Demystifying the inflation conundrum

Some economists worry that uncontrolled inflation will soon surface following the money printing antics of the central bankers. Still others believe that deflation will arise instead. So what to make of this contentious issue? If economists themselves can't agree on how a major situation will unfold, can we dummies, with no formal learning in economics, be more prescient than them? Worry not, you only need to know a little bit about money to trump them. Once you understand money, you can easily grasp the cause of inflation, hyperinflation and deflation. For this post, we'll deal with inflation to be followed by deflation in the next post. As we are dealing with the real world, our lodestar to understanding money is economic history, not economic theory which is good only for the surreal world.

To know what money is, you don't need to rely on the economists' M measures, i.e., M0 to M3 or sometimes M4. Same goes for the velocity of money, a crackpot idea that should have never seen the light of day. Those are red herring measures which serve more to distract than illuminate. The only measure that should be used is total credit. Credit is money. In fact between 95% and 98% of money is credit except in a hyperinflationary environment wherein physical money will drown credit. So under normal conditions the physical bills in your pocket don't make a dent to the money supply.

Economists who fear unconstrained money printing by central bankers are exposing their money ignorance (See "Money 101 for the Fed"). How much cash do you carry on your body or stash under your pillow? Compare that with the amount you keep in the bank and invest in bonds. If the cash that you keep in its physical form is more that 5% of your total cash holdings, you belong to the 1%, at the bottom, that is. Your cash in the bank is not sitting there idle. The bank will lend it to someone. So instead of tallying the cash, you can get the same effect by looking from the opposite angle, that is, the amount of credit drawn by the various borrowers. However credit from the bank is only one element of the total credit in the system. Credit also arises from bonds issued by corporations, municipalities and the government.

What about the newfangled financial instruments, such as the alphabet soup of derivatives? No need to feel overwhelmed. Their only impact is to make credit widely available. They don't reduce the risk though they may lower the price, i.e., the interest rate, of credit because more money now gets to the market and the cost of the intermediary, that is, the bank has been eliminated.

However money is only one of the causes of inflation. Recall the 4C framework of currency, capacity, consumption and communication. In simple terms, if the goods or services production lags the supply of currency, the result is inflation (see left panel of left picture). In rare circumstances, goods or services production may decline at a faster rate than that of money supply; that also leads to inflation (see right panel of the same picture). Another combination which only Robert Mugabe can magically conjure is a fast climbing money supply accompanied by a declining goods or services production. This is hyperinflation.  Note that hyperinflation is a state in which price increases are experienced daily while inflation monthly. Hyperinflation disastrously disrupts an economy that only insane politicians would allow it to proceed indefinitely.

What drives the movement of each component of the 4C? The supply of goods or services is dependent on advances in capacity and communication. Every Kondratieff Wave has witnessed a significant leap in both capacity and communication, resulting in lesser input for greater output. Even now a disruption in either capacity or communication could drive costs or prices up. The recent Pakistani blockade of the border crossings along the Afghan-Pakistan border has driven the cost of delivering fuel to NATO's remote outposts to US$400 a gallon.

The supply of money on the other hand depends on the increase in credit unless we talk of hyperinflation which requires the government to print money and spend it. However in most true representative democracies, it's not possible for governments to create hyperinflation because there are enough checks and balances to constrain their budgets. Only autocratic government can foster hyperinflation. Weimar Germany, the post WWI German government, although democratically elected, was different because of its unique circumstances which will be explained later.

Direct borrowings by businesses that bypass the bank usually through corporate bonds cannot be blamed for contributing to inflation. A non-financial business is restricted in the level of debt that it can raise relative to its capital, this proportion being termed the gearing or leverage. A gearing of 3 to 4 would have been the maximum tolerable for a non-financial business. Financial corporations however have a tremendous ability to create credit or money. Usually, they could push the ratio to 15 although the excessive risk takers among them have stretched this ratio to the extreme limits, with disastrous consequences. The gearing of Long-Term Capital Management which succumbed in 1998 skyrocketed to 292 (including total derivatives) or 62.5 (based on assumed risk only), while in the 2008 failures of Bear Stearns and Lehman Brothers, they were having ratios of around 35 and 31. The financial corporation thus are the obvious culprits for any inflation fostered by excess money supply.

So the rule for inflation in most modern democracies is this: for normal inflation, it is always caused by increased financial institution lending, not government printing unless it is hyperinflation in which case, the culprit will always be the government. But excessive lending need not necessarily lead to inflation if the goods and services production capacity can match the increased money supply. As is typical of any 60-year Kondratieff Wave cycle (see left chart from The Economist for the fourth wave which began in 1960), the first half of the wave is always plagued with capacity constraint but the second half is blessed with capacity surplus. So even though there may be pockets of inflation during the second half, they are mainly due to short-term inelastic supply of certain goods, such as houses and oil. Their prices are doomed to fall when the capacity bottleneck is broken. A similar portrayal of the inflation chart of the third Kondratieff Wave for the period 1900-1960 however would not appear so clear cut as the two world wars distorted the inflation numbers.

