Not All Inflation Is Created Equal

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Includes: DIA, GLD, QQQ, SPY, TBT, UDN, UUP
by: Desiderius Erasmus

“A rising tide lifts all boats” (John F. Kennedy)

The rising tide President Kennedy referred to in the above quote was not the rising tide of the money supply, but rather the rising tide of the economy – i.e., economic growth benefits everyone, rich and poor alike.

As any student of economics can tell you, this is not necessarily true– an economy, as measured by GDP, can rise (i.e., grow), merely because the population grows. Without rising productivity, per capita GDP will remain the same or even fall despite the rise in GDP, leaving the average person’s standard of living either unchanged or lower than before.

But what about when the money supply rises? Or the price level rises? Does a rise in those . . . tides lift all of our. . . er, boats? The answer is . . . it depends.

In my last post, we explored the fact that the economy, due to the obscene run-up in asset prices over the past decade-plus, is bound to experience either unusually high inflation or unusually high deflation, but that experiencing one of the two is inescapable.

I happen to believe that inflation is the better of the two options for the overall economy, but many readers provided thoughtful and compelling arguments against the inflationary path. There were a handful of posts, however, that argued against inflation because, it’s claimed, inflation always leads to a lower standard of living through debasement of the currency.

While it’s true that sometimes that is the outcome of inflation, it is far from always true. Whether it does or not depends greatly on why the inflation arose in the first place – whether it was mostly the result of an increase in the money supply (roughly analogous to demand-pull inflation), or whether it was mostly the result of a decrease in the supply of inputs relative to other goods, and hence an increase in the inputs' costs (roughly analogous to cost-push inflation).

To see a case of the former, let’s tweak our earlier example of the pirates stranded on the deserted island.

This time, imagine that there are three pirates stranded on a deserted island. Before they joined the captain’s crew, one pirate used to be a fisherman, one used to be a woodsman, and one used to be a lumberjack. Each of them has a single gold coin that he had on his person when he was washed overboard. They decide that each of them should do what he did before his life of piracy: the fisherman will catch fish in the lagoon, the woodsman will gather edible tubers from the soil, and the lumberjack will gather wood from the forest.

The fisherman soon learns that the lagoon is teaming with fish, and it only takes him half a day to catch nine fish – the most the three pirates can eat. The woodsman soon learns that the soil is overflowing with tubers, and it only takes him half a day to gather nine tubers – the most the pirates can eat. And the lumberjack soon learns that the forests floor is littered with dry wood, and it only takes him half a day to gather 18 bundles of wood – the amount it takes to cook the nine fish and the nine tubers (one bundle per fish/tuber).

With their roles assigned, the pirates form a primitive economy. At the beginning of each day, they each have a single gold coin in their possession. They all go to their respective places of work, and then each afternoon they gather on the beach. There, the fisherman and the woodsman each give their gold coins to the lumberjack for his 18 bundles of wood – nine to the fisherman, and nine to the woodsman. The fisherman then uses the wood he just bought from the lumberjack to cook his fish. The woodsman also uses the wood he just bought from the lumberjack to cook his tubers. When the fish are cooked, the fisherman sells three of his fish to the lumberjack for one gold coin. When the tubers are cooked, the woodsman sells three of his tubers to the lumberjack for one gold coin.

As the last economic transactions of the day, the fisherman gives his gold coin to the woodsman and receives three cooked tubers, and the woodsman gives his gold coin to the fisherman and receives three cooked fish. Now, all three pirates each have exactly the same thing: one gold coin, three cooked fish, and three cooked tubers. Finally, they sit down to their bountiful supper and relax.

Now, imagine the pirates discover a treasure chest buried on the island that has 267 gold coins in it. They decide to split the treasure three ways. So now, each of the pirates has 90 gold coins. That day, when the lumberjack returns to the beach to sell his wood to the fisherman and the woodsman, he demands that they each give him all 90 of their coins.

