(Note: In this "Inflation and Yields" series, I am outlining the fundamental relationships between and within yield and price complexes. In Part I of this article, we noted that deflated commodity and producer prices have been highly correlated with equity yields since 1871, in much the same way that producer prices were correlated with bond yields under the gold standard, a phenomenon Keynes called Gibson's Paradox. What is the connection? Part II looked at Britain. Part III looked at commodities in America. Parts IV and V examine the revolution in consumer inflation and stocks.)
The first thing we do, let's kill all the lawyers.
--Dick the Butcher
The Dollar's Service Charge: From Gibson to Gibson, Fisher, and Baumol
Perhaps the most frequently offered explanation for the inflation of services (including legal services) is an appeal to "Baumol's disease." Simply put, it is a wage and relative-productivity phenomenon. (See this PDF for an extensive discussion of services inflation and Baumol's hypothesis).
And, yet, real wages have been in a state of decline since 1973, after rising above trend from the 1940s. Wage inflation might have been a plausible explanation at mid-century when services inflation assumed its new role in the inflationary vanguard, but forty years later, can wages still explain the rise of services?
When I think about services such as education, which I'm slightly more familiar with, it is hard for me to think of any educators who are rolling in the dough because of the rise of education prices. Perhaps because my background is in the humanities, I have been oblivious to the wealth of teachers and professors in the sciences and social "sciences," but I just don't get the impression that educators are really cashing in on this bonanza in the services sector.
If both the service sector and the price of services have been in a constant state of expansion for the last fifty years or so (both absolutely and relatively), but the impetus is not from wages, the only thing that occurs to me at the moment is an expansion of the services infrastructure. An expansion in hiring, construction, and bureaucracy. Not just a physical expansion in terms of people and material, but also of systems, regulations, documentation, certifications, and-although I may be projecting my own demons onto this-jargon. In other words, the rise of the scholar-administrator and technocracy in pale, bloated imitation of the scientist and technology.
We don't just want our scientists and doctors to be "doctors." We want as many teachers and military officers and administrators to be "doctors," as well. And, this can be legitimized and funded by redefining a field (education, history, politics, psychology, even economics and investing) as a "science," with its own arcane professional standards and self-referential and impenetrable terminology, an ivory firewall.
It is also hard not to notice the overlap between service sectors (education, medicine, finance, law-and defense and public safety?) and the growth of government. Has the government, by over-regulation and over-spending, managed to push up prices in sectors that are characterized by low-productivity growth, while free enterprise drives prices goods down in the private sector?
Although that is an appealing interpretation, since inflation seems to be even more rampant in those kinds of services than in areas such as entertainment, my hunch is that what is simultaneously pushing up services prices while driving prices for goods down (especially technological goods) is a constant state of debt-fueled over-consumption across the economy. Government may contribute to the problem of services inflation, but I am skeptical that it is government spending as such that is the primary source of that inflation. Government, after all, plays no mean role in research and technology.
But, the more I get into a qualitative formulation of these forces, the more apt I am to put my ignorance on display, confound my analysis with my ideological predilections, and just generally engage in wholesale error.
So, let's return to the data by looking at some of these forces from a year-on-year perspective.
It is not hard to see why people blame commodities such as oil for inflation or regard them as true measures of inflation. They have an immediate impact that is easy to trace (e.g., high oil prices to high gasoline prices).
Yet, the truth to the modern inflation story is probably somewhere in this much more prosaic chart.
Services such as medical care have dominated every other non-commodity category since the 1950s virtually without interruption, whereas in the very brief window prior to that, it is not apparent that any category was more or less prone to inflation.
I am not aware of any price series for services that go back before the 1930s, so I cannot be sure, but it appears that the chronic rise of services prices from the late 1940s is simultaneous with both the chronic rise in consumer prices and the decline in deflated goods prices-especially technological goods- and that prior to that, prices across all sectors existed in a state of relative equilibrium.
