Diatribes of Jay

This is a blog of essays on public policy. It shuns ideology and applies facts, logic and math to economic, social and political problems. It has a subject-matter index, a list of recent posts, and permalinks at the ends of posts. Comments are moderated and may take time to appear. Note: Profile updated 4/7/12

18 February 2015

Money, money everywhere but not enough to spend


[For a 3/16/15 update on the so-called “wage-price spiral,” click here.]

Introduction: the enigma of deflation
Is money really demand?
Corporate hoarding
Individual hoarding
Geezer hoarding
The effects of price elasticity
Differential in/deflation

Introduction: the enigma of deflation

Why is virtually the entire developed world in or near a deflationary spiral? Why is much of the developing world not far behind?

Among major powers, Russia is a special case. It’s suffering inflation because it has not diversified its economy, provides poorly for consumers, courts economic ostracism with disastrous foreign military adventures (in Syria and Ukraine), and relies far too much on oil and gas for exports and to finance government operations. Some minor powers are also suffering mismanagement-induced inflation; they include Argentina and Venezuela. But outside these few outliers, deflation, not inflation, is the economic risk du jour.

Things were different early in the last century. The Weimar Hyperinflation in Germany and Austria helped spark the greatest economic depression in modern history. The Hyperinflation and the Great Depression that followed led to the rise of Hitler and history’s most terrible war.

Now, a bit less than a century later, the rampant inflation that once caused such human misery has turned into deflation, except in mismanaged nations.

What has caused this dramatic and relatively abrupt change? Isn’t that the most important economic question of our age? Does anyone have any satisfying answers yet? If so, I haven’t heard or read any.

It’s not as if there’s a global deficit of money and monetary equivalents. Beginning with its “quantitative easing” (QE) some years ago, our Yankee Fed has injected some $3 trillion of artificial money into our Yankee economy. Japan’s central bank has followed, and the Eurozone’s central bank is just now beginning the process.

Then there are financial derivatives. These complex financial instruments are just another form of “liquidity.” Despite all the efforts of global regulators and our feckless, bought-and-paid-for Congress, we still have outstanding derivatives in an aggregate face amount of well over half a trillion dollars. (Estimates vary, for despite all the efforts to impose transparency, a lot of this financial gambling is still private and secret.)

But quantitative easing and derivatives are pittances compared to national debt. Nearly every major economic power—and lots of minor ones—has incurred substantial government debt since the Crash of 2008. The borrowing has reached rarely precedented levels here at home, in Japan, and in large parts of Europe. Our Yankee national debt alone now amounts to some $18 trillion.

So the total new “liquidity” in the aftermath of the Crash of 2008 is probably north of twenty trillion dollars. A recent private bank report puts the total at $22.5 trillion. Either way, that’s real money!

The classical, if simplistic, explanation for inflation is too much money chasing too few goods and services. If that explanation were right, then the twenty-trillion-plus of new liquidity should be driving prices through the roof, both here at home and globally. But over the six years in which this new liquidity has been added, the needle of inflation hasn’t budged much.

In fact, it has retreated. Japan and Germany—the world’s third and fourth largest national economies—are facing a serious threat of deflation, as are the UK and much of the rest of Europe. In December, the entire Eurozone had 0.8% annualized inflation, excluding the effect of lower energy prices. That was well below the central bank’s target of 2%. As for us Yanks, the yearly average of our own Yankee inflation rate, averaged over the last six years, was less than 1.6%.

Is money really demand?

So what gives? When in doubt economically, go back to basics. The most basic law of economics—after “there’s no such thing as a free lunch”—is the law of supply and demand.

The blowhards on Fox—as well as myriads of inflation hawks—equate supply of money with demand for goods or services. If there’s more money or “liquidity” out there, they think, consumers and businesses will bid up the prices of goods and services, and all will get more expensive. For these consummately non-expert thinkers, money or liquidity equals demand. (I confess that I, too, have fallen into that simplistic way of thinking at times; simplicity is so attractive, even when it’s wrong.)

