The global outlook for asset prices and costs. Do we fear inflation or deflation?

In our recent article we alluded to a real threat posed by ‘structural adjustment’. There are a number of concerns that give rise to inflation fears. First of all, its worth discussing the origin of inflation, and whether its a concern.

Price variance

Prices of things go up and down in a market economy. There are however two senses in which this can occur. It can be a:

  1. Market phenomenon in the sense of a price fall because supply exceeds demand; a price rise because demand exceeds supply, or it can be a ‘cost push’  consideration because costs are a relatively higher ratio of existing price levels. There is also the prospect of falling prices too if a producer gets productivity gains, from say an greater production. This would permit lower product prices or higher profits, if the producer did not pass the benefit on to the consumer. In this last case, you can expect a real wealth effect. This is what capitalism does. It achieves productivity gains in the real economy.
  2. Inflation phenomenon occur when the cost of things does not rise, but rather the value of the currency is falling because it is being debased. We need to consider that there are two reasons why inflation can come about:
    • Destruction of capacity that diminishes the production capacity or real wealth of the economy, whilst the amount of credit and currency in the economy remains the same. i.e. There is a ‘relativist change’ in the proportion of money and/or credit to the size of the real economy.
    • Printing money entails the creation of more ‘notes’ for circulation in the economy. i.e. The Treasury decides to print notes and for those notes to be used to pay the wages of staff, so they come to diminish the value of other notes in the economy if they don’t result in more productive capacity. It is not a given that the education spending does not create new capacity, however the perspective is that the private sector would have done better because there are real consequences when private counterparties don’t perform. When the government doesn’t perform, under the prevailing system, political relativism demands that we get a ‘different’ bad government.
    • Real credit creation which is directly tied to economic activity. This is efficient lending if the prevailing interest rates reflect the ‘real value’ of money. If you think about it, the real return expected on credit should be constant; but in fact it tends to be inversely priced to risk. i.e. When there is evidence of weakness in the economy (i.e. excess capacity), you would expect diminished capacity development because the ‘fixed’ cost of capital would undermine new projects. When the government controls credit, the prevailing interest rate does not reflect risk, but the government’s imperative to preserve its control of government. The problem in every democracy is that entrenched political parties are dedicated to this system.
    • Transitory credit creation that potentially finds its way into the economy, i.e. Quantitative Easing. The difference between qualitative and quantitative easing is purely the quality of the debts (‘assets’) purchased by the sponsoring central bank.[1]

One of the travesties in market discourse, and even economic discussions, is that people generalize inflation and deflation, leading one to wonder whether they even understand prices and markets. The problem with inflation is that the government monitors and defines it. Now, the problem with price variance is, not that it goes ‘up’ or ‘down’, but that it does it unevenly. You could argue that there are ‘two economies’ – an economy for:

  1. Assets
  2. Costs of living

Consider that in the 1950s the British Empire collapsed leaving a lot of ‘third world’ economies in a parlous state of administration. Throughout the 1960s and 1970s these economies were run by brutish military dictators. It was only in the late 1980s that we saw democracy instilled with some notion of property rights, giving Western investors the confidence to invest and issue bonds to third world countries. Power Purchasing Agreements (PPPs) and Fuel Supply Agreements (FSAs), which heralded the financing of critical power infrastructure culminated in an end to the crippling power shortages (or ‘brown outs’) that plagued these countries. This layed the ground for the ’emerging markets’. These countries were basically looking to Japan and Taiwan and concluding ‘why can’t we be like them’? The result was the Asian Industrial Boom that unleashed an oversupply of cheap labour. That cheap labour today has proved to be very effective at keeping wages, product prices and ‘cost-of-living’ inflation down. By doing so, it has caused ‘wage restraint’ to undermine spending whilst leaving corporations and skilled workers with high earnings to invest. There is therefore an imbalance in wages and salaries which is causing:

  1. Rapid rises in the standards of living in emerging markets. Make no mistake. Asians, on their $300/month salaries are very happy because they can afford to set up a business, buy a car, or even an apartment. The result has been a rapid drop in the global absolute poverty level to just 10%. Global poverty will therefore no longer be a cause of suffering in a decade. That is quite an achievement. That will not however signal an end to war. Poor people don’t fight wars; they are displaced by them.
  2. Drop in real wages for unskilled Western workers as well as rising costs due to more impositions by Western governments, usually of a regulatory nature, but also expanded welfare programs that cause more hardship, or misappropriation. The result is higher costs for businesses and the poor to middle income earner. In the West, it is the salary earner who pays the greatest costs.

The result has been a surge in investing instead of spending. This pattern has only been exacerbated by the ‘culture’ in Asia, where families look to their children to support them in old age, rather than any pension system. The family buys only the basic goods like a cellphone, clothes, a motor bike/tricycle, car or an apartment. Asian savings rates is relatively high by Western standards, so this has only added to the ‘cost of living’ deflation in the West, since it has diminished consumption in Asia. The resulting low consumption has mean low interest rates, and that has resulted in an asset boom.

