I think so many people are arguing about inflation, especially after the CPI report, that I need to drop my inflation-adjusted 3 cents.
If you really want to understand inflation, just go to Mish blog, it’s all there. Just open it in another window, finish reading this post to the end and read it.
There are many scientific definitions of inflation. As I’m not an economist, I’ll give my own, not scientific:
Inflation is the expansion of money and credit divided by the expansion of economy and produced goods. When economy is doing very well, more goods to purchase is produced and more of public business and assets to purchase is available. But usually the credit is growing even faster, so there are more and more money for goods produced, so the sticker price of assets and goods is growing. It is impossible to properly measure the expansion of credit and goods, so instead economists are watching just the price level to understand how big the inflation is
So inflation has nothing to do with price level, but it can be partially measured by price levels
Some prices are unrelated to inflation, as they depend on politics, wars and weather. So those prices must be ignored
For example, corn price is unrelated to the inflation, because it is affected by new ethanol policies. So corn prices must be ignored.
Price of oil are unrelated to inflation, too. They are affected by tensions with Iran, wars in Africa and the fear of Middle East that they are running out of oil (maybe they are). So the prices of oil and gasoline are unrelated to inflation and must be ignored.
What is important is the level of outstanding credit in the mortgage market and the junk bond market. The quality of this credit is so low and the risk premium is so low, too, that there is a danger that massive defaults will eventually trigger the contraction of the credit. And defaults usually produce cross-defaults, so the credit contraction will spread.
Eventually the reduction in money supply will go so far that there will be much more goods than money. Much more homes than mortgages. Much more cars than car loans. Much more stuff in the malls than shoppers. The prices will decline, as a result of deflation.
Remember – price decline is not deflation, it is a result of deflation. Deflation is when there is no money in the system and there is no enough helicopters to throw more money.
June 16, 2007 at 12:18 am
For example, corn price is unrelated to the inflation, because it is affected by new ethanol policies. So corn prices must be ignored.
But the flaw in that reasoning is that corn is used as the basis for many things: feeding cattle for example. So meat prices go up. As do dairy prices.
Price of oil are unrelated to inflation, too. They are affected by tensions with Iran, wars in Africa and the fear of Middle East that they are running out of oil (maybe they are). So the prices of oil and gasoline are unrelated to inflation and must be ignored.
But again, oil is the basis for just about everything in our modern society: transport, plastics, fertilizer…. I could go on and on. Those higher prices are making their way through the entire system. Some economists will talk about how when one item becomes more expensive then consumers will turn to another cheaper alternative (chicken instead of beef for example), I believe this is called hedonics. However, when it comes to oil there are no readily available, cheaper substitutes; too much of our infrastructure is based on it now. Yes, I’m basically a believer in the peak oil scenario, and I believe that we’re, even now, in the throes of Kunstler’s Long Emergency. Oil may go down over short periods of time, but the long term trend is for it to go way up… we waited way to long to develop alternatives (and corn based ethanol will do more damage than good)
Eventually the reduction in money supply will go so far that there will be much more goods than money. Much more homes than mortgages. Much more cars than car loans. Much more stuff in the malls than shoppers. The prices will decline, as a result of deflation.
The Fed has cleverly hidden M3 from us for a few years now, but by all accounts it would seem that that M3 has been growing at a double-digit rate for a while now.
June 16, 2007 at 1:05 am
Let’s say Sam who lives in a small town is known as the wealthiest in the surrouding countryside. he owns a big estate and purchases everything with his IOU’s. In fact his IOU’s are so good even though there is other currency available most people trade with his IOU’s in this small town. Sam gets old and now has three generations of worthless kids who continually get into trouble drink to much, eat to much, fight to much, bust up the little town to much, gamble to much and have spent the old man real wealth so if you calculate all the IOU’s there is a much greater claim than assets. Sam has a long time servant Chin who does all the work around his house has sent all his kids to the best schoool in town who are hard workers. Chin has bought himself a house with his employer’s IOU’s Set up a mechanic’s shop and now is able to buy and sell things in other currencies than his master’s IOU’s. The question is when people realize that Sam is really broke are there deflationary and inflationary forces in play for the little town, Sams useless offspring, and Chin’s productive offspring?
June 16, 2007 at 7:59 am
TG, great example.
UncleOxidant, you are certainly right that corn and oil prices are extremely important.
But my purpose of watching prices and understand inflation is to figure out the condition of the economy, the location in the infinite boom-boost cycle we are now.
I’m trying to watch prices to predict when next recession happens, when stock market turns to bear, what will happen with interest rates and treasuries. Not to determine how much people are suffering or enjoying the prices.
So instead of watching oil and corn, I watch prices of copper, aluminum, steel, intermediate goods, cars, trucks, semiconductors (are in freefall now), real estate, rentals and so one.
June 16, 2007 at 1:24 pm
In the town there are two banks whose owners understand that Sam’s family is bankrupt by looking at the long term liabilities against assets. They also know most of the town is dependent on being paid in Sam’s IOU’s and most of them are highly in debt to their banks. There is beginning to be whispers of the reality of the situation by a few social misfits in the town. The bankers know if they do not come out and support Sam’s IOU’s there will be a quickening of the realization that Sam is bankrupt. With the banks money they sell off the other currencies in the town raise interest rates on the IOU’s (but not to high) and continue to take new IOU’s from Sams kids. Privately they realize the end game is coming and are diversifying their own assets into other currencies. They are cyncial enough to realize when the end game comes they can buy back the IOU’s at a fraction of their current worth and take control of Sam’s real assets.
