The Mass Deceit That Is Inflation

 | Oct 28, 2013 | 9:00 AM EDT
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Economists, and certainly Federal Reserve decision-makers, are quite convinced that a little bit of inflation lubricates the economy, helping to generate faster growth than what would otherwise occur. (The New York Times surveyed the subject this weekend as part of a discussion catalyzed by a new book from former Fed chief Alan Greenspan.)

Most of the arguments in favor of inflation revolve around the idea that relative prices can adjust more efficiently -- and that inflation confuses people as to what those relative prices really are. The classic example is the problem that John Keynes identified during the Great Depression, that of "sticky prices." Prices and wages always move up easily -- people always want to make more money -- but they do not adjust downward quickly. Especially as it concerns wages, no one likes a pay cut or to make less money, so they hold out for higher prices longer than what is economically appropriate. This effect of "holding out" slows necessary economic adjustment. With some inflation thrown in, prices and wages can be cut invisibly if they simply stay flat or grow more slowly than the inflation rate.

While I agree that this behavioral effect is real, at least to a certain extent, I do question the wisdom of social policies designed around the idea of making it easier to cheat other people. The implicit thinking is that employees who don't get raises will not notice a decline in their standard of living -- or that, when creditors are paid back in less valuable dollars, they will not notice the loss of purchasing power. The practice of changing the value of the unit of account, whether that effect is inflationary or deflationary, rips to shreds the idea of a contract.

Why should debt be made "easier" to pay back? Debt is simply the other side of an asset -- so why should the asset be devalued without the consent of the creditor? Why should employees be tricked into thinking their wages are rising when the raise is actually lower than the inflation rate and they are falling behind? Why should they not be fully aware of this?

Inflation always cheats one party in any transaction and, sadly, that party is usually the less sophisticated of the two. At its worst, inflation is also a method of quietly shifting the costs of society -- for instance, government spending or bad debt -- to those least able to protect themselves from it. The educated readers of this site, for example, will comprehend the onset of inflation and adjust their asset mix (perhaps by adding more gold), or the rate of interest they demand, or even the currency in which they operate. The line worker at the Nissan plant in Tennessee may not have a similar knowledge or capability to protect himself -- until it is too late and purchasing is already gone.

For policymakers and observers like us, the pertinent question is whether this newfound belief in the power of inflation is really justified. The U.S. was on a gold standard in the 1800s, and that restricted any ability to use inflation to promote economic growth. Despite the screams of pain ("crucified on a cross of gold"), the country innovated, invented and expanded, accompanied by incredible advances in the standard of living for everyone.

Real U.S. Gross National Product Per Capita, 1869-1918
Sources: Robert Gordon and the U.S. Census Bureau

Who knows? Perhaps, when people feel the pain of not getting easy gains in nominal income, they are forced to work harder and smarter, with attractive results. I could make a strong case that economic thought today is completely backward, and that the "feel-good" strategy of making price adjustments easy and invisible may actually backfire. Because price signals are buried in the noise, they don't trigger the behavioral changes described above. "Feel-good" fits the zeitgeist of this generation, so maybe we are getting what we deserve.

The investment implications of this view are simple. If our policymakers think "feel-good" is the best path to prosperity, they will pursue it and inflation is here to stay. Furthermore, because people adjust to inflation rates, it will need to accelerate in order to be effective. Again, the readers of this site are among those privileged capital owners I mentioned earlier -- and, as such, you should be positioning your portfolio to protect yourself from inflation. Pick up equities in companies with a competitive "moat" and/or pricing power, as well as some hard assets like gold and real estate that sustain their relative values -- and avoid bonds!

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