Saturday, October 31, 2009

Again Random Thoughts, Again on Inflation, Paper Currencies and Other Topics

"Government is the only institution that can take a valuable commodity like paper, and make it worthless by applying ink."-- Google who said it.

If you are a newbie to the inflation discussion on this blog, please take time to read this, this and this. I have a PhD in Macroeconomics focusing on inflation from Garage Logic University, and, consequently, some of my ideas are not from the US mainstream books written by the macro-cabal. They come from reading real accounts and from bruised knuckles, not from lofty, enriching beret-tweed-pipe discussions in the faculty club.

Some of my examples present real dark case scenarios. Do not dismiss them as "this will never happen here." We've been very lucky in this country, and luck runs out eventually, especially if unappreciated, like the talent of a gifted basketball player who hangs out in the wrong crowd.

Black Swans do happen, and they are called Black Swans, not fluffy puppies, for a reason.

Inflation is asymmetric
This is an FYI point that I think I should clarify upfront. Most textbooks define inflation as the overall increase in price levels, including the price of labor. This is an overly simplistic view.
The prices do not go up in unison. Essentials go up drastically and first, and keep rising (water, food, energy, medicine, security items); non-essentials sometimes take years to catch up (salaries, many services). In E Europe it took years for salaries to catch up to the pre-hyperinflation real levels. Any credit-based products (think housing) will also lag in real terms because credit will disappear, and other "normal" drivers, such as incomes, employment, mobility and household formation stall. Try selling a house if the price is 200 American Eagles, the only accepted form of payment.

Inflation will not solve the entitlement crisis
The problem larger than the $12 trillion in debt is the $50-60 trillion in promises the government has handed out to the American people. Here and there you hear that inflation will help with the "national debt." However, the $60 trillion in Medicare, Medicaid and Social Security are present value amounts. They will not disappear unless there is entitlement reform (read, massive reductions). No elected politician will stand for it, and the majority of the electorate do not understand neither the cost nor the complexity of the problem, nor its implications. But, my point here as it relates to the rest of the article, is that inflation will not help with the unfunded promises.

Inflation in a service-based economy
The sad truth is that most services are non-essential. As essentials take up more and more of the consumer budget (in Weimar Germany, food went up for 30% to over 90% of the average family budget), many service businesses will collapse. As in, $0 in revenues. Think about it, when the choice is bread or a haircut. Or keep contributing to the $1 mm life policy when a gallon of gasoline is $2 mm? All 401(k)'s cashed out in a mad rush for food hoarding? What would be the demand for real estate appraisers then? Drycleaners? Florists? Car detailers? Professional baseball? Most retail? Hotels? Management consultants? Roofers?

Inflation is very hard to control
Inflation cannot be "controlled" once the genie is out of the bottle. It becomes as much of psychological phenomenon as it is a monetary phenomenon (as described in your favorite macro texts). What does it mean that inflation becomes psychological, and what are the implications?
Inflation becomes a front and center event. If it is on top of everyone's mind, then society as a whole will overreact to it, thus exacerbating the problem: pre-emptive price increases daily, workers demanding weekly raises, any money earned is spent right away (which really speeds up the velocity of money, making the problem deeper), and so on. The implications are that things that have historically worked to slow down inflation, such as raising interest rates, will not work as intended: businesses will still raise prices all the time anticipating inflation, no matter what the discredited (by now) government says. People will still be rushing to spend, keeping the velocity of money high. In short, the participants' actions to protect themselves individually will be hurting the collective outcomes. In addition, there will be supply-driven inflation, as inflation brings about business shutdowns, thus reducing capacity/supply of goods. Imagine the following headline: "Fed Raises Short-term Interest Rates to 400%; Bernanke Says Inflation Now Under Control" If we get to 400%, do you really think the Fed's decision will matter to anyone?
Only credible actions from credible people will solve the psychological problem, such as a new government instituting a credible currency board.

Inflation: dispelling the serious misconceptions about how it happens and how it affects people and businesses
Many people here in the US that actually have a clue about inflation think of it in textbook terms. In other words, both incomes and prices rising more or less at the same pace; no inflation if there is high unemployment and low capacity utilization; inflation helps companies as they can raise prices while debt service gets "easier", and so on. All in all, inflation is business as usual, may be with some more aggressive pricing action.

No, no, and no.

The above statements are true at when inflation is at low single digits. If unemployment is at 7%, inflation will be 2%, vs. 3% if u/e is 5.5%. Companies target price increases of 3-4% every year, and costs rise at about the same rate. So far, so good. This is roughly the US experience over the last 30 years.

