made base of support among the memesters. But I don’t have the economic or statistical background to understand how much this would change things, maybe CEO’s have always been picked for dumb reasons. What do you think?

Markets tend towards completeness: the story of Ric Flair and terrorism

There’s a funny story about Ric Flair: Flair was at the height of his career making millions of dollars every year, but he knew that the good times would someday end and that he had to invest his money for retirement. He decided that he would invest in a business he knew well, and what could be a better business than a gym. Wrestling is a body business, and during his world travels as a wrestler Flair had been to all sorts of gyms to keep his physique in top shape for his matches. He knew what he liked and knew what a gym needed, so he put his money into building a high-end luxury gym in the Bahamas, then he starting dropping the name of his new gym in his promos so his legions of fans would want to buy memberships there. It was all coming together, but tragedy struck when in its very first year of operation a hurricane hit the Bahamas and wiped out Flair’s gym. Flair was distraught, but his friend tried to comfort him saying “surely you haven’t lost everything, didn’t you have insurance?” Flair shot back “what do I look like, an idiot! Why would I ever pay for insurance!”

It’s a story I like because it speaks to the mindset of many professionals, most of whom can be experts in their own field but just don’t understand how finances work. It’s easy to throw your hands up and see financial markets as a tool by evil rich people to take our money, but it’s important to know that everything in finances is just a bet or a hedge usually made in good faith. When you insure your property, you’re reducing your downside risk by ensuring you get a payout if the property gets destroyed, but in turn you reduce your upside return because you’re forced to pay for the insurance for as long as you hold the policy. The insurance company meanwhile is increasing their downside risk because they have to pay you money if your property gets destroyed, but in turn they increase their upside return by forcing you to pay them money for the policy. The insurance policy can also be seen as a kind of bet: the person paying for insurance is betting that the value of the payout will be more than the amount they pay towards the policy, aka a hurricane is more likely to hit the property. The issuer of the insurance is betting the opposite, that the payout will be less than the amount paid towards insurance. It’s funny to realize, but buying hurricane insurance is sort of like a placing bet that your property will get hit by a hurricane.

But what if the insurance company wants to reduce its own risk? There are various tools and instruments an insurance company can use to hedge its risk, in the same way a gym owner can use insurance to hedge the risk to a gym, and they all work in much the same way: one party bets than an action will happen, one party bets that it won’t, and the money goes to whoever is correct. A whole bunch of insurance policies can be securitized into catastrophe bonds for example. Let’s say Ric Flair builds a second gym and this time he insures it, in that case the insurance company can sell catastrophe bonds based on his policy. Now let’s say I buy 100$ worth of catastrophe bonds based on Flair’s insurance policy: the bond has a lifetime of 3 years, so if after 3 years no hurricane has destroyed Flair’s gym then I am entitled to my 100$ back plus some extra money known as the “coupon.” If on the other hand a hurricane does destroy Flair’s gym, then I lose my 100$ investment because the insurance company takes it to pay back Ric Flair. By buying this catastrophe bond, I am participating in a bet in which I think a hurricane won’t destroy Flair’s gym, and I make money if my bet is correct.

Now remember that a catastrophe bond is a security, it’s like any other bond that I can sell on the open market. If I need money, I can sell my bond to someone else for a fair value, but the amount I can sell it for will change as it gains or loses value based on outside forces. Say for example that scientists publish a report saying that the upcoming hurricane season will be the most destructive in history, suddenly it looks more likely that Ric Flair’s gym will get destroyed, meaning my bond won’t pay back the money, meaning the price of my bond will go down because people think it’s a less good investment. The opposite could occur too, if the Bahamas institute some national policy which mitigates hurricane risks for all residents, then it becomes less likely that Flair’s gym will be destroyed and thus more likely that my bond will pay back the money, so the price of my bond will go up. And because the price of bonds can go up or down, you can go short or long on them essentially betting on their price movement which is in part determined by the underlying risk.

Now let’s add another twist: hurricanes aren’t the only thing you can insure against, what about terrorism?

Let’s paint a scenario in which Ric Flair insures his gym against terrorism instead of hurricanes. The insurance company securitizes his policy into a bond which someone buys, I then take a short position against that bond. My short position means I’m betting the price of the bond will go down, and why would it go down? It could go down in part because people think terrorism is more likely to happen and destroy Flair’s gym, and in the aftermath of large terrorism attacks many catastrophe bonds’ prices do go down as the markets become fearful of follow-up or copycat attacks. By shorting a catastrophe bond on Ric Flair’s terrorism insurance, I make money whenever terrorism happens.

