This Week in... Inflation
Innovation & Tech Review Week 18/2022
The world is turning. And also, the venture world is moving forward.
The pandemic has exposed the weakness of global supply chains:
When sudden events like viral threats, natural disasters or war disrupt supply chains, the shortage of goods leads to rising inflation rates.
The mechanism is simple:
Over time demand and supply tend to move towards equilibrium in which no firm makes profits. All demand is fulfilled and all supply is purchased at the equilibrium price.
When supply goes down, prices rise and vice versa. When demand goes up, prices rise as well. But short-term markets can be disrupted.
Both scenarios lead to inflation since prices are rising.
But what causes such disruptions?
What causes inflation?
Why is that a problem?
And what is the way out?
What to know about the 6 main causes of inflation
In recent years the average annual inflation was stable at around 2% per year in the US and Europe.
It wasn’t always the same, and in the history of the monetary system, there were times when inflation was significantly higher.
In this article, the author describes the causes of inflation:
What to know about the 6 main causes of inflation
Causes of Inflation
Here is another angle on the answer to the same problem:
What causes inflation?
Causes of Inflation - Economics Help
What did Milton Friedman do?
According to Wikipedia, Milton Friedman was an American economist and statistician who received the 1976 Nobel Memorial Prize in Economic Sciences for his research on consumption analysis, monetary history and theory, and stabilization policy complexity.
One of his most famous quotes was:
“Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.
Friedman (1970) The Counter-Revolution in Monetary Theory.
In principle, what he was saying is that the changes in money supply create inflation or, on the contrary, deflation. There is no other influence on inflation than a change in the supply of money.
In 2022 Jerome Powell seems to follow Milton Friedman’s advice since he started taking money out of the system and helping to raise interest rates.
Why?
The following article describes the thinking behind the monetary idea:
Monetarist Theory of Inflation - Economics Help
Let’s deconstruct Milton Friedman’s Approach
Milton Friedman’s approach leaves room for criticism. When I look at the years from 2008 to 2020, the FED and ECB have already flooded the markets with new money.
The inflation? It was close to 0–2% per year.
Why did the inflation rate not go up?
The answer lies in Milton Friedman’s monetary policy formula with a detailed explanation in this article:
Fisher's Quantity Theory of Money: Equation, Example, Assumptions and Criticisms
The fisher quantity theory of Money assumes that the velocity of money and the number of goods available for transactions are fixed in an economy.
The only variables are the money supply and the prices.
All then boils down to a change in money supply as the sole impact factor on inflation — aka rising prices.
But what if the number of goods is not fixed but can increase and decrease quickly?
Looking at the last three decades, many new goods have been created:
Smartphones and Tablets in the Hardware sector
Bitcoin and other cryptocurrencies
Access to equity markets was democratized
NFTs as collectibles
The Metaverse
In principle, these digital areas can create an infinite supply of goods, as long as someone demands them. A perfect pool for excess money in the system.
Maybe such changes in productivity due to an open global economy and technological advancements (digitalization) led to the situation that inflation wasn’t affected as much by the monetary policy of the last decade.
A similar phenomenon occurred during the pandemic. FED, ECB, and governments flooded the market with measures that according to Milton Friedman should have caused immediate hyperinflation.
Inflation is measured in CPIs that contain baskets of goods for daily life like energy, food, and travel but don’t mirror the entire economy.
When I look back to the years 2010–2020 the economy was open, global, and digitally connected. The supply chains for energy, food, travel, and other goods in the CPI were stable.
Where did the excess money supply go in all these years, since Milton’s theory of rising prices with rising money supply didn’t really occur?
In my opinion, into assets and novel digital goods like Bitcoin.
Rising Inflation in 2022 — What Now?
However, in 2022 inflation is rising, and the FED is taking action:
Quantitive Tightening — taking money out of the system
Rising interest rates
But will this lead to the desired effect that inflation goes down?
And will this be at the cost of a recession or, even worse, a depression?
This article summarizes the main points of criticism of Friedman’s Theory of Money.
The world is more complex, and inflation is not only caused by an increase in money supply:
Fisher's Quantity Theory of Money: Equation, Example, Assumptions and Criticisms
The number of goods or velocity of money can also vary short term.
When I look at today’s world, in my opinion, the current inflation is mostly driven by the disruption in the supply chains during the two years of lockdowns, on the one hand.
On the other hand, the global power shift after Russia attacked Ukraine led to another disruption, especially in the food and energy sector.
It seems that Europe and the US governments and companies tend to end trade relationships with Russia. In that case, commodity supply chains must be reorganized on a historic global scale.
The third point is the new waves of lockdowns in China, which inflates the logistic prices, which ultimately will increase the prices of all goods in the CPIs.
Distorted markets with disrupted price levels are the result. It might take some time to come back to normal now.
Are the measures Milton Friedman recommends, and Jerome Powell executes producing the desired effect?