The fisherman and woodsman aren’t happy about the lumberjack’s demand, but since they need his wood to cook their fish and tubers, they reluctantly hand over all of their gold coins to the lumberjack. When they finish cooking their fish and tubers, however, they have their revenge: if the lumberjack wants to eat, it will cost him 90 gold coins for three tubers and 90 gold coins for three fish. Being very hungry after spending all morning in the forest gathering wood, the lumberjack reluctantly pays 90 coins to the fisherman and 90 coins to the woodsman. With a new price having been set, the fisherman and the woodsman each pays the other 90 gold coins and they exchange three fish and three tubers.

Now, all three pirates each have exactly the same thing: 90 gold coins, three cooked fish, and three cooked tubers. Finally, they sit down to their bountiful supper and relax (though in awkward silence).

In the above story, there was quite definite inflation – 8,900% inflation, to be precise. Yet are any of the pirates worse off than before? Absolutely not – each pirate still works half a day and eats three cooked fish and three cooked tubers every afternoon, just as he had before the discovery of the treasure chest. So, in theory, inflation that occurs solely as a result of an increase in the money supply (in this case through the discovery of the treasure chest) should leave all participants in the economy equally well off compared to before.

There is a form of inflation, however, that does leave everyone worse off – a form we’ll look at by returning to the pirates’ island.

Imagine the pirates have been on the island for over a year. The lagoon is still teaming with fish. The soil is still overflowing with tubers. The forest floor, however, is no longer littered with dry wood. Whereas it used to take the lumberjack just half a day to gather 18 bundles of wood, it now takes him a full day just to gather 12 bundles. How will this effect the island’s economy?

When the lumberjack shows up at the beach, he tells the fisherman and the woodsman that he only has 12 bundles of wood to sell. Both the fisherman and the woodsman want enough wood to cook all the food they brought, so they bid up the price of the 12 bundles to what they used to pay for 18 bundles: 90 gold coins each. Since it takes one bundle of wood to cook one fish or one tuber, though, there’s only enough wood to cook six fish and six tubers.

At the end of the day, each of the pirates has only TWO cooked fish and TWO cooked tubers, not the three he used to enjoy before the wood became scarce. But since the fisherman and the woodsman had to pay 90 gold coins each for 2/3rds as much wood as 90 gold coins used to buy, they also demand 90 gold coins each for 2/3rds as much fish and tubers as 90 gold coins used to buy.

Again, inflation has occurred, though this time to a lesser degree – just 50%. Are the pirates worse off than before? Yes, absolutely – each pirate eats just 2/3rds as many fish and tubers as he did before the wood became scarce. So inflation that occurs as a result of an increase in the cost of an input (in this case, the wood used to cook the fish and tubers) should leave all participants in the economy worse off compared to before (anyone see the similarity between this case and oil prices?)

And yes, the three pirates in the second story would have to arrive at a new division of labor to reflect the fact that it takes so much longer to find enough wood. But no matter how they decide to solve that problem, through the lumberjack being paid more for his labors or through the other two giving up some leisure time (which they have more of, since they now only need to catch/gather six fish/tubers) to scrounge the forest floor for twigs and branches, collectively, all three of them will be worse off than before the wood became scarce.

Obviously this is a highly simplistic model that comes no where near to capturing all the nuances of our complex, modern economy. And it completely leaves out the effects of foreign exchange on inflation – an issue of significant importance to America, a net importer. But the central lesson still holds: Not all inflations are catastrophic! Depending on why the inflation occurs, it can either be the cause of a lowering in our standard of living, or just the cause of mild annoyance as we find that we must multiply in our head by 1+x% to arrive at future prices. The central point is we should examine why inflation is occurring before we panic about its effects on our standard of living, or what it will do to our portfolios.

This question was touched upon in the first post in this series, which covered why the economy must experience either unusually high inflation or unusually high deflation (and argued, admittedly sparsely since space was tight, that inflation would be the better of the two). This post covered what the very, very basic drivers behind inflation are, and why some forms of inflation are bad for our standard of living and others are not.

The next post will return to the inflation vs. deflation debate, and argue that we are more likely to see the former than the latter (irrespective of which is preferable to the economy as a whole).

Until then, proost!

Disclosure: Long GLD, GDX, TBT, EWA, DBE, PWE