This old equilibrium was the classical formulation of Gibson's Paradox whereby all prices--commodities, producer and consumer goods, and services--were more or less correlated with yields.
I have to note, too, that unlike high technology groups, furniture has not had a deflationary episode since the 1950s. In some sense, it has behaved similarly to services, although it has generally tracked just below CPI, while cars tend a little more towards the behavior of televisions.
Apart from the rest of my argument thus far, it seems likely that the rise in services inflation and the role of the services sector in the economy is linked in some way to the growth of technology. There is good reason, therefore, to attribute this change in the structure of the price complex and the economy to fundamental changes in the real economy.
But, what effected the change in the real economy? Was technological change the impetus, or was it changes in the monetary system? And, if technological progress was the cause, why did real wages blossom roughly at the time of Bretton Woods, only to collapse once Bretton Woods gave way, never to recover?
Based on the behavior of the various price series we have seen, I would like to offer a revised tripartite division of price sectors. One could think of it as 'Baumol meets Gibson.'
In the standard division, there are commodities, manufactures, and services.
I would suggest that a better division might be commodities, technological products, and labor-intensive products (services and mature manufactures). Commodities are cyclical and volatile; technological goods tend to deflate; and labor-intensive products, especially services, tend to inflate. But, the important thing for our purposes is to note that these tendencies are kept in some state of equilibrium under a metallic standard but are exaggerated in a fiat monetary system.
It would seem that Gibson's Paradox was only a gold standard phenomenon insofar as it tended to force manufactured goods and services to rise and fall roughly in sync with commodities.
Among the various gaps in the historical data, the biggest one is the lack of services data, but if relatively low-tech goods such as furniture can be thought of as something of a proxy for services because of the commonality between them (labor-intensive, low productivity growth), it would at least seem as if services adhered to Gibson's Paradox or was restrained by it.
In sum, it is likely that there has been continuity between commodity prices and equity rates for the last three centuries, while the prices for services and technological goods have been impacted in diametrically opposite ways by the transition to the dollar standard.
This transition was timed precisely to the transition from the various permutations of the equation
EY - DY - 10y + 1y = 0
to those of
EY - DY - 10y + 1y = CPI%.
I believe that a look at the yield spreads suggests a migration beginning in the late 1940s to the post-1960 yield equilibrium.
Although somewhat odd, this simultaneous change in yields and prices reflected in those equations and the data I have put forward here suggests that the inflation generated under the dollar standard is somehow dictated by the relationship between yields, where inflation tends to fill the gap that had always existed in the original equation. As strange as that seems, I cannot help but notice that the yield side of the equation was in place a century before the inflation side, and that inflation simply replaced the zero from 1960. It is almost as if inflation has been cannibalizing something since World War II.
I do not mean to say that the yield complex determines the rate of inflation under the dollar standard, only that since mid-century, the rate of inflation seems to have displaced some economic force that was latent in the yield complex as far back as the gold standard.
This occurs simultaneously with the transformation in the behavior of money velocity and supply noted by Friedman and Schwartz in their history of money in America.
It has to be noted, as well, that the behavior of the two components of the earnings yield, prices and profits, have changed radically over the last century.
Under the gold standard, the earnings yield was driven primarily by profits, and the stock market generally moved both with profits and the yield. But from World War I, the stock market and profits tend to play an equal role in determining the earnings yield. Up until the end of World War II, this dynamic was still somewhat unsettled, but from the time of Bretton Woods on, it is clear that corporate profits and the stock market will take turns in driving the yield up and down, respectively. Considering the heaps of analysis that are put into judging what the relationship between the earnings yield (or PE ratios) and stock market returns are and will be, this is interesting enough.
What really makes this remarkable, however, is that through all of the changes in the behavior of technology, politics, culture, religion, stock markets, money variables, interest rates, and the dollar-induced rise of Baumol's cost disease, the main of Gibson's Paradox and the yield equation remained intact throughout the last 280 years.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.