Sunday, October 21, 2007

Valuing Theories of Inflation, as the tide recedes

Pragmatism asks its usual question. "Grant an idea or belief to be true," it says, "what concrete difference will its being true make in anyone's actual life? How will the truth be realized? What experiences will be different from those which would obtain if the belief were false? What, in short, is the truth's cash-value in experiential terms? William James

Only when the tide goes out do you discover who's been swimming naked
Warren Buffett

It's been so long since lasting, cumulative inflation has been a valid concern in the west that pressure to have a useful theory thereof is almost non-existent. In Pragmatic terms, until recently, theories which asserted its death, i.e. new economic paradigm views, were more profitable than those which suggested that it might come again. Like a family that would ride away from Pompeii at the first hint of a rumble, only to be ridiculed by those who stayed on their return; those fearful of inflation have often prepared for the worst, for naught.

In the arena of speculative finance, however, the cost of a false view isn't ridicule but loss of money. Yet how does one discern a true view from a false view, but in the event? An imaginary bond trader who, since 1983 asserted that inflation was a thing of the past and would never happen again has been rewarded for that faith while one who, over the same period, but, having lived through previous periods of inflation, and having read of many others, repeatedly cut and ran at the first hint thereof has been severely punished for his view.

Thus, as my friend, Stephen Plant, is (correctly, in my view) wont to argue, do the movements of capital engender their own belief structures.

It's been so long since
lasting, cumulative inflation has been a valid concern in the US that many people still expect gas (and other) prices to "come back down" in much the same manner that people in the early 70s were sure that prices would fall back to "normal" levels, without understanding that "normalization" requires an anchor that had been cut. Once the price of oil left the $3.00 level, it never returned- an observation we might soon be making about the $50 level.

It's been so long since lasting, cumulative inflation has been a valid concern in the US that I suspect some even of the money managers have forgotten the part that wages play. On the one hand many will cite the ability to out source, i.e. find cheaper labor, as a key feature in the relatively-inflation-free 90s, but few, apparently, seem concerned about rising wage pressures in, say, China.

Of course, to be concerned about the potentially inflationary effect of rising wages in China one would have to believe a theory thereof that included such as cause.

The reason I'm flogging this (inflationary theory) horse to death is because prices of key commodities, notably, but not solely, oil, seem to me to be, unlike much of the 1983-2004 period, moving into permanently higher ground. Ironically enough, to the extent faith in a new economic paradigm where lasting cumulative inflation does not occur is still prevalent, this will, to the extent my forecast proves accurate, seem to some, like a new economic paradigm, although it won't be. That is, it seems to me the tide is going out- a cash value is about to be assigned to certain theories of inflation- the event is now.

So what causes inflation? Quantity theorists will tell you that more money means more inflation, and I believe in the link, although there seem to me to be other necessary factors- one key factor being a closed system.

The integration of the old Soviet sphere of influence into western commercial and financial circles as well as the opening of China played a key role in undercutting faith in the variants of quantity theory, as they are all, to an extent based on the notion of money as entirely endogenous. The end of the cold war and opening of China threw a lot of exogenous shocks, albeit largely of the positive kind, at the West, and especially at the US.

Now, of course, we're globalized, by which I mean, it's all endogenous now, which is why I suspect quantity theorists may well be coming back into vogue as the tide recedes. Money may soon matter again.

Another thing I suspect we might learn is that the US is no longer able to wag the world economy or so I read the tea leaves of recent price changes. In decades past, when the US household sector's balance sheet was impaired world growth slowed, but this time may well be different- the US consumer may no longer be the fulcrum on which the global economy pivots. According to the IMF, China made the largest contribution to world growth of all nations in 2007, and is expected to do the same in 2008.

So how does lasting cumulative inflation become entrenched in an economy? The Austrians will tell you that money moves through different parts of the economy in turn and that a general wage gain will, in a sense, complete the cycle, and set the stage for another round. Thus, one could, and I suspect this has been one aspect of Fed policy, try to keep wages low so as to forestall cumulative inflation.

If the IMF's expectations of Chinese growth prove accurate, the old game of keeping US wage gains low enough to forestall entrenched inflation, which had worked pretty well, may no longer prove effective, because Chinese growth may overwhelm US weakness. Indeed, that tactic seems to me to be risking a disastrous stagflation if goods prices, which have already been rising faster than wages in the US, really jump.

Who knows, maybe it's about time to end the great inflation charade and let wages (and government transfer payments) rise.
For too long, I think, policy has been based on a view that you can get a little bit pregnant...err, have a little bit of inflation and abort each cycle. If (and I'm not advocating the policy just arguing that the policy has consequences) we're going to inflate our way out of the financial mess, wages are going to have to rise, and reasonably quickly. Time, alone, won't heal these wounds.