Today's world with digital goods, globalization, pandemics, historic high debt, and the Russia/Ukraine conflict is much different than the days when Milton Friedman developed his monetary theory.
I am not confident that monetary policy changes recommended in Milton Friedman’s model will lead to the desired outcome — decreased inflation — without any severe negative consequences like a recession or depression.
Let’s remember that the great depression in the 20s of the last century was the soil on which the idea of World War 2 started taking roots.
Today’s inflation rates are driven more by disrupted supply chains due to lockdowns and wars rather than an overheating of the economy or aftereffects of monetary policies.
To me it looks like three sectors suffer the most from price increases:
Energy
Food and
Logistics
Since the last 12 years didn’t produce much inflation rate despite the expansive monetary policy, it might well be that also the monetary policy countermeasure is ineffective.
The energy price will most likely not change much with the change of M1 and M2 — the money supply— since it is a direct result of ending trade relations with Russia. New sources of energy, new suppliers, or reverting the sanctions for Russia might do the trick better than changes in M1/M2.
The same applies to logistic costs due to lockdowns in Europe from 2020–to 2022 and now in China. A change in monetary policies will most likely have no direct effect on the availability of logistic space on ships, as well as the dispatching of goods from Chinese ports.
The food sector is disrupted because Russia invaded Ukraine. Both Russia and Ukraine are major producers of agricultural products and fertilizer.
All 3 sectors are more or less price inelastic, which means the demand doesn’t vary much with the price.
I believe that Interest Rate Increases and Quantitative tightening do not help fight inflation in this situation. The desired result of those measures is the dynamic that starts with raising interest rates that households reduce their demands and increase savings.
Since Milton Friedman’s approach assumes that the Velocity of Money and Supply of Goods are fixed, the only solution is a variation in Money Supply. And yet, these days, the supply of goods seems to be the biggest problem.
A fixed price inelastic demand meets a restricted supply.
As a result, prices rise.
I much rather would see governments intervening short term directly in prices and, if need be, subsidizing companies to avoid bankruptcy.
Midterm, the governments need to restore the supply chains and incentivize the creation of productive assets — whatever it takes.
Finally, we shouldn’t forget the elephant in the room is the historic high debt rate of governments, companies, and households. Rising interest rates could easily become a death sentence for households, companies and overindebted countries.
The consequence for monetary policy: No change at all.
Upcoming Events:
May 12, 03:30 pm CET - Richard Doherty, Podcast Host - Why is Content Marketing With Podcasts and Youtube Key to Success in this Decade? Also for B2B Companies? - postponed on speaker request
May 13, 03:00 pm CET - Kimberly Cornfield, UCL - How to apply for Horizon Europe Programs
May 18, 4:00 pm CET - How Did the Pandemic Change the Conference Industry – Insights from Rich Masters, CMO Bio US
June 10, 03:00 pm CET - Jonathan Sporn, Gilgamesh Pharmaceutical - How Psychedelic Drugs Help Ease the Mental Health Burden in Society
June 10, 07:00 pm CET - Ivan Anz - Philantroinvestor - tbd
2 Podcasts from this week:
E78: VC fund metrics that matter, private market update, recession, student loans, Bill Hwang arrest
#73: Bharat Kanodia - How to Value Unique Assets
1 Youtube Takeaway from this week
Books I am reading this week
From legendary investor Ray Dalio, author of the international bestseller Principles, who has spent half a century studying global economies and markets, Principles for Dealing with the Changing World Order examines history's most turbulent economic and political periods to reveal why the times ahead will likely be radically different from those we've experienced in our lifetimes - but similar to those that have happened many times before.
A few years ago, Ray Dalio noticed a confluence of political and economic conditions he hadn't encountered before. They included huge debts and zero or near-zero interest rates that led to massive printing of money in the world's three major reserve currencies; big political and social conflicts within countries, especially the US, due to the largest wealth, political and values disparities in more than 100 years; and the rising of a world power (China) to challenge the existing world power (US) and the existing world order. The last time that this confluence occurred was between 1930 and 1945. This realisation sent Dalio on a search for the repeating patterns and cause/effect relationships underlying all major changes in wealth and power over the last 500 years.
In this remarkable and timely addition to his Principles series, Dalio brings readers along for his study of the major empires - including the Dutch, the British and the American - putting into perspective the 'Big Cycle' that has driven the successes and failures of all the world's major countries throughout history.
Dalio reveals the timeless and universal forces behind these shifts and uses them to look into the future, offering practical principles for positioning oneself for what's ahead.
— Principles for Dealing with the Changing World Order: Why Nations Succeed or Fail by Ray Dalio
Best Quote From This Week
"Inflation swindles the bond investor ... it swindles the person who keeps their cash under their mattress, it swindles almost everybody," Buffett said at the Berkshire Hathaway Annual Shareholder Meeting 2022
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