June 17, 2007 at 3:14 pm
Price of oil are unrelated to inflation, too. They are affected by tensions with Iran, wars in Africa and the fear of Middle East that they are running out of oil (maybe they are). So the prices of oil and gasoline are unrelated to inflation and must be ignored
At current prices, oil sands, oil shale, and even coal liquefaction are profitable. These sources alone could produce 200+ years of oil even at current growth rates. And, even better, North America has the worlds biggest reserves of coal, oil shale, and oil sands. Yet, oil companies are not investing in these technolgies at the same rate they did in the 1970′s.
Concerns over global warming and uncertainty related to government policies has greatly increased investment risk for carbon intensive technologies. As a result, oil companies are only investing money in only the lowest risk investments where profits are almost guaranteed.
They are even canceling refinery expansion in the face incredibly high refinery utilization because of ethanol mandates.
I’m not sure why Mish believes that you can ignore supply shocks. I know why he would want to. Removing supply shocks would gives him a lot more wiggle room. Inflation can be deflation, but deflation is always deflation.
I’d believe an honest assessment would be that we are in a period of slowing inflation that may lead to deflation. The only way to avoid deflation is through a supply shock (stagflation) or an increase in demand through wage growth.
June 17, 2007 at 7:31 pm
I’ll take on the “are there enough helicopters?” question. Given that my current good fortune is the result of the increase in defense spending and that government is a source of much of the financial activity in this country, can the government continue to increase spending by issuing bonds that are now purchased by printing money instead of by foreigners?
I am far more concerned about the micro impact than the macro impact!
June 17, 2007 at 8:03 pm
Deflation doesn’t mean all prices drop. Maybe oil will remain around $60 (I don’t think so, but why not)?
If we get a collapse in shelter prices, i.e. landlords will chase renters with impossibly low prices, but gasoline will remain where it is – the overall price level will drop.
When price of labor starts dropping you will discover that all services all of sudden will become a whole lot cheaper, too. The horde of jobless plumbers and carpenters will chase you with offers you never saw yet.
June 17, 2007 at 11:32 pm
You dont need helicopters to distribute money. Its not like you need any kind of lifting capacity to do the deed.
All you need is a method by which vast amounts of money can be placed into the economy in a way that nobody really notices because they cant believe anybody would do that.
deflation is more or less impossible.
June 18, 2007 at 6:44 am
Worried, you can make a fortune by selling your method to Japan. They are fighting deflation for over 15 years.
June 18, 2007 at 10:35 am
The method is somewhat deceitful since it is always going to devalue money, and for the method to work the money has to stay in the country rather than fleeing to high yield areas elsewhere.
Anyway is Japan actually experiencing difficulties? Is it poor? Is it having to avoid a crisis in the not too distant future of some catastrophic nature during which time geo political manoevers are taking place to secure resources?
Besides the Japanese appear to be savers rather than spenders. If money was placed into the economy for free, it would be accumulated perhaps rather than be spent as desired to stimulate and inflate prices.
Americans though, just love to spend money.
June 18, 2007 at 2:17 pm
>>> Americans though, just love to spend money
Actually this is wrong. I don’t have any charts at hands, but I recall charts I saw a while ago -
in different periods of history Americans were big spenders and big savers, with huge swings between extreems. Usually continous periods of savings and spendings are very long – like 15-30 years each.
This is all to do with Kondratieff wave (I’ll write about that one day). US and Japan are at different point of Kondratieff wave now. They are in late Winter. We are in late Autumn.
If I’m correct we’ll be very big savers very soon.
June 18, 2007 at 2:24 pm
>>> Anyway is Japan actually experiencing difficulties? Is it poor?
Well, the Winter of Kondratieff wave, or a Great Depression in our words, is not necessary the slide to powerty. Yes, millions of Japanese went bankrupt and stock market fell 80% from 38,915 to 7,607.
5 times down.
I don’t know, when Dow Jones will fall 5 times (I think it will) – we’ll be poor or not very poor? Depends on where you kept you money.
June 20, 2007 at 12:01 am
Therox,
In my view, core materials such as paper, steel, copper, aluminum etc. are more indicative of inflation than semis, which follow the more eratic ebb and flow of tech innovation.
The XLB has been on fire since ’03. This goes the same for copper (2.0-8.0) and aluminum (1.5-2.7). Do you think these charts are on the verge of breaking down? What’s your take on gold?
June 20, 2007 at 5:17 pm
twenty-niner, no, I do not think metal charts will break down right now. It will take some cool-down in consumption to do that.
But yesterday I heard on Bloomberg radio one analyst on industrial metals whe said all those metals are 2-3 times overvalued, mostly because of speculation. He said sooner or later they will correct.
Again, it could be later rather then sooner, but it will happen.
June 20, 2007 at 5:19 pm
Gold is confusing me so much, that the more I think the more I understand that I do not understand gold.
I’ve decided that I will not touch gold until I develop an opinion.