But is that so? What if that equation is just plain wrong? What if having money doesn’t necessarily mean bidding up the price of things? What if a lot of businesses that got free money at the Fed window used it to pay down debt, quarantine toxic assets, or simply hoard? What if a lot of affluent individuals are just sitting on their money, fondling their bank notes or bars of gold like Silas Marner?

Something like that is indeed what appears to have happened.

Corporate hoarding

The Great Bailouts of banks, car makers and others “too big to fail” weren’t exactly venture-capital investments! They were not designed to finance new risky ventures, buy new equipment, hire new employees, or build new plants.

Quite the contrary. Their primary purpose was to: (1) retire corporate debt threatening solvency or (2) unwind complex financial transactions which had a lot to do with gambling and swindling by big banks and little to do with real life, aka productive activity.

Most of the rest of the free money went to banks and other corporations whose management, having learned hard lessons from the Crash of 2008 and its aftermath, wanted to build big rainy-day funds cheaply. In other words, the Great Bailouts went mostly into storage, whether in toxic-asset quarantines, debt retirement, or safe investment jars.

If there was any real buying of goods or services, it was minimal on the goods side. The Obama 2009 stimulus package, as many have noted, was laughably too small. Not much of it went for buying goods, except for asphalt, cement and some road equipment. And anyway it happened six years ago.

The services side employed hordes of bankers, accountants, lawyers and other consultants to figure out what had happened, unwind the bad transactions, and later do or encourage some more, perhaps a bit less flagrantly bad. Hiring of ordinary people was minuscule; that had to await slow recovery of the real (non-financial) private sector, which just started to happen last year.

Individual hoarding

On the individual side, the free or cheap money was used for similar purposes, with somewhat reversed priorities. There was less debt retirement because individuals—unlike corporations and their management—had to learn the lessons of capitalism the hard way. Many had to lose their underwater homes and (in states with no anti-deficiency laws) suffer bankruptcy or years of painful debt repayment for nothing.

The much-belated and overvalued virtue of “austerity” was forced on individuals as banks and other corporations enjoyed unprecedented corporate welfare. So individual debtors had to work for years to repay debt and/or emerge from bankruptcy, just as Detroit will be doing for decades. These folks—and Detroit—weren’t spending much and probably won’t be for a while.

But there was also a lot of rainy-day provisioning. Prudent folk who could do so cut debt, cut spending, and built up rainy-day funds. Even California did, under Governor Jerry Brown’s belt-tightening “Zen.” As a result, comparatively little money went into any markets for real (i.e., non-financial) goods or services.

Geezer hoarding

These phenomena were particularly acute among seniors. In order to understand why, it helps to be a geezer in or near the Baby Boom and in comfortable retirement. If you are there, as I am, you can see three big reasons why you might not be at all eager to bid prices up by buying a lot of stuff.

First, your parents endured the Great Depression. They taught you to be frugal, to know value, and not to live beyond your means. If they also endured periods of economic hardship (even if only relative), they taught you to preserve capital and save for a rainy day. The Crash of 2008 reinforced these lessons big time.

So even if you now have money, the security that having it on hand gives you is far more important to you than anything the money can buy. By and large, you keep your money in the bank, or in cash-equivalent investments such as stock, bonds, mutual funds, and ETFs. (If you favor Rand Paul or follow Fox, you might even keep it in gold bars or under your mattress, along with your assualt weapon.)

So one big reason why inflation is low is that most or all the new liquidity that ended up in individuals’ hands went into investments, not out into markets for goods or services. To correlate this investment flow with the effect of corporate bailouts, just remember that individual consumers account for 70% of economic activity, at least in the US.

A second reason for low inflation is demographics. Unless you inherited money or are an Internet-boom CEO or celebrity able to “monetize” your fame, you’ve had to achieve financial comfort the old-fashioned way: by earning it. Usually earning it meant decades of effort.