This exact situation has been seen by some as a monstrous moral hazard because since I get paid when terrorism happens I have a financial incentive to support policies that make terrorism more likely. What those policies are I won’t speculate, but some have painted grim pictures in which hedge funds could secretly move money to support terrorists in order to scare the market and make bank on their investments. In the aftermath of the Financial Crash this even led some to propose banning securitized insurance altogether, because not only was it speculative and dangerous just like the credit-default-swaps that were blamed for the crisis, but it also came with an in-built hazard in that people were incentivized to ensure terrible events happened. I feel like this is a misunderstanding of financial markets: these markets tend towards completeness. What that means is that every angle of a financial transaction tends to have space for someone to make a bet, because if there’s no monetary incentive for the price to move in every possible way then there’s less of a mechanism for price discovery. If you can securitize a loan then you can securitize an insurance policy, and if you can short a stock you can short a bond, these are just ways for companies to hedge their risk and for the market to discover the correct price of something. And note that the person shorting a catastrophe bond isn’t the only one with a financial incentive for terrorism: Ric Flair himself would have a financial incentive since he gets an insurance payout if his gym gets destroyed by terrorism. We’ve had laws to investigate and prevent this kind of thing for hundreds of years with arson and other forms of insurance and if we think people are breaking those laws then we should investigate and prosecute them, not ban an entire financial market.

“No one wants to work”

Inflation is up, unemployment is down.  This year there have been tons of stories about shortages and supply chains, and invariably a call has arisen from business owners: they’d like to hire more people but no one wants to work.  

When I see stories on local restaurants and businesses closing, inevitably I see an owner blaming their failures on no one wanting to work.  They had a good and profitable business going on, then after the pandemic suddenly no one wanted to work anymore.  This meant they couldn’t hire employees and so couldn’t do anything at all to make money and thus were forced to close down.  This is a dumb argument for many reason’s but to just pick one: labor has a market just like any other service. There is a supply and a demand for labor.  If you are demanding labor while the supply is constricted, the price you pay for labor will go up, and if you refuse to pay that price then you will go without, just as if I refuse to pay more for a Pepsi I can’t get one.  The price you pay for labor is the wage or salary so if you can’t get people to work for you then you need to increase the wage or salary you are offering.  No one is going to work for less than the market rate and so if you can’t afford the market rate of labor then I’m sorry but you’re going to go out of business just as if you couldn’t afford the market rate of rent or supplies or anything else a business needs.  People want to work, but no one wants to work for you if you’re not willing to pay them.

This “no one wants to work” nonsense got spread around a lot as the price of labor increased and many businesses found themselves unprofitable.  It was easier for owners to blame the moral failing of society than to admit that they weren’t good enough to turn a profit in a high wage environment.  But while this nonsense was rightly criticized by many, it reminded me of a similar economic trope that I don’t see get much criticism.

I’ve been reading “The Rise and Fall of Nations” by Ruchir Sharma.  What stood out to me was his discussion of immigration where he used a very popular left-of-center talking point that “immigrants do the jobs natives don’t want to do.”  He justified this with several anecdotes, but to me this smacks of the same false narrative as “people don’t want to work”.  It’s not that natives don’t want to do those jobs, it’s that those jobs are unwilling to pay a higher cost for labor and so usually receive special carve outs and exceptions allowing them to pay less.  This in turn makes the jobs unattractive to natives who have other options, and when the job creators whine to the government saying “no one wants to work!” the government responds with selected programs to allow the importation of cheaper workers.

Just look at agriculture in America.  In Massachusetts the minimum wage is $14.25, but it’s just $8.00 for farm workers!  Farm workers are also except from overtime pay and some OSHA requirements alongside the NLRA and many state laws.  The law has excepted farm workers from a majority of the protections and benefits afforded to other workers, so why would anyone work on a farm?  Why work on a Massachusetts farm for $8.00 an hour with no overtime, no safety, and no protection when you could make $14.25 an hour working for Walmart.  So instead these jobs go to immigrants, especially immigrants on special visas which only allow them to work on farms!  There’s no fear of your workers leaving for a better job if your government forbids them from doing so!  So let’s be honest, are these jobs that natives don’t want to do?  Or are they jobs that natives refuse to do because they have low pay, low benefits, low safety, and there are plenty of better options available.  

Farm employers say that it has to be this way: they can’t raise wages or they’d go out of business, or prices would rise, or America’s food economy would be destroyed by cheap imports.  This is the same excuse the “no one wants to work” crowd gives for refusing to raise wages, and is strikes me as the same 19th century nonsense that people used to use to argue against the minimum wage and every single worker’s rights law for generations.  Which is why it’s so infuriating that many left-of-center voices believe in the “jobs natives don’t want to do” narrative, even while they rightly point out that “no one wants to work” is a false narrative.  If farm jobs were as good as Walmart jobs we’d see far more Americans take them.

Will inflation become persistent?

Currently most of the western world is experiencing inflation of between 8% and 15% a year (although there are some stark outliers).  The question on everyone’s mind is “will this become persistent,” my question is “how will we know if it has?”  

