A Continued Era of Deflation
or
A Premature Expectation of Inflation?
© Martin A. Armstrong
Economists and analysts argue that double-digit inflation is something of the past – a freak of nature that took place during the Carter years of the mid-70s. On April 19th, 1993, Alan Greenspan (Chairman of the Federal Reserve) made a statement before Congress… “The inflationary pressures that so dominated the economic events or most of the last quarter-century appear largely, though not as yet wholly, subdued The post-Vietnam economic experience appears to be running full circle, back to the early 1960s: a period of low inflation and strong productivity growth.” While it might be true that of the six decades since the Great Depression, only the 1970s were marked by high inflationary tendencies, such statistics can also be quite misleading. Nevertheless, coming to grips with history takes a bit more than mere one-dimentional analysis. If the debate between the inflationists and deflationists is to be decided, a realistic review of the facts is certainly in order.
It is true that during the past six decades since the Great Depression, only the 1970s were marked by high rates of inflation as measured by the CPI (Consumer Price Index). Despite this fact, one out of six decades does not make an aberration – nor is it possible for powerful institutions such as the Federal Reserve to protect the country from inflation when the Fed has absolutely no control over government spending. As we have stated countless times in the past, the monetary history of the world, as we know it today, only began on Aug. 15, 1971 with the closing of the gold window by President Richard Nixon. That one act, a result of a breakdown in trade negotiation with Europe of Agricultural subsidies, ended the period of the gold standard and drastically altered government. While the gold standard existed, domestic policy of a nation was held in check by the mandatory international fiscal responsibility imposed by the gold standard. Once governments were free from worrying about redeeming their currencies in world markets, deficit spending could become a new means of political corruption to gain votes. Domestic policy objectives were no longer tied to fiscal responsibility. ®From that starting point, inflation began to run wild posting significantly higher rates of growth than at any time before during this century within the United States. This trend, however, was not confined only to the United States, but in fact it began to infect the world economy as a whole on every continent around the globe. Despite the fact that many would have us believe that inflation has been vanquished, one dollar created in 1972 is now worth a mere 27 cents.
Even though inflation dominated one out of two decades since the birth of the floating rate system, many people still credit the “deflation” era of the Eighties to the reign of the former Fed Chairman Paul Volcker, who supposedly injected discipline back into the dollar by taking a rigid monetarist approach. This same group of deflationists claim that while price inflation, as measured by the CPI, averaged 8.7% per year between 1972 and 198 1, inflation fell to an annual rate of only 3.3% from 1982 to 1987 dropping to a mere 2.9% for 1992.
While it is true that a recessionary trend has emerged since the peak in our Economic Confidence Model in December 1989, it is NOT true that the period produced “deflation” or “zero inflation” as many economists have claimed. The cost of doing business has skyrocketed along with the cost of living. The cost to run Congress if up 500% since 1985 alone! Housing has more than tripled since 1980 even at the current depressed prices. Cars still cost more than they did just 3 years ago along with just about everything else. Interest rate charges of credit card are still in the mid double-digit range while t-Bill rates fell to under 3%. So where is this “deflation” or “zero inflation” the gurus are taking about? Surely, it has to be visible somewhere outside of a mere government prepared index of inflation?
The answer to this paradox is complex. It involving a lot of fancy shuffling of statistics combined with constant revisions of the even how and what goes into the CPI itself. But at the core o f the issue lies the key question often missed in the fanfare – what is inflation anyway?
Starting at the top, if the cost to run Congress is up 500% since 1985, how can we call the last 8 years a period of zero inflation? The answer to this enigma is quite simple. You have obviously heard that all things are avoidable except death and taxes. Well, guess what? Government considers itself to be a necessary part of life which man can not exist without. Therefore, the cost of government is not, and has never been, a part of the CPI. So while Clinton raises taxes which reduces the net disposable income of the normal working class individual by raising the cost of h is living, government believes that your cost of living is not increased because the money they take belongs to them – not you! Therefore, taxes are excluded from the CPI.