So for most of us, increasing means come with increasing age. The old have more wealth than the young. And having been weaned on the lessons of the Great Depression, the old are not spendthrifts.

These trends will only become more pronounced as populations continue to age, due in part to increases in medical technology, better public health and healthier life styles. As national populations age, aging retirees will continue to create large and stable sinks of ready cash—a geriatric money pit.

Third, geezers don’t spend much because appetites and energy decline with age. As you get older, you just don’t eat, need or use as much as before. You don’t travel as much. Long trips are painful and boring, whether by car or plane, even if you drive a Tesla or fly first class.

There are only so many movies, concerts, operas and plays you can attend. Today, photographic-quality free broadcast TV with surround-sound makes watching at home or going out a tossup. Interest or capacity, if not sheer time, imposes limits. Not that many people spend their declining years collecting things: conspicuous consumption is for the striving 1% banker in his prime, not the average geezer.

These three factors—a lust for security rather than luxury, aging populations, and consequently declining appetites—decouple age-related wealth from spending. Retirement savings, by and large, don’t chase goods and services and raise their prices. Geezers sop up the pool of age-coupled wealth and keep it in jars, leaving little liquidity to flood markets for real things.

Investments are another story entirely. They are the jars.

The global explosion of retirees and their wealth has created an unprecedented, global boom in financial investments and markets of all sorts. Many of these investments feed on others of their ilk: mutual funds of stocks, funds of funds, index funds, and long- and short-term options on all of the above. This boom in investment alternatives is likely to continue, perhaps with occasional busts, at least until the Baby Boomer pig has moved through the demographic snake.

The effects of price elasticity

Yet another factor decouples theoretically available liquidity from inflation. Roughly speaking, it’s the distinction between necessities and luxuries. If there’s a flood of money sloshing around and food gets scarce, the price of food will go up. Why? Because everyone needs food, even retired geezers living on their income. So all bid up the price.

But what if only arugula gets scarce? How far can its price rise?

How many people eat it to begin with? Of those, how many will pay more for arugula than for, say, spring mix or iceberg lettuce? How many will pay a lot more? Probably not many.

If you want to correlate gross, undifferentiated increases in the money supply with increases in the prices of goods or services, you have to consider the price elasticity of demand (and supply) of each good or service. Inelastic prices will rise—the higher the more they reflect true necessities and have fewer substitutes. Elastic prices will rise less or not at all.

That’s why housing prices are still going up, although not yet (in many places) above their pre-Crash bubble levels. Everyone needs a place to live. Even geezers want to help their kids and grandkids find housing, or at least get the Millennials out of their children’s homes and on the road to independence. And there’s no substitute for living in the best neighborhood or (for families) the neighborhood with the best schools.

So housing prices are relatively inelastic. They continue to advance, especially in more desirable areas. That’s why there have been successive and recent housing bubbles in places as diverse as the US, Ireland, Spain, China, Hong Kong, Tokyo, London and Sydney.

But food? Not so much, at least in developed nations. There, epidemics of obesity attest to surfeit. You can eat only so many hot dogs, whether in an hour-long contest of gluttony or in a week, month or year. Just walk into any supermarket, anywhere in the OECD, and you will see that there’s not much you can buy to eat these days that doesn’t have reasonable substitutes. Had anyone ever seen a fat Chinese or Japanese much before this new century?

Food is a necessity generally. But in OECD nations there are very few specific items in that category that are necessities, let alone ones that don’t have good substitutes. Therefore the prices of most food items, as distinguished from food in general, are elastic. Their prices go down as demand goes down, and demand does go down as populations stop growing and age.

What of the poor and malnourished, you ask? Well, they may have inelastic demand in theory, but they don’t have much money. Just give them a raise—as with a higher minimum wage—and you might start to see some inflation in basic foodstuffs. But if the poor are barely scraping by, and if the rest of the developed world has too much food and too many choices, inflation in food prices is unlikely, barring crop failure or other agricultural disaster.

