Weekend Ponderings - Economy, Inflation, and how usual or unusual is it?
That seems to be the only thing that matters nowadays isn’t it? The economy, recession, and inflation. Earnings and buybacks do less for a company’s stock price than these macro concerns. Having not completely gone through the historical data, I don’t have hard evidence for anything I’m about to propose…just throwing this out for discussion’s sake. So, my main question:
HAS AMERICA BEEN LIVING IN AN ARTIFICIALLY LOW INFLATION ENVIRONMENT??
First, the implications. If we have been living in an artificially low inflation environment, then the Federal Reserve’s “comfortable” target range of below roughly 2% inflation per year might be too low (and wrong) for the environment we’re in today. By steering our country towards an unrealistic (and thus unstable) inflation goal, the Fed might actually be slowing, straining, and sputtering our economy like a car that doesn’t hit it’s stride till it’s running at it’s optimal cruising speed (which might be a slightly higher or lower inflation target). As Annaly CEO Mike Farrell noted in his latest piece, The Keynesian Nightmare, much of modern economic policies and concepts grew out of Keynes’ and other’s theories in the early part of the 20th century. However, the world has been growing strongly long before Keynes’ came around. Even with Keynes’ great ideas and theories, which I love and respect for various reasons, Mike Farrell argues that the world that happened after Keynes’ and where his ideas have been applied is an abnormal world (including the explosive growth of debt and leverage leading to the crisis we now see ourselves in - hence the title Keynesian Nightmare)
There are several reasons why I think the world has been in an abnormal economic state since the early parts of 1900’s, resulting in misguided beliefs of what “inflation should be.”
- WWII threw the world completely off balance, resulting in a post-war era where America was the only country standing on its own two feet. A post-war era completely different from what was there before. Europe got thrown back into the dark ages while Russia and Asia neutered their own growth as they went deep into communism. The U.S. was the only one left to grow industrially and economically, innovate, and have much of the world’s resources at our disposal to do so. That’s how we got “used to” using up 25% of the world’s energy with only 5% of the world’s population. But in most other periods of expansion in history, at least 2 or more superpowers had been battling for resources, thus somewhat keeping each other in check. Sure, if your family went away for the weekend, you can go crazy at home…but once they come back, you’ll have to get back to living with each other. I believe that’s where we are now, the world coming back into the picture, and America not enjoying the company. With many more people using the limited resources on earth, inflation is inevitable as prices rise due to simple rise of demand. Americans have been living TOO luxuriously, expending too much of their disposable income…and nondisposable income. We would likely have to live without a iPod or two and use that money towards higher food prices. The rest of the world is paying the high price too, and living with a lot less. We should be the last to complain. Which brings me to the question, does anyone know the sustained inflation rate during expansion periods such as Europe’s Imperial Age and the Industrial Revolution that followed?
- Debt. Whether as individuals or as a country, Americans love to spend more than we have. I’ll defer you to Mike Farrell’s “Keynesian Nightmare” as he is a much wiser man on this topic than I am. My question here is, has Americans been “feeling” low inflation because we don’t pay for 100% of everything but use debt to finance part of the cost? Instead of considering the Consumer Price Index (CPI) for indications of inflation, I’d rather consider the average American’s purchasing power (are Americans able to buy more or less given their current paychecks and the price of the good they want to buy?) We might not be able to afford the cars or homes we own now if we didn’t use debt. So, if we didn’t use debt, our purchasing power would be less, thus living in a relatively higher price environment. However, what we HAVE been doing is, even if there were higher inflation and prices rose, we simply used more debt to finance the purchase. In a way, we could give ourselves artificially low inflation, up to the limit with which we could use debt to “pay for” the inflation. I wonder, might we have had high periods of inflation, but money and debt was so cheap we paid for inflation with debt, and didn’t really see it show up in the economic data?
- Another abnormality of the Post WWII Era - America, as the only solid growing country, was given this luxury of using debt because ours was the only nation dependable enough for people to lend us their money. If it wasn’t for the fact that the rest of the world were in decades of recession, we might not have gotten so willy nilly with charging up America’s credit card around the world with trillions in national debt. Again, as the rest of the world comes back into the picture, other economies strengthening and countries like Brazil actually in fiscal surplus and acting as a net supplier of capital to the world, America’s less able to use debt to finance…whatever…including inflation. This phenomenon is playing out as the $U.S. dollar continues to hit all time lows- the world voting (with the dollar’s value) that there are many other countries now that they’d rather lend to and invest in than America. So, with all the talk by Ron Paul about how lowering interest rates devalues the dollar and steals from Americans, there’s much more at work lowing the dollar than just interest rates. America was in an abnormal time, enjoying high value for our dollar because there were nothing else out there that could compete with our dollar. In a absolute sense, I believe our currency is still stronger than other currencies. It’s just that the world has limited capital, and that is being spread more evenly across a basket of currencies now, not just in the U.S. dollar as in the past.