What happens if inflation is higher?
High inflation leads to both high unemployment and low capacity utilization. How's that possible? Most businesses actually cannot pass on the cost increases simply because most businesses do not offer essential products or services. As a result, they simply shut down: you have both high unemployment and low capacity utilization. This also leads to product scarcity in many areas, further increasing prices.
Just think what would happen if diesel prices go up 3x tomorrow (not out of the normal for an essential good in a hyperinflationary environment). What would happen to UPS and FedEx? Will they be able to pass it on? No. They will shut down. What happens to shipping costs? They go up. What happens to unemployment? Up. Capacity utilization? Down.

What worries me even more is that the vast majority of US management teams are simply too young to have been in management in 1979-1980. They would have had to be born in 1940 at the latest, or they'd be 69 now. More than likely, these people are golfing somewhere in Florida.
US businesses are not run with an eye towards inflation: long term fixed price contracts, vendor credit, reliance on short-term and variable-rate borrowing, even mundane things, like gas station pumps having only single-digit per gallon prices, vending machines accepting only $1 bills, or average employee commuting distance becoming prohibitively expensive. Sure, they can adapt in the long run but only few will.

Inflation: how it happens even without "printing" and without changes in the wider money supply, and without changes in the velocity of money
Here is something I do not think you can read about anywhere else. First, inflation rates are personal as personal consumption patterns differ, housing choices differ (i.e. own outright vs. rent), etc. How is it possible that you can experience inflation even if you do not purchase products or services with rising prices?
Here in the US the last 40 years have been marked by increasing governmental involvement in healthcare and education. As a result, the healthcare and educational costs have risen far faster than the overall CPI. Even if you are not a user of either (unlikely) your personal inflation rate reflects it because there is no free lunch. The new money the government spends comes from taxes (sooner or later), and this means lower disposable income for you. All of a sudden, for a unit of your labor, you can buy less. De facto, your own personal inflation.

A similar mechanism works when there is a government decision to limit say, oil drilling. Prices go up across the board because of the higher oil costs. No change in money supply or anything, but what is in effect a tax, creates inflation as your money is now worth less.

Inflation: the signs you will see when it is already here
This section is for the benefit of my US/Canadian/Western European readers. People from Latin America, Africa and Eastern Europe will likely find nothing new in it.
- Inflation is headline news
- New dollar denominations: $500 bill, $1,000 bill, $5,000 bill, $10,000 bill
- Disappearance of coins (both because the prices now have zeros and the value of the metal)
- Lack of essential products: everything you take for granted now is gone
- Explosion of petty theft: gasoline siphoning, food, light bulbs from common living areas and offices, hospital thefts
- Disappearance of credit
- Currency controls: limits on foreign currency transactions, gold and silver ownership, limits on bank withdrawals, etc.
- Blame game: incessant attacks on a gray subset of the population called "speculators" and "hoarders". If you think the Exxon hearings in Congress two years ago were a farce, this will be much worse. Read up on Venezuela's confiscation of food producers. Think it can't happen here? Think again. "Chevron's new management committee compromised of ACORN activists will work to ensure fair distribution and prices for gasoline." Or "Kraft Foods pledges to produce 100 tons of cheese in 2015 in order to reduce prices." The theft, of course, has happened at the printing press.
- Social unrest: If you think that the LA Lakers championship celebratory events were riots, wait until the monthly food stamp benefit can't buy a loaf of bread
- Non-stop "initiatives" to control price increases at the federal, state and local levels: price and wage controls, rationing, new laws and regulations about "black markets", "hoarding" and "speculation"
- Breakdown in services such as hospitals, ambulances, public transport and police; even electrical and phone services become unreliable (imagine the local utility company with regulated rates not being able to cover half of their nat gas purchases at market)
- Rise in bartering
- Rise in reference rates for pricing (i.e. products priced in today's dollar equivalent of euros, gold or some other rate)
- Rise in foreign currency circulation
- Rise in local currency circulation (how does a Dixie Dollar sound?) and other methods of payment aimed at avoiding dealing in the depreciating currency
- Widespread disbelief in the "official" inflation rates and money supply stats (I strongly recommend that you start keeping track of several products that you purchase often now)
- Widespread drop in the standard of living (wages take forever to catch up)
- Change in societal values, usually for the worse (things like civility, respect, etc.)

Reading first-person accounts from Weimar, Argentina, Yugoslavia and Zimbabwe can give you a pretty good idea of how things change.