Differential in/deflation

The more you think about it in this nuanced way, the more it becomes clear that general inflation is likely a thing of the past, at least in any developed nation in which population growth continues to decelerate, demographic aging continues, and people continue to acquire more wealth as they age and put it in jars. Inflation will spike only in limited, specific markets for goods and services that are necessities (or are perceived as such) for a particular demographic that is increasing in numbers and/or wealth.

Thus, for example, our aging population, coupled with the concentration of wealth with age, helps drive inflation in health-care products and services. Continuing population increases will also drive inflation in residential real property and, indirectly, commercial property, especially consumer-oriented commercial property. At least this will be so in the more desirable property markets in wealthier and more politically stable places. Yet food will continue to enjoy modest or small increases in price in developed nations, as long as they keep their populations under control and there are no systemic disasters in agriculture (such as a newly mutated blights or diseases affecting crops or food animals).

Energy will have a particularly interesting future. At the moment, large fractions of our species still have achieved nowhere near the level of energy use of OECD citizens. As the vast masses of global citizenry slowly rise toward that level, global demand for energy may jump by as much as five times. What then will happen to prices?

The answer depends on the source of energy. Oil has a global market and (at the moment) few substitutes, although electricity and natural gas are rising in use for transportation. So oil’s price, and the prices of its derivatives (gasoline, diesel, jet fuel, and heating oil) could skyrocket.

Ditto for coal if every nation continues to use it. But OECD countries are now on a course of phasing coal out for less polluting and less expensive alternatives that have less disastrous effects in accelerating global warming. If these trends continue, coal could perhaps get cheaper for the few poor nations that continue to use it, incidentally encouraging them to continue accelerating global warming.

For natural gas (at least for now) and for renewables like solar, wind, and hydroelectric energy, the outlook is quite different. These sources of energy have no global market yet. Renewables, in particular, are resourced and used only locally or regionally.

Each of these sources has the potential for a global market. Natural-gas is closest, with a few liquified natural gas (LNG) tankers and terminals available now and more on the drawing boards. If hydrogen from electrolyzing water can be made cheaply enough—and transported in liquified or compressed form cheaply enough—renewable energy, too, might evolve into global markets, in the form of trans-shipped hydrogen.

But until these or other similar hard-to-predict events occur, natural gas and renewable energy will continue to enjoy the opposite price-inflationary effects of oil and coal. As long as any OECD country (or indeed and developing country) keeps its markets for these energy sources local and its population growth under control, and as long as it works at energy conservation and greater efficiency of energy use, local prices for these local forms of energy, decoupled from global markets, should fall as demand stabilizes or even decreases, and as supply expands. The great global mass of poor consumers moving through the development snake should affect the local markets for these local energy sources little, or not at all.

So except for a few things like real property (in desirable markets), oil, and health care, deflation is the new big risk. It looks as if it will remain so for the foreseeable future, as global population growth decreases, populations age, and our species begins to come to grips with Malthusian realities. Deflation might actually get worse as global economic activity falls with decelerating population growth, aging populations, and more modest and conservative devloped-nation lifestyles with more electronic “travel” and less profligate use of fossil fuels.

In this environment, a single figure for general inflation (or deflation) will be of limited use as an economic gauge. All it can tell us is whether central bankers worldwide are doing something very wrong. It’s at best a “panic stop” or “blast ahead” indicator. It will be of little use to professional economists like Janet Yellen.

To track inflation or deflation meaningfully, let alone to predict anything useful, we are going to have to follow it on an industry-by-industry or sector-by-sector basis. Just as in medicine we no longer judge a patient’s health by body temperature alone, the days of judging the health of an entire economy by glancing at a single figure for general inflation are over.

So, my fellow geezers, should we all put more money in our little jars?