The problem with any asset boom is its sustainability. i.e. When a government has the power to impact the market interest rate, it assumes the role of ‘credit subsidiser’ at the expense of market stability. This is a typical measure by governments to extend their economic fortunes. The problem is that it imperils the hapless consumer, household or worker, who is less adept at reading market signals, or understanding market machinations. i.e. Persistence of the economic miracle today arises at the expense of households tomorrow. Everyone pays. There is no good to reap from profligate government.

So the global context is this:

  • Rising real incomes in Asia matched by lesser rises in prices
  • Rising real incomes for skilled workers in the West whilst unskilled wage earners experience a fall in earnings.
  • Rising asset inflation in the largest Western cities (where people want to live) as well as the most populous and prosperous emerging markets

The question is – ‘how long can this go on’?

  • How long can Western asset prices keep rising?
  • How long will unskilled wages remain ‘cheap’?
  • Are skilled wages under pressure?

On all of these counts, the global market is under pressure; albeit not immediate. There is no reason for Western asset prices to fall, other than the fact that they are high, yields are low, and they are due for a ‘sell-off’. There is therefore some reason to think that they should stay high, i.e. interest rates are low, and are destined to stay low, even if the Fed has made a nominal rise in interest rates. In our prior article however, we alluded to the threats to the US economy. There is every reason to expect a sell off for these reasons. A sell-off in asset prices however does not in itself mean ‘less investment’; simply less ‘long positions’ and more ‘short’ or derivatives investing. i.e. The Fed will just orchestrate more ‘financial investing’ to compensate for the absence of real investing. Based on this paradigm; you might wonder where the ‘virtual economy’ is. Is it on the World Wide Web, or is it more like the ‘Black Market’, except its been legitimatised and sanitized, and constructed as an over-arching ‘government agency’. The scheme of course rests upon the ‘ever-trusting’ taxpayer/voter, preserving their trust in government. Or does it? The real economy does. Financial markets don’t. Fortunately, there is a link between the two, however you might not see evidence of that ‘tenuous link’ for the next few years. The Fed, global governments and the media will however do a very good job at convincing you that its there.

The elephant in the room then is inflation. We have plenty of inflation at present – called asset inflation. That however is not the type that concerns governments because it can skirt that type. The type it cannot avoid because most investors don’t recognise it as ‘inflation’, but rather as a ‘wealth effect’, in the form of an asset price increase. These asset price increases were achieved by:

  1. Lowering interest rates to extraordinarily low levels
  2. Debasing the US dollar by underwriting most debt in USDs

Financing assets is not a concern because financial markets have derivative instruments to cover long and short positions. The trauma to the system can only arise from:

  1. Rapid liquidation of debt, i.e. If there was a crisis of confidence in the banking sector, i.e. If there was a global pandemic. Even then; global governments would rapidly create more debt to fill the gap
  2. Rising cost-of-living inflation; given that it would necessitate a rise in interest rates that would make financial speculation difficult. The good news however is that ‘cost-of-living’ inflation would be associated with higher levels of consumption in the real economy, so diminished financial debt would simply give way to more debt spending in the real economy, whether in emerging or Western markets.
  3. Declining skilled wages is another possible threat in Western markets. We have of course seen Asians taking jobs from Westerners as new capacity shifts or develops in Asia, and elsewhere. The question is whether we might expect Asians and other emerging market players to ‘rob’ Western workers of their ‘high remuneration’. This prospect is higher in some sectors of the economy more than others. It does pose a risk, though if these areas pose a threat to Westerners, it might be in the form of ‘skilled immigrants’. The question is one of whether skills ought to be outsourced to Asia, or elsewhere. Such a threat is moot however for equity-rich household investors.

The final threat of inflation comes from rising unskilled wages. This fear only arises if there is a ‘balancing’ of wage levels between the Western and emerging markets. There is of course ‘leakage’ in the form of:

  1. New factory capacity development – Emerging markets vs Western markets
  2. Shifting old factory capacity – Emerging markets vs Western markets
  3. Immigration – Emerging markets to/from Western markets

The lifestyle benefits of the West, and absence of secular culture and institutional provisions in emerging markets tend to skew immigration towards the ‘West’, however international marriages allow some scope, particularly for wealthy ‘jaded’ Westerners seeking an escape from omnipresent government.

GlobalWageDisparity

For this reason, there is no apparent reason to expect anything other than a healthy market correction in global markets. My Austrian School (of Economics) peers have predicted crisis. Whilst not identifying readily with this school, or their praxeology (‘rationalism’), I have to agree with their disdain for ‘big government’. As long as they continue to predict financial chaos, and not simply ‘market inefficiency’ and ‘injustice’, they are really doing market participants a grave injustice.

References

[1] “Quantitative easing and qualitative easing: a terminological and taxonomic proposal” by Willem Buiter, Financial Times, website, 9th Dec 2008.

 

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