The so called age of “deflation” was in fact a period makes by a decline in the rate of growth for inflation among private sector goods and services. But, this same period was marked by a 20% increase in taxation nationwide. The inflation that did take place was in government and therefore was excluded from the CPI altogether. If we look back to just 1985, state and local government generally accounted for a surplus which in effect was equal to nearly 40% of the federal deficit. But between 1985 and 1993, state government expanded so rapidly, the surpluses disappeared. As they did, state and local taxation exploded. Many states raised sales taxes by 20% or more. Man states that did not have an income or sales tax, came up with them. This huge expansion in taxation at the state and local level, more than wiped out any reductions under the Reagan era. Social Securities taxes jumped so high that many Americans paid more in SS taxes than they did in income taxes. Is it fair to say that inflation when down when the Democrats themselves argued that the rich got richer and the poor got poorer under Reagan/Bush? Net disposable income did decline not because the rich raised prices, but because government raised taxes! Their own CPI shows that clearly since taxes are excluded.
How Does The CPI Work?
The CPI is one of the most widely used economic statistics and perhaps the most misunderstood. Nearly 100,000 items are included in the U.S. Consumer Price Index. Even though the Bureau of Labor Statistics has tried supposedly in “good faith” to design an accurate CPI, there are several major flaws within its design. In addition, several major revisions have been made to the CPI over the years. In fact, today’s CPI is not the same CPI that was used even 10 years ago! To make matters worse, the internal structural flaws of the CPI are only exaggerated by the general misuse of this index in trying to adjust contracts, government statistics and interest rates.
One fundamental flaw stems from the change in quality. Quality adjustments alone can contribute to the underestimation of inflation rates. For example, pollution devices were added to automobiles by law. On average, these devices cost the consumer nearly $500 per car. Because a pollution device was a new item which became standard equipment, it was viewed that this was a “technological improvement” to quality. Consequently, the added cost was NOT considered to be an increase in price since the consumer was receiving additional quality. Conversely, if an apartment rent always included heat and a change occurred whereby heat became an additional cost, such additions are viewed as a rise in the cost to the consumer.
However, items used in cars for “appearance” are not regarded as a change in quality. For example, while pre-1970 cars normally carried real chrome fittings whereas post-1970 cars began to replace such fittings with plastic, change s in quality in this regard are ignored. By and large, dry wall substitutions for plaster walls in housing are another example of “appearance” factors that go ignored.
As a result, the actual cost to build a brownstone house in New York today is far greater than that it would be to build a mere frame drywall dwelling of comparable size and space. The CPI over time has watered down the major changes in quality by viewing the cost to build per square-foot without regard to materials. Thus, the consumer ends up with particleboard versus plywood just in the last 5 years. But then again, plywood was a substitute for real planks decades before which in turn was a cheap substitute for stone and mortar of the turn of the century.
In addition, the CPI has been revised over the years taking the position that a fundamental difference exists between investment and the actual cost of living. The revisions which have taken place in the housing component reflect this attitude. For example, the CPI reflects the cost to rent the house more so than the value of the house. This revision followed the 1980 peak in housing prices and consequently, this revision was a major change given the 39% weighting housing plays within the overall CPI. This is why real estate boomed going into 1987 and 1989, yet inflation did not reflect this more than doubling in the price of housing.
In addition, housing prices used by the CPI are those from the FHA (Federal Housing Administration). The data used to measure changes in housing costs are therefore limited by the ceiling imposed by the FHA which is $60,000. Therefore, because housing itself has risen sharply in the 1980s, the sampling of data employed by the CPI based upon FHA data reflects the extreme lower levels of the housing market where prices have risen the very least.
This aspect of housing is in our mind the most serious flaw since it accounts for 39% of the total CPI. The second serious flaw is that of the quality adjustments. Given these problems alone, the CPI understandably lacks a real correlation to today’s inflationary economy.
From a real perspective of the consumer’s cost of living, government taxation is largely ignored with the exception of property taxes. When we take into account that the average consumer spends slightly more than one-third of his total salary on taxation at the federal, state and local levels, it is grossly unfair to ignore this large component in the inflation index. This is particularly true in the case when the cost of government as measured through revenues, has been the single greatest added cost in everyone’s budget at the personal level.
So What Is Inflation Anyway?
