If people expect an increase in inflation to be temporary and do not build it into their longer-term plans for setting wages and prices, then the inflation created by a shock to oil prices will tend to fade relatively quickly.
–Ben Bernanke at Harvard, June 4th 2008.
The term inflation only applies to rises in the consumer price index. When the price of shares (or houses) inflates, it is called a bubble. This is because the consumer price is the final price, no more added value, no selling on at a profit. And because the price of shares (and houses) goes up and down on a regular basis, whereas the consumer price index rises constantly (1).But the double terminology also suggests that bubbles resemble each other and have nothing to do with inflation.
On the stock market, prices vary according to supply and demand, as they should. A general rise in the price of shares across the board means that demand exceeds supply. This can happen because demand increases, when more and more punters put their savings on the gaming-table. But it can just as well happen because supply is reduced, when shares are hoarded. However, only increasing demand can result in a stock market bubble, as was the case some years ago, when everyone wanted a piece of the dot-com gamble. A stock market bubble draws in cash when it inflates, and destroys that cash when it bursts. By attracting money and reducing demand elsewhere, inflation on the stock market and its final destruction of liquidity tends to be deflationary, in the sense that it reduces demand on the consumer market.
Prices on the housing market also vary according to supply and demand. But these two variables have little in common with the supply of and demand for company shares. New-comers to the property market usually need more than their savings to buy a house or an apartment, and so increasing demand depends largely on borrowing. Reducing supply by hoarding urban real estate does happen in a few large cities around the world, but it is marginal and its effect on prices is local (2).
A housing bubble is inflated with debt and does not destroy that debt when it bursts. The price of houses falls but the debts remain. Based on debt, inflation on the housing market does not reduce demand elsewhere. Instead, as long as the amounts lent out exceed the amounts paid back, the increasing demand for houses inflates the price of building materials and generously circulates liquidity. It is only when the bubble bursts and the flow of credit dries up, when more is paid back than is lent out, that consumer demand is reduced to essentials.
Stock market bubbles have a deflationary effect. They draw in cash and seemingly destroy it when the bubble bursts. Though, in fact, it has fed huge profits and fat wages that may have affected the price of luxury goods, “art” and up-town apartments, but not the consumer price index. Housing bubbles have an inflationary effect on building materials. As house prices rise, building accelerates and demand for materials increases faster than supply. But this does not directly affect the consumer price index either. When the tide of credit recedes, for lack of credit worthy customers or because the limits of over borrowing are reached, demand drops and house prices fall. All the more so that the building sector is in full expansion and a large number of new houses are being built. However, the value destroyed by falling house prices was paid with credit, not in cash. Not with unspent incomes from the past, but with as yet unearned future incomes. And, as the value of the mortgage becomes greater than that of the devalued house, each dollar paid back is devalued in proportion to the devaluation of the property.
Future incomes will be paying the house more than its market value, so each dollar will pay back less than a dollar’s worth of house. This contradiction is resolved by inflation, when the house regains its nominal price in a devalued dollar.
A housing market has borrowers. It must also have lenders. As the bubble begins to deflate, some of these lenders are faced with multiple foreclosures and have trouble surviving. But the larger institutions write off their losses and carry on their business as usual. Except that lending is almost at a standstill, while most borrowers are still paying back their debts. Vast sums are being repaid that cannot be lent out again. So where can all this money go to make a profit? As long term interest rates are rising, bonds are not a good buy (3). Share prices on the stock market are like a roller-coaster, brief ups and scary downs. Real estate is out of the question. So all that remains are futures on the commodity market.
Prices on the commodity market vary according to supply and demand. Demand resembles that of the stock market, cash and short term credit. Whereas supply has its own particularities. Commodities are produced to be transformed by the production process, and have a relatively short life span. They can be hoarded but, as they occupy space and mostly need special storage conditions, this is at a cost. In fact, most storage is either “strategic” or imposed by seasonal crops. But it is the nature of commodities that makes their supply different from the supply on other speculative markets.
The supply of public debt increases and occasionally decreases. The number of companies that have shares on the stock market goes up and occasionally down. Houses are being built all the time and some are occasionally blown down or swept away. But the supply on these markets concerns not only the increase but, potentially, the whole of the stock. Old and new are bought and sold without distinction. Whereas commodities must be constantly produced anew to supply the market, before being transformed by the production process. As the supply of commodities is a flux rather than an increasing stock, it can be interrupted. Natural disasters, war, peaking non-renewables, climate change, all threaten tomorrow’s expanding production of commodities. This being so, any rational analysis must conclude that the actual flow of commodities is more likely to slow down than to accelerate, at a time when demand is expanding as never before. An ideal situation for speculative investments.