The Federal Reserve’s view that inflation would be “transitory” didn’t seem so unreasonable when they made it in early 2021.  Inflation was caused in part by the sudden drop in supply due to the COVID19 pandemic.  That drop in supply had also caused a drop in demand, but as the economy opened up demand was rising and it was assumed supply would as well.  This could have meant that within a year or two supply and demand would restablize to somewhere around their 2019 levels, when the factories and supply chains were fully staffed and the consumers were fully consuming. But something went wrong, at some point it seems that demand got well ahead of supply and at that point supply couldn’t catch up as long as low rates and easy money remained a policy of the Fed. And so in 2022 the Fed quietly retired the “transitory” label and started raising rates in earnest.

To digress a little, Argentina experienced an inflation rate of around 300% on average from 1975 to 1990, and the results on consumer habits were amazing.  People generally spent all their money as soon as they had it, no saving in sight, because inflation erodes the value of saved money almost immediately.  People would buy cars as soon as they hit the market, drive the car for a few years, and then sell it used and were able to make a profit because with 300% inflation the price of their car had gone up tremendously even as they drove it.  The lack of any sort of savings, and the sky-high demand as people spent every peso they had, both became entrenched in the buying habits of Argentine consumers and those habits were difficult for the central bank to overcome.  Worse still, these habits created a “tragedy of the commons” among the Argentine consumers, if everyone would be willing to spend less pesos and save more, then demand could cool off and supply could increase to match it, taming the inflation.  But if only some of the consumers stopped spending and started saving, then inflation would persist at sky high levels and all those consumers would accomplish is the swift erosion of whatever money they put towards savings.  If you wanted to keep your wealth during hyperinflation, you had to spend it (or convert it to dollars, which also didn’t help the peso).

The persistence of Argentine inflation was what made it so impossible to cool, not just the constant sticker shock.  That’s part of why the Federal Reserve has been so deliberate and communicative, it wants to maintain the trust of the American consumers and producers.  As long as people trust that the central bank will cool inflation, they will continue to save and not just spend spend spend.  But if people don’t trust the institutions (as they did not in Argentina), then any attempts to maintain trust in the currency are futile.  I haven’t detected the sort of tell-tale signs that inflation is becoming ingrained in American’s buying habits, we’d know if it had when people start buying things today on the assumption the price will rise in the near future, and I haven’t seen a lot of that.  On the other hand I’m a scientist who doesn’t have much money for big purchases, so what do I know about spending habits?

Technology is supposed to be deflationary

Elon Musk and Cathie Wood are complaining about deflation again.  For the most part they’re just sad that the Fed’s actions have cut off the flow of cheap money, reducing the price of stocks and thus reducing their total wealth.  But they both have a tiny kernel of truth within their whining, technology is deflationary by nature and our monetary policy should be prepared to deal with it.  But what does that even mean for technology to be deflationary?

I’d like to go back to a post I did on dividends for an example here.  Let’s look at the Oil Shock of the 70s for a good example of an inflationary period.  The rise in the price of oil led to inflation as companies and people who still needed it bid up the price in order to compete for what little oil was left to go around.  This in turn pushed inflation into other sectors, as the lack of oil meant there was a lack of goods that relied on oil, thus the price of those was bid up as well.  If we take the example of a company which uses oil to make certain goods, how do they deal with the oil shock?  

Most directly, they can continue to buy oil at a high price and raise the price of their goods to compensate.  As long as every other company in their sector is also forced to raise prices, the company will survive by pushing inflation onto their customers, but if the other companies making their good are not affected by the price of oil, then this strategy won’t work as the company will just bleed market share into bankruptcy.

Alternatively, they can look to find ways to reduce the amount of oil they use per unit product.  In this way they can try to keep their prices low while their competitors’ prices are forced to rise, thereby gaining market share.

In a very real way, reducing the amount of oil used to create products would require some sort of innovation in technology, the creation of things like electric cars and nuclear power plants so that less of some stuff (oil) is being demanded and more goods are being supplied. This decrease in demand and increase in supply will cause deflation as prices drop due to these factors.  Remember that this is why some neoliberals pushed back against price controls and rationing during the oil crisis, those things depress the market forces which would otherwise cause people to invest in innovation and trigger deflation.

So today we don’t have an oil crisis, but in Europe we have a gas crisis, and European countries have also declared their intentions to accelerate the gas crisis by subsidizing demand instead of reigning in supply.  The problem here is that the government will pay the cost of this gas inflation and so there’s no reason for market-actors like companies to change their behavior or invest in alternative technologies.  Perhaps the governments themselves will try to force investment in alternative technologies, but I’m skeptical they’ll do as well as the market would.

So what does all this mean? Well if you believe that we’re on the cusp of a technological revolution, then it’s true that the Fed could accidentally flip us into deflation without even trying. On the other hand one of the biggest drivers of inflation this year, energy, is being subsidized by the government with price caps or tax reductions so companies and individuals aren’t being forced to invest in new technology in order to limit their use. Technology is supposed to be deflationary, but that’s no guarantee.