The commonplace definition of inflation is a rise in the cost of general goods and services relative to the medium of exchange or currency unit (money). By definition, one is initially misled with the assumption that the cause of inflation is deeply rooted somewhere within the market structure – be it either supply or demand – rather than in the real value of money itself. In other words, using government’s preferred definition of money always points the finger at the private sector. Prices of goods and services are rising and that rate of increase is what we commonly refered to as inflation. But at the same time, the flip-side of this definition should also be considered. It is NOT that the price of goods and services are rising, but the value of the dollar is declining. Therefore, a 1972 dollar today buys only 27 cents. This basic assumption, therefore, sets the tone for all solutions to inflation. If inflation is defined as the increase in the price of goods and services, then it is the fault of the private sector. Therefore, government intervention in either demand or supply utilizing the modern- day tools of interest rates, taxation or price control mechanisms of all sorts, becomes the justified right of government. However, if the definition is not the rise in prices of goods and services but the decline in value of the currency, then the fault lies with too much government spending and the private sector should intervene by throwing out the politicians. As you can see, the solution is determined solely by the definition of the problem!
Is Inflation Definable?
Inflation is something which most people perceive as a single dimensional force with its cause and effects one and the same. But inflation is far from such a simplistic explanation. Its causes are numerous a s well as its effects.
Inflation is largely multi-dimensional. It can arise from labour demands, raw material shortages, overall changes in government spending relative to the supply of money as well as changes in the value of the currency in world markets relative to imports. Nevertheless, inflation fails to conform to any one single source or cause preferring to remain a multiheaded dragon.
The Monetarist Theory of inflation rising and falling in union with the supply of money, is hardly valid after our recent experiences between 1980 and 1985 . After all, the fiscal deficits of the United States exploded, the national debt more than doubled, yet inflation subsided while the value of the dollar soared to record highs. According to the Monetarist Theory, those events should have produced outrageous inflation. Instead, this same period is called the beginning of deflation created by Volcker.
Nevertheless, the impossible has happened and in the wake of this madness, new guidelines have become necessary f or our definition of inflation itself. These new definitions are not only necessary from the economist’s perspective, but also for our sense of what the future will bring from a market and investment perspective.
The 1960s was a period known as the “Wage-Price” spiral. It was a period during which a legitimate scarcity in skilled labour resulted in escalating wages. That period produced the highest gains in the American standard of living which, to this day, h ave not been exceeded. It was a period called the “Wage-Price” spiral because wages took the lead and prices followed in a lagging relationship. It was perhaps this first cycle in wage increases which set the tone for what was to come later during the ’70s. Nonetheless, the rise in the cost of labour resulted in a “Cost-Push” style of inflation with wages being the source.
The 1970s was a period that became known as the “Price-Wage” spiral. Spearheaded by oil price hikes and shortages in commodities, prices in most sectors increased at a far more aggressive rate than actual wages. As a result, labour fought for CPI increases during the ’70s in an effort to keep up with rising price inflation. ®But the commodity boom turned into a “Demand-Lead” style of inflation between 1978 and 1980. The public became convinced that it was cheaper to buy today rather than tomorrow. Speculation entered as a result of steadily rising commodity and real estate values. This speculative form of inflation eventually produced yet another form of “Cost-Push” inflation. Therefore, while the ’60s Cost-Push inflation was initiated by wages, it was the oil price increases that generated the initial “Cost-Push” inflation of the ’70s.
Simultaneously, the dollar was collapsing to record lows on world exchange markets. Much of the price increases in raw commodities and foreign goods, was in direct proportion to the decline in purchasing power of the dollar on world markets. Therefore, the inflation of the 1970’s began as a “Cost-Push” and transformed into a “Demand-Lead” form of inflation aided by speculation, but a large part of both was caused directly by Currency-Inflation.®®Despite the fact that many would like to credit the end of the “Demand-Lead” inflation spiral to the Federal Reserve, the facts suggest otherwise. Banking on the notion that Reagan was indeed serious about stopping the inflationary spiral, spending in the private sector began to cut back instantaneously following the Presidential elections of 1980. Speculation not merely subsided, business surveys indicated that expansion plans were put on hold until Reagan could be assessed. The Fed continued to raise the interest rates into April of 1981, but their continued hikes in the discount rate between 1976 and 1980 $FAILED to reduce inflation or dampen the speculative fever of the times. People often forget that if expectations for something are double, then 20% rates of interest are not onerous. The forecast s going into 1980 were calling for $100 oil by 1985. The net result of all this was a disinflationary period not a deflationary one. The rate of inflation as measured through the price of goods and services declined but never turned negative. The election of Reagan also marked the low in the dollar and a 40% appreciation going into 1985. The dollar therefore BOTTOMED with the peak in interest rates and rose as interest rates declined. So much for those who think that raising interest rates supports a currency and lowers inflations.