Commodities are the produce of the planet. The production of minerals, fossilised organic matter, plants and animals depends primarily on that amazing and improbable system we call Earth, and only secondarily on human activity (4). A technological adaptation of ancient eschatological fantasies, had led to the dream of travelling through space to other worlds. But it is increasingly obvious – was there ever a reasonable doubt? – that living anywhere else but here is beyond our scope. One planet, one world, and its generous abundance has limits. As does its capacity to absorb our waste emissions. By digging and pumping things out of the ground and diffusing them into the air and water, we are modifying the composition of these two primeval elements. Lakes and rivers are poisonous and the sea merely dilutes these toxic waters, as ocean currents spread the poison all around the globe. At the same time the atmosphere’s complex mixture of gases is being changed. Not so long ago, CFCs gave a clear sign of what was possible. To-day, the increasing proportion of CO2 and the decreasing proportion of oxygen in the air seem to be having an effect on atmospheric conditions. Though this is still under debate, we can be fairly sure that the carbon trapped underground as coal, oil and methane was taken out of the atmosphere by very large plants and very small animals, long before Australopithecus roamed the Rift valley. By burning fossil fuels, we are replacing oxygen molecules by molecules of carbon dioxide. This is recreating conditions that pre-date human presence on Earth, and could make parts of the world uninhabitable for a variety of species, including our own. It has already increased the frequency and force of tornadoes and tropical storms.
The consumption of mineral resources is close to its Gauss curve peak (5), and powerful storms are wrecking the plains and swamping the deltas. The world’s supplies of minerals, fuel and food will stop growing as a result, and may drop because of interactions between the two. Producing food needs fuel and minerals, and producing fuel and minerals needs food. But demand has no reason to stop growing, as long as it is solvent, as long as it can pay. What remains to be seen is who can continue paying ever rising prices. America prints the stuff, the wherewithal, while China, Japan, Germany and a few others are holding vast quantities of it in cash and bonds. On the world commodity market, the dollar reigns supreme, with the euro and the yen playing a very minor role. So rising prices simply need more dollars. The US Treasury has been working hard at it for years and seems set to accelerate the new supply. In a world awash with the green stuff, there is nowhere better for it to go than on the commodity market.
Inflation is often described as too much money chasing too few goods, and this description does seem to apply to the stock, housing and commodity markets, but not to the only accepted measure of inflation, the consumer price index. As yet there is no sign of excess money in the consumer’s pocket. In fact, most consumers are already finding it difficult to face up to the rising prices that are manifestly the result of a top down effect. So the description above may apply to speculative and credit bubbles, but it does not describe inflation as such, measured by the consumer price index.
Rising consumer prices and rising wages are usually associated, and this has become a dogma with the onus placed on wages. And, because wages are a part of the selling price, rising wages do automatically push up prices all along the chain and on to the consumer. This observation has led to the application of a lowest possible minimum wage linked a posteriori to inflation. Meaning that inflation happens and then, hopefully, wages follow. So that neither the low level, but chronic, inflation of the past twenty-odd years, nor the build up of hyper inflation over the past months, can be blamed on wages. Wages rise when wage earners can no longer manage on their earnings and, even then, strike action or some more general social upheaval is usually necessary. A problem that can be countered for a while by easy credit and tax rebates. But this is a move that leads unerringly to over-borrowing by both the government and individuals.
Wage rises are a reaction to consumer price inflation, not its original cause. But rising wages do in turn push up consumer prices. This is because wages are competing for a share of added value with the other two main beneficiaries, taxes and profits. If wage rises are compensated by falling profits or taxes, prices are unchanged. Whereas low wages and low taxes leave room for large profits. And, as profit is the driving force of capitalism, all is done to keep wages and taxes as low as possible and to compensate the lack of spending power with credit. For the past twenty years or so and at in increasing amounts, profits have been invested abroad and credit granted at home, so that a growing proportion of home demand is based on future incomes.
Overdrafts, credit cards, mortgages and T-bonds – not to mention the subprime stuff – have insured growing consumer demand at home, while profits were out-sourced as investments and came back as consumer products. Growing profits invested overseas have built up an equivalent debt at home, to compensate the low level of wages and taxes. This process seems to have reached its limits, and returning investments are as forlorn as paid back housing debts. And the commodity market beckons them all. That much more money chasing too few goods.
The inflation chart (1) shows three periods of high inflation, 1916-1921, 1941-1948, 1973-1982. All three are linked to war and fossil fuels. The first period starts during the war in Europe, where the possession of coal reserves played a major part. The second period starts when the Germans tried to take control of the Caspian oil fields and the Japanese, after bombing Pearl Harbour, briefly took over the Indonesian ones. The third period starts after the Yom Kippur war, when oil sales were interrupted and prices soared. In 2008, we have government borrowing for war and soaring oil prices. And if that were not enough, food prices are reacting to foreseeable supply shortages, house prices are plunging and climate change seems upon us. Finally, if inflation is simply a phenomena resulting from the long borrowing cycle – every thirty years – then the time is ripe.
KENNETH COUESBOUC can be reached at: kencouesbouc@yahoo.fr
Notes
1. Deflation seems to be a thing of the past, possibly due to the demise of the gold standard.Inflation in the US, 1914-2006
2. Bubbles stimulate and increase supply on both markets. But when the bubbles burst, the star-ups disappear whereas the building sites remain. The effect on employment is also quite different.
3. When the rate of interest increases, existing bonds automatically lose value. For example: $5 = 5% of $100 = 10% of $50. I-bonds have variable interest rates that increase with inflation. This theoretically prevents them from losing value.
4. However, it is human activity that creates the exchange value of commodities. The rent, royalties and concessionary rights that are added are the privileges of private and state property.
5. The precise position in time of the different production peaks for non-renewables can only be known after the event. But there are signs (other than price inflation) that suggest we have reached the peak for several products, including oil.