As for consumption, since the start of the Industrial Revolution, it has been benign because population growth has always been growing or at least hasn't faltered. But that's about to change with the fourth Kondratieff wave. The entry of women into the labour force has escalated the opportunity cost of raising kids. Women's total fertility rate (TFR) is falling all over the world, in some places, such as Japan, even below replacement rates. Population declines mean that consumption would now count far more towards contributing to deflation (less goods consumed means more goods available at a given money supply).

Although consumption now struggles, capacity flourishes. It is obvious now that we need less manpower to achieve a given level of production. What happens to the unneeded manpower? In the past, they could move from agriculture to industry or migrate to the new world of the Americas. Even up to the third Kondratieff Wave, manufacturing was still employing many workers. That enabled many to move up to middle class status. That has now changed as technology has automated many tasks while globalisation, aided by containerisation, has offshored tasks requiring many workers to foreign countries with cheap labour. Those in middle class  now are being demoted to lower class, worsening the wealth and income gap between the upper and the lower class.

One more issue that has been confusing us is whether inflation is cost-push or demand-pull. Generally, since the Industrial Revolution it's been demand-pull as mankind's ingenuity has enabled it to break the supply constraints. On occasions, when cost-push arose, the situation wouldn't last long, meaning round about 10 years. Take the 1973 oil crisis. The oil prices jumped then because the producers hadn't been exploring for new oil fields as prices had remained low despite the increasing demand. We've been fed the story of how Paul Volcker tamed the inflation in 1981 by hiking the interest rates to more than 19%. That's a half-truth. If Volcker had been Fed Chairman in 1974, his action would have needlessly put a great number of people out of work for a prolonged period. Luckily it was the early 1980s because by then the oil producers' spare capacity was reaching record highs, so the convulsions wrought on the economy by the sky high interest rates didn't last long. Compare this with the oil price hike that pushed oil to more US$140 per barrel in July 2008. That didn't have much ripple effect on the inflation numbers simply because of excess capacity in goods and services production. The goods and services producers had to absorb the higher energy costs and soldier on with wafer thin margins.

Let's get to the hyperinflationary world of Weimar Germany to see why it happened and why it wasn't a disaster it had been made out to be. In reality it was a relatively short-lived episode lasting from July 1922 to November 1923 but has been given too much bad press and wrongly accused of fostering the rise of Hitler. The cause of the hyperinflation was money printing by the German government during World War I. To finance war spending, the German government issued bonds which were subscribed fully by the Reichsbank through the issuance of new notes. These notes then circulated through the economy. However rationing and price controls during the war postponed the consumption of goods and price inflation. After the war the new socialist government increased spending to pay for higher wages and compensate displaced war victims at a time when capacity was still constrained. Prices rose but then stabilised after February 1920. The government however continued printing money. Prices held steady until May 1921 before continuing their rise, finally erupting into hyperinflation in July 1922.

Wasn't it easy to kill off hyperinflation and if so, why did the German government continued with its money printing madness? It actually was but the German economy then was burdened by war reparations which amounted to US$64 billion in gold. Had Germany paid the war reparations, its currency would have depreciated and the economy would in time regain its competitiveness, given the industriousness of the German people. But after a string of defaults by Germany in its war reparation payments, France and Belgium occupied the Ruhr in January 1923. In response, Germany printed more money to pay the companies, that suffered from the occupation, and their evicted workers. This was the trigger that unleashed the hyperinflation. However by November 1923, the hyperinflation was subdued through the replacement of the much devalued Papiermark by the Rentenmark at the rate of 1 trillion Papiermark for 1 Rentenmark, which was in turn replaced by the Reichsmark the following year. The reparation payments were rescheduled to more manageable terms. The sum was eventually reduced to US$29 billion in 1929. Money from abroad to invest in the stabilised German economy especially from the US provided support for the Reichsmark.

How bad the impact of the hyperinflation, it didn't lead to the rise of Hitler. Hitler attempted a coup d'état only in November 1923, about the time the hyperinflation was tamed. If hyperinflation was the villain, Hitler's popularity would have plummeted right after his failed coup d'état. To be sure, the conditions in Germany during the inflationary years were chaotic with lots of violence but that was to be expected of a losing combatant which had lost territories and had war reparations to settle.

However such conditions paled in comparison with the economic depression that afflicted Germany beginning in late 1929. This time the German economy instead of being flushed with money as in the hyperinflationary years was now short of funds as the Americans had pulled out their money for more profitable stock market speculation on Wall Street. Export markets dried up and banks were hit with closures. In 1932, the year before Hitler's ascent, Germany's unemployment rate was 25%. These negative conditions smoothened Hitler's rise and his eventual consolidation of power.

So which is worse, hyperinflation or deflation? Surely it's deflation. The conditions we're in now are ideal for a deflationary environment. The economists who have been warning us about the danger of money printing and hyperinflation very soon have to eat humble pie as prices data all over the world are pointing towards lower inflation. It won't be long before deflation rear its ugly head and these very same economists will be warning of deflationary dangers instead.