Throughout the disinflationary period of 1980-1985, money supply more than tripled and the national debt doubled. While Volcker may have talked a rigid monetary policy, the evidence points to anything but! Therefore, the inflationary forces shifted from the private to the public sector. In part, this was caused by President Carter who took the budget from a “zero-based” system to one that w as automatically index to inflation according to the CPI. Government spending was thereby increased in proportion to the CPI which in turn doubled the national debt. These two contrasting forces, therefore, met head to head for perhaps the first time since the new deal in a big way. If public spending had not increased significantly, the economy would most certainly have headed into a serious recession of deep proportions. The drastic increase in government spending did not create inflation be cause of the simultaneous contraction in the private sector spending.
Currency inflation has also reemerged since 1971 within the economies of the main industrialized nations only due to the floating exchange rate mechanism. With average swings of 40% every 2 to 3 years in the foreign exchange markets, the value of the currency can cause dramatic changes in the domestic rate of inflation within any nation depending upon the level of imports. Yet, currency inflation is not restricted to import s alone. The Japanese were lulled into buying US real estate because the dollar fell 40% between 1985 and 1987. As the dollar fell, the value of US real estate appeared to rise 40% in terms of yen. As the Japanese bought up commercial and residential properties, the cost of housing soared. So while a lower value may have made a Toyota more expensive to American consumers, it also raised the cost of importing oil and resulted in capital asset inflation caused by foreign investment domestically. ®®Inflation, therefore, is far from one dimensional. It has several faces and has struck in different forms from one decade to the next. The 1990s, however, will be a period of not merely record volatility, but a new age of record global inflation as well.
For the first time within this century, we will experience all three forms of inflation SIMULTANEOUSLY combined with currency inflation on a country by country basis! We will see a Wage- Price spiral combined with both a Price-Wage and Monetary forms of inflation. As the yen peaks for this decade, Japan will experience a rise in inflation as the cost of importing raw materials rises in terms of their local currency. The same will be true for Germany and most of continental Europe. Inflation in Australia will be partially offset by a rising A$ and this will be true to some extent in Canada, Britain and the United States.
The low in commodity prices during 1986 is a major low. The sharp advances in raw materials have been both abrupt and shocking. This is not a trend of freakish events. Instead, this is a real trend responding to real live capacity restraints. After a brief relaxation in commodity prices during 1988-1991, the uptrend has been renewed. The banks remain reluctant to lend to small business which only helps to keep a cap on the ability to expand the capacity to produce commodities. Thus, this trend itself is aiding in rebuilding inflation from a Cost-Push perspective. The recent rise in taxation by Clinton, combined with expectations for even greater taxation on the horizon due to healthc are, will also contribute in rebuilding the foundation for a Cost-Push form of inflation next year.
Fighting Inflation
Right War – Wrong Weapons
The most startling thing about general economic expectations, is the lack of understanding about inflation. The general concensus remains biased toward believing that inflation is being held in check by the central bank. Some have been so bold as to regard inflation as a completely dead issue while 0.others has gone as far as to proclaim “zero inflation” is upon us.
The notion that the Fed or any central bank can actually control inflation is seriously flawed in today’s new economic era. Just because the monetarist’s view of inflation is a rise in the supply of money resulting in “too many dollars chasing too few goods” does not mean that the Fed can control inflation simply because its charter calls for it to control the supply of money. The Fed was formed under a gold standard and its role was to regulate the flow of money throughout the nation to avoid shortages in one area versus another which often caused short-term runs on local banks. The Fed can no longer control the supply of money because government itself creates it at will. The Fed has no direct control over the deficits Congress runs up at the Treasury and therefore it is impossible to regulate the overall supply of money.
Some would argue that government does not create cash, it borrows the money it needs to cover the deficit. However, if we are dealing with a close economy, this statement would be true. The reality is simply different than the theoretical classroom scenario. If 30% of a new debt offering is purchased by a foreign buyer, then that cash is transferred into the domestic economy from outside. It will eventually have the same 3 inflationary effects domestically as an increase in the money supply.