Update 3/16/15: is the “wage-price spiral” dead?

The notion that government can cause inflation merely by printing money, discussed above, is not the only simplistic theory on the origin of inflation. Nor is the underlying fallacy that money equals demand the only flaw in logic. Another simplistic theory of inflation is the so-called “wage-price spiral.”

People who lived through the Nixon-era inflation of the early 1970s are familiar with the theory. It goes like this:
“When unemployment gets too low—a desirable social condition!—employers bid up wages in an effort to attract new employees and retain old ones. Since most private employers are not eleemosynary institutions, they raise the prices of their products and services to compensate for the higher wages they must pay. If all employers act the same way, increasing wages just barely keep pace with increasing prices, and inflation accelerates, leaving retirees and other fixed-income folk in the lurch.”
It takes only a moment’s thought to see some holes in this logic. First, it paints with far too broad a brush. There are thousands of jobs in our diverse nation, in dozens of sectors. Surely employment and wages in all of them don’t follow exactly the same trends.

For example, right now unemployment is increasing in two important sectors of our economy: the oil patch (due to low oil prices) and finance (due to the continuing aftermath of the Crash and an acceleration in automation). As it turns out, these sectors enjoy particularly high salaries. So if employment in them is decreasing, while employment in relatively lower-paid professions such as nursing and retail sales is increasing, isn’t the result at most a wash, insofar as the average consumer’s market-basket expenses are concerned? As in the case of the money-equals-demand fallacy, don’t economists have to look at things more granularly, at least sector by sector?

Second, demographics may skew the supply of labor, especially at the high-earner end of the wage spectrum. By and large, older people earn more money. But the Baby Boomers have just begun to retire. As the head of the Baby Boomer pig (pun intended) moves into the retirement snake’s maw, there is still a big body of population bulge—excess labor supply, if you will—waiting to leave the field, whose transition out of the labor market at the high end may drive average wages down. Only when the demographically smaller next generation (Generation X) reaches its peak earning years might a real upper-income labor-supply crunch come. We’re decades away from that place now.

Finally, under current conditions there may be a mis-application of the theory, even if it’s basically sound. Economists start to worry about inflation, we are told, when the official unemployment rate gets down near 5%. But we all know that the “official” unemployment rate does’t reflect real unemployment. It doesn’t, for example, include people who’ve dropped out of the labor force (whether or not temporarily) or people who have part-time work and want full-time work. Informal, “unofficial” estimates put total unemployment, including these workers, in the teens in percent—far from any inflation threat under conventional wisdom.

In fact, economists are puzzled now because inflation in most states does’t seem to be following the conventional wisdom. Wages and salaries aren’t rising in most states although unemployment is down near 5%.

Some economists worry that inflation is a lagging indicator, so it may be hiding, ready to leap. There may be some truth in that. Janet Yellen must be ever on alert.

But don’t scientists, who include (or should include) economists, fit their theory to the facts, rather than vice versa? Isn’t it possible that a theory from the 1970s, for a society with entirely different economic sectors, job categories and demographics, is inappropriate for today’s information economy with the Baby Boomers at their peak earning years? Could anomalously high inflation and low unemployment in North Dakota and Texas simply reflect the importance of the shale-oil economy there, the high salaries available to young roustabouts, and the fact that low oil prices haven’t quite yet either (1) cratered jobs or (2) been reflected in official statistics? After all, don’t government statistics, too, lag reality?

Doesn’t Apple’s status as the world’s most valuable company, not to mention its coming induction into the Dow 30, tell us that something significant might have changed?

If these musings are right, then maybe conventional economic wisdom from forty years ago is, to use Obamanian understatement, “inaccurate.” Maybe we are seeing a new secular trend, or “new normal,” based on massive changes in our workforce structure, the passing of the huge Baby-Boomer demographic bulge through its peak earning years, and retiring and retired Boomers’ tendency to hoard cash in passive investments rather than spend it.

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