- Finally, my personal favorite topic: Infrastructure. As I’ve been pounding the table on again and again, America’s infrastructure horribly outdated and the deterioration will only accelerate. Sempra Energy’s CEO Donald Felsinger mentioned on CNBC on Tuesday that 25% - 50% of America’s energy infrastructure needs to be replaced as they were only designed to handle the capacity from 20 years ago- everything from transmission lines to LNG terminals have to be replaced as well as expanded. But he’s only referring to the energy infrastructure! There are many more public infrastructure from water utilities to telephone lines that need to be upgraded. This, I believe, will only make inflation worse (from a purchasing power standpoint) as we will eventually have to pay for all these upgrades. Whether it be through tax increases or higher utility bills, we will have to pay for these, which means we’ll be left with less money to buy other stuff and thus less purchasing power. We ignored paying for these years ago when they needed to be replaced, choosing to spend money on other things for economic growth. Now the Loan Shark’s coming calling, and Papa Baby Boomer has left his problems to his kids.
** Energy hub and terminal resource on SuckingLess.com**
So, it appears that a perfect inflation storm still lies ahead for the U.S. In addition to the first 3 points I discussed, our infrastructure is nearing its breaking point and a huge upgrade simply has to be paid for in the very near future, adding to such a burden that American’s haven’t experienced for decades. I’m not sure what this all means, and not sure long term investing view comes with it. I just have a funny feeling that the world is reverting to a norm, and I don’t think that norm is what America has enjoyed for the last half century.
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March 15th, 2008 at 6:46 pm
has America been living in a historically low inflation environment?
I would argue that what we see is more a product more of Ricardo, and not Keynes. One thing I appreciated from Ricardo’s work on rent. He worked specifically on agriculture. He argued that land had different levels of productivity, which lead to differential rents - more productive land could garner a higher rent than less productive land. The relevant part of his analysis is that if prime agricultural land rose high enough, farmers would eventually start growing on more marginal land.
What I take away from this is that in any economic system, incumbent agents have an advantage. They have already claimed the low-hanging fruit. In order for new entrants to the market to compete, they will increasingly make use of more marginal investments and business strategies. The eventual result, of course, is that many new “innovations” become complete crap and fail.
Keynesianism is only a nightmare in that (1) it’s improperly implemented, (2) it has been successful in providing a safety net, and (3) moral hazard. Keynes originally envisioned government deficit spending during downturns and surpluses during boom times . But though the economic strategy is seemingly straightforward and symmetrical, the political incentives don’t quite match up. It makes perfect political sense for the government to mitigate a downturn by increasing liquidity and creating new jobs, even if the purpose is merely to keep people employed. However, in periods of economic growth, there is no political gain to be had by increasing taxes to pay off previous deficits. Coupled with the heady optimism that “the market solves all”, it becomes impossible to institute this second part of the Keynesian two-step.
I remember reading that the Fed nominally (pun intended) has an inflation target of about 2-3% in order to prevent dollar hoarding. That there has been a “great moderation” may reflect a combination of (1) greater regulation of the financial sector, (2) disappearance of a balancing superpower (USSR), and (3) productivity gains that increased profits while keeping inflation down.
I’m particularly interested in the productivity issue. Labor tends to be the largest cost for a business. How much of the gains have come about from (1) technology, (2) outsourcing of jobs? Given that the US Census predicts population growth of about 0.7 percent a year for the next 20 or so years, economic growth of 2-3% will largely be productivity driven. But I wonder how much potential there really is without serious restructuring of how we live, how we learn, and how we consume.
The infrastructure problem is an interesting one. If municipal authorities really do either get (1) comparable ratings as Wall Street firms, or (2) forego reinsurance altogether, they may save a bit of money in fees. On the other hand, if there are no willing buyers, some important and not-so-important public projects will not get financed in a timely fashion. I would like some more numbers before I make a strong judgment either way - it’s possible that increases in efficiency will help with both carbon and cash.