Great in debt

It is said that Margaret Thatcher and Ronald Reagan were the two great leaders of the western world in the 1980s, instrumental in ending the Cold War and ushering in a new era of small government, low taxes, free trade, weak union, prosperity and freedom. With the current palpable lack of leadership in the major economies, the public is yearning for the good old days of Reagan and Thatcher.

We don't want to revisit the legacy of both leaders; that would be the job of historians. Indeed they were truly admirable. But were there to be a leader of similar ability, could he or she reach the great heights of global stature especially in these trying times? Or was there something else about Reagan and Thatcher that has yet to be made known to us, the gullible public?

With the benefit of hindsight and a vast treasure trove of information on the web, we can now reexamine the reasons behind their prominence from the perspective of the 4C (see "Reality in 4C"). You should have been aware by now that Reagan secured his second term by paying homage to the credit market. But let's get into the details to debunk the conventional wisdom surrounding Reagan first, to be followed by Thatcher in a future post.

We begin with the tax and spending cuts, two issues frequently cited by the Republicans to justify their calls for similar action by Obama. When Reagan came into office in 1981, he reduced the top marginal tax rate from 70% to 50%, and federal spending by almost 5% of the federal budget. However this step could only last one year as coupled with Volcker's high fed funds rate that topped 19%, the economy was plunged into a recession (see left chart from The New York Times). The fall in inflation rate following Volcker's tight money policy accentuated the fall in the tax intake. So Reagan had to reinstate the tax revenue in 1982 not by reversing course but by transferring the burden onto businesses. Still, his tax cuts were much more than the increases; by the end of his administration the top marginal rate was further reduced to 28%.

The result of the tax cuts was reflected in the ballooning federal deficit, tripling from US$900 billion to $2.7 trillion by the end of his administration (blue column on the left chart). However this deficit actually boosted the economy. It supplied the spending and liquidity that uplifted the incomes of households, businesses and foreign nations. In turn the businesses and households took on higher borrowings of their own, resulting in a spike of total US debt that started from the end of Reagan's first term.

Now, two questions remain a puzzle to most observers of the Reagan administration. First, can't we continue the borrowing binge by all sectors that brought prosperity not only to the US but also to the whole world? Second, why was the inflation subdued when in fact the money supply as reflected in the debt increase during his second term was skyrocketing? Nobody has satisfactorily addressed these issues. Our attempt will demonstrate that Reagan came into office at the most propitious time. Because of that, his mistakes, which would have been calamitous to any other president, were glossed over.

He gained much from the cautious policies of his predecessors. Not only were they conservative with deficit spending but the inflationary conditions that had characterised their presidencies reduced the relative level of the federal debt. For example, Carter increased the federal debt by about 30% but because of the inflationary condition, the debt/GDP ratio actually decreased by 3.3%. Reagan's two terms however marked a new era of debt financing, not only by the government but also by the other sectors: businesses and households. Reagan took advantage of the depressed borrowings of the earlier years to let rip the borrowing and spending spree.

Also, unlike Nixon, Ford and Carter, Reagan didn't have to endure periods of high inflation, commonly known as stagflation because of the stagnating GDP. Milton Friedman used to remark, erroneously in fact, "Inflation is always and everywhere a monetary phenomenon." It should have been a 4C phenomenon instead of only a monetary phenomenon. The other important factor is capacity in which oil plays a very significant role as the driver of virtually all economic activities.

Remember that oil prices started to experience wild swings following the 1973 OPEC oil embargo. In fact, the sudden jump in prices wasn't totally unexpected had the buyers observed the declining spare capacity leading to the embargo (see "Oiled for Turmoil"). But as new oil fields took at least 7 to 10 years from initial exploration to production, it wasn't until the early 1980s that these fields managed to boost the spare capacity. However the 1979 Iranian Revolution followed by the Iran-Iraq War in the following year further scuttled oil production leaving the Carter administration wondering why his increased spending didn't translate into higher economic growth instead of higher inflation.

Only in 1985 did the prices drop to US$26 per barrel and by the following year to as low as US$11. Until the end of Reagan's second term the prices remained favourable, hovering around US$20. So Reagan could have the cake and eat it too, his spending going straight into the consumers' pockets instead of the oil producers'. Production capacity could increase to take care of the spending when previously any increase was constrained by higher input costs.

These two factors explain why no one else can repeat Reagan's feat and why there is so much yearning for Reagan's leadership. Although oil prices will likely go down as vast new fields in North Dakota, Colorado, North Sea, Colombia and Brazil's coastal waters come onstream in the next couple of years, the debt could no longer be increased. It has reached the peak of the S-curve and the only way forward is down. Those who want to spend no longer have the income to afford the debt while those who have the means have no use of further borrowings.

Poor Obama, intelligence alone is not enough to guarantee good leadership. More important is the external environment which in these troubled times can do far more to make or break a leader.