There are also those who believe that inflation c an be fought with interest rates. However, inflation only subsided during the 1978-1981 spiral after the prime rate hit 22%. A rise from 6.5% to 22% is quite a long way to go before inflation declined. Speculative inflation will only subside when the rate of interest comes close to or expects expectations of inflation.
Besides interest rates being a rather shotgun approach to managing the economy, we have the problem of government debt itself. When the whole idea of the Fed fighting inflation through changes in the rate of interest was proposed, government was less than 10% of the economy. Today, government is the single greatest debtor within society employing 33% of the work force. If the Fed attempts to fight inflation by raising short-term interest rates by 1%, they will increase the current fiscal expenditures by nearly $100 billion. Because the government owes $4 trillion and nearly 70% of the national debt is short-term funded, the Fed’s interest rates tool is no longer as effective as it once was when the government owed only $27 billion prior to World War II.
So Will The Future Bring
Inflation or Deflation?
While the weakness in business activity, the surplus in the labour market and the somewhat steady commodity prices would seem to suggest that the future holds more of the same, it does not hold true that the country is simply “too weak” to inflate. Those who would argue that the economy is not getting stronger by leaps and bounds should also remember that inflation can emerge from external sources even if the economy remains weak. Inflation is currently running at 17% in China due to an economic boom and a Demand-Lead form of scenario. In Russia, inflation is in excess if 40% per month due to a lack of confidence in government as they print rubles in an uncontrollable atmosphere. Inflation within the main industrialized nations can emerge either from a strong economic boom, or a collapse in confidence that government will bring down their current deficits.
In the United States, the year-over-year increase in the federal deficit is currently more than $350 billion. Adjusted Fed Credit, which is the Fed’s holdings of government securities, is currently increasing at more than 12% a year on a seasonally adjusted basis. In the past 2 years, the Fed has monitized through the absorption of nearly $62 billion in bills, notes and bonds. That cash has been injected into the economy compared to a rise of some $57 billion in real GDP over the same period. This implies that the Fed has been monitizing at a rate which is faster that the economy as measured through the eyes of GDP.
Another significant factor in the dynamics of our present situation is also directly linked with the abandonment of the gold standard in 1971. Since that time, the Eurodollar market has grown substantially. In fact, the Euro currency market is outside the domain of the Fed which means it is an unregulated market! This market today has grown larger than M2. Additional changes in the financial system have replaced the S&Ls and banks with Fidelity, GE Capital, Merrill Lynch, Prudential and others not to mention the countless number or bond funds. The old statistics of money supply growth being measured by savings and checking accounts belong to the days of historians.
In today’s new global economy, all roads no longer lead to Rome, but to inflation in virtually every land. When voter s put someone like Clinton in office, is there any hope for the future? The problem is not the rich, its government stupid! Unless government spending is honestly reduced, we do not have a chance in heel of surviving this decade without another major economic upheaval that will overshadow the great depression. Clinton’s proposed $500 billion savings is nothing but smoke, mirrors and a lot of lies. What the press won’t tell you is that nearly $300 billion is ASSUMED SAVINGS from lower interest rates in the future. But what if interest rates do NOT decline – what happens? There will be NO $300 billion savings. If they rise by 1%, there will be another $500 billion in expenditures without indexing spending to the CPI.
Inflation is a strange bird. It comes to us in many forms. It can emerge from a buoyant economy on the back of rising demand, do to economic expansion like in the good old days of the gold rush of 1849 in California or as in China today. But it can also come from a sharp decline in confidence on the part of people toward their government as we see in Russia and in most of the Banana Republics. Inflation can also emerge from external sources like the oil price shocks. It can suddenly emerge from severe flooding or natural disasters.
By no means do we live in an era of “zero inflation” nor do we reside in the “deflation” era. Instead, we are the humble residents who have survived only half the storm residing in the strange calm that marks the eye. The other side of the storm is upon us and that appears to be ready to hit land next year. With the 1994 turning point on our Economic Confidence Model, we expect inflation to rise from all sources simultaneously. The tax hikes of Clinton will only add fuel t o the Cost-Push scenario and by 1996 we will once again see the speculative side of inflation rise again. So don’t expect the good old boom days of the late ’70s, look more for the first leg of inflation to be more like the shock-therapy style as the economy simply tries to adjust to higher costs that can no longer be absorbed. This time, higher taxes will be passed on to the consumer from every sector within this fragile entity we can our economy.