Deflation: is it all that bad?
Is deflation bad? Some say so, I disagree. Here is why.
Deflation, widely defined, is a lot more controllable than inflation. Deflation helps with "creative destruction": a business should be built and run in a way to survive the lean times (in other words, with less debt than what the bankers told you at the presentation.) Deflation is natural in many businesses as a part of the cycle (think iron ore pricing for example). Deflation is inherent in businesses such as computing power, and yet, you do not see Intel complaining that the price for a certain computing chip drops all the time. This deflation in computing costs has been a boon both for the players there as it has expanded demand for their products, and to society as a whole. Deflation in housing is great because the prices had gotten ahead of themselves. Deflation in the overall CPI is good because the US worker is squeezed by both global wage arbitrage and by the bubble policies of the government. Deflation in living costs can help soften the blow. There should be deflation in education and healthcare costs, if you ask me. Of course, it won't happen so long as the taxpayer is on the hook for the massive programs in both areas.

At the end, I'd like to present you with a paper currency story, that of the not-so-mighty Bulgarian lev (pl. leva).
The story starts in 1944. Bulgaria started WWII on the side of Germany but switched over to USSR once the Germans left, and the Russians showed up on the border in 1944. Fortunately, save for some Allied bombing, there were no battles on its territory, unlike most places in Europe. The USSR installed its own muppet government, and the said government went on to execute, chase into exile or put in forced labor camps most of its political opponents, including most of the "bourgeois." Post-war inflation picked up (see Hungary), in part because there was no one to produce any goods after the factory and land confiscations (see Chrysler LLC). By 1952 inflation forced a replacement of the "old lev" with new ones at 100-to-1 (these numbers are a proxy for the actual inflation) but prices were changed at 25-to-1 (the government can do whatever it wants to prices in a planned economy). In other words, the purchasing power of the lev went down about 400 times in the post-war period.

Think of it this way, if in 1944 you had 100 leva that could buy you 100 boxes of nails at 1 lev each. By 1952, those nails were worth 100 devalued "old" leva each, and 4 leva each in "new" post-reform leva. Those 100 leva you had in 1944? They could then buy you 1/4 of a box of nails post reform (you had 1 "new" lev but nails were at 4 leva each.)

But wait, there's more. Scratching zeros does not work that well. Continued inflation forced a 10-to-1 conversion ten years later in 1962. Again, this is a proxy for the devaluation that happened. Those 1944 100 leva you had turned to 1 lev in 1952 are now 0.1 "new new" leva. The box of nails at 4 leva in 1952, probably went up to 40 in 1962, back to 4 after the 10-to-1 exchange. Your 1944 100 leva that could buy you 100 boxes of nails can now buy you 1/40th of a box.

But wait, there's even more! Several years of price stability followed largely due to below-market oil from the Soviet union. However, inflation accelerated again in the late 1980's leading to a currency board, pegging the lev to the Deutsche Mark, and a subsequent exchange into the "new new new" leva at 1,000-to-1. Again, using the exchange ratio as a proxy, those 1944 100 leva could buy you a 1/40,000th of a box of nails, when they could have bought you 100 boxes of the same product in 1944.

How does your purchasing power go from 100 boxes to 0.000025 of a box? The same way you go from 1 box to 0.00000025 of a box. Inflation.

Of course, the example is highly theoretical, as the old paper money itself is no longer a legal tender after each exchange, and the money exchanges are a proxy for the actual inflation rates. They could be over or under those but not by much.

Wikipedia has a nice list of examples of what inflation does to paper money. For example, 1x 1992 Argentina peso is 100,000,000,000 (100 billion) pre-1983 pesos.
Greece, the 1953 1x drachma was 50,000,000,000,000 (50 trillion) pre-1944 drachmas.

Of course, the winner and the runner-up are Hungary (1946) and Zimbabwe (to Jan 2009).

My ($0.02) advice is: do not take inflation lightly. Do not think it cannot happen here. Do not think that it can be "controlled" once the ball really starts rolling. "You can't predict but you can prepare."

Update 1 11/2/2009:
Mish, one of the top econ/business bloggers, has a good post on deflation. I strongly recommend clicking through on the links to read up on the deflation argument. He makes the best argument for deflation that I have seen. There is one to be made, and some would argue we are in a real deflation (if Case-Shiller is subbed for owner-equivalent rent in the official CPI). There is a particularly interesting link about debt deflation: no doubt we have seen some, but I think the paper overall is too academic (1), and (2) does not look at all mechanisms through which we can have inflation spiraling out of control: currency shocks leading to supply problems, new legislation that will undoubtedly raise both taxes and prices (health care and cap and trade are the two big ones): remember your own "personal" rate of inflation goes up if you can buy less with your labor as I described above.

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