Inflation: Myths And Beneficiaries

``Inflation is socially disruptive in that the management of fiat money — as all today's currencies are — causes great hardships. Unemployment is a direct consequence of the constantly recurring recessions. Persistent rising costs impoverish many as the standard of living of unfortunate groups erodes. Because the pain and suffering that comes from monetary debasement is never evenly distributed, certain segments of society can actually benefit. Ron Paul Challenge to America: A Current Assessment of Our Republic

It is commonly thought that consumer goods and services inflation is bad for EVERYONE. While inflation represents as stealth tax and is bad for the society from a generalized perspective, on a relative basis some groups benefits from inflation more than the others.

To quote Ludwig von Mises Institute President Lew Rockwell (highlight mine), ``For most people, it is seen the way primitive societies might see the onset of a disease. It is something that sweeps through to cause every kind of wreckage. The damage is obvious enough, but the source is not. Everyone blames everyone else, and no solution seems to work. But once you understand economics, you begin to see that the value of the money is more directly related to its quantity, and that only one institution possesses the power to create money out of thin air without limit: the government-connected central bank.”

So when you see people on the streets scream for price controls, in the understanding that “inflation” is caused by anything BUT the government themselves. They mistakenly believe that government can control the economic laws of demand and supply by intervening in the markets.

And you have politicians pretending to address “inflation” with even more interventionist “inflationary” actions, from Ludwig von Mises in Economic Freedom and Interventionism (emphasis mine), ``To avoid being blamed for the nefarious consequences of inflation, the government and its henchmen resort to a semantic trick. They try to change the meaning of the terms. They call "inflation" the inevitable consequence of inflation, namely, the rise in prices. They are anxious to relegate into oblivion the fact that this rise is produced by an increase in the amount of money and money substitutes. They never mention this increase. They put the responsibility for the rising cost of living on business. This is a classical case of the thief crying "catch the thief." The government, which produced the inflation by multiplying the supply of money, incriminates the manufacturers and merchants and glories in the role of being a champion of low prices.”

Therefore, inflation is fundamentally ALL ABOUT GOVERNMENT, whether it is caused by monetary expansion (Milton Friedman-“always and everywhere a monetary phenomenon”) or government spending (Dr. John Hussman- “government spending expansion, regardless of the form, will tend to raise the marginal utility of goods and services while lowering the marginal utility of government liabilities…but as long as a government appropriates goods and services to itself in return for pieces of paper that compete as stores of value and means of exchange in the portfolios of investors, you'll get inflation”).

Under a free market environment, marginal utility-satisfaction of consumers from consuming one or more unit of goods or services (investopedia.com)-imbalances via supply constraints or unfulfilled demands or generally “relative prices” are usually temporary and resolved by market forces, through the natural adjustments in production and consumption guided by market prices.

Thus, the prolonged nature of imbalances or the popular known “inflation” are nonetheless caused by distortions on the public’s marginal utility by government instituted policies, spending and or money expansion.

Remember, the MISMATCH OF INCENTIVES that guides government actions (preservation of political power or non-economic motives) and the general public (economics) reinforces the inflationary dynamics within a society.

A very lucid example is the biofuel subsidies in the US which have been meant to promote agri based (corn) feedstock biofuel as alternative energy source in order to reduce dependency of fossil fuel.

The subsidies had been political in nature, i.e. promoted agri industries (and its corresponding voters and political financiers) at the same time aimed to reduce the political power of unfriendly oil exporting nations by reducing revenues via lower US imports, but this came at the expense of public as an unintended outcome, i.e. through higher world food prices due to reduced acreage for food. The Guardian reports that a soon to be released study from the World Bank discloses the impact of such subsidies to as much as 75% of price hikes in food! Yeah, government knows what is best right?

Today’s monetary architecture has the de facto US dollar “paper” standard system as the ultimate source and transmitter of world inflation, especially punctuated under today’s globalized or more integrated financial landscape compounded by cumulative effects of currency pegs/US dollar links or monetary structure by many countries aside from the disparate policies (fiscal and monetary) of each nation.

While globalization has its benefits (see recent post Globalization Highlights From Past To Present), it has equally carried over some of the imperfections.

So who benefits from inflation?

Primarily the government. Political pressures from the public for government to intervene in the marketplace mean further empowerment of governments (of course the politicians and the bureaucracy).

This means more government spending or roots for added inflation in the future. Example, because of the Rice crisis, the Philippine agricultural department is asking for an additional/supplemental budget of Php 15 billion (US$337 million) allegedly “to help farmers and consumers” (inq7.net). More long term distortions in the marketplace, yet more potential loopholes for corruption for the purpose of short term mitigation.

Second, the affiliates of government or economic agents that deals directly with the government. The Banking industry, for instance, as primary agents for the fractional reserve banking system has been a recipient of “privileged deals” from the US Federal Government at the expense of US taxpayers. Think the Fed engineered JP Morgan’s takeover of Bear Stearns.

Or how about today’s Fannie Mae and Freddie Mac (F&F) episode; the recent rescue of the GSEs highlights the chain of special “political” connections by the Federal government-banking-mortgage industry.

Figure 2: US Global: World Holdings of US Long Term Agency Debt

From RGE Monitor’s Nouriel Roubini (hat tip: Craig McCarty), ``The existence of GSEs and the implicit subsidy that they provide to the housing sector and mortgage market is a major part of the overall U.S. subsidization of housing capital that will eventually lead to the bankruptcy of the U.S. economy. For the last 70 years investment in housing – the most unproductive form of accumulation of capital – has been heavily subsidized in 100 different ways in the U.S.: tax benefits, tax-deductibility of interest on mortgages, use of the FHA, massive role of Fannie and Freddie, role of the Federal Home Loan Bank system, and a host of other legislative and regulatory measures. The reality is that the U.S. has invested too much – especially in the last eight years – in building its stock of wasteful housing capital (whose effect on the productivity of labor is zero) and has not invested enough in the accumulation of productive physical capital (equipment, machinery, etc.) that leads to an increase in the productivity of labor and increases long run economic growth. This financial crisis is a crisis of accumulation of too much debt – by the household sector, the government and the country – to finance the accumulation of the most useless and unproductive form of capital, housing, that provides only housing services to consumers and has zippo effect on the productivity of labor. So enough of subsidizing the accumulation of even bigger MacMansions through the tax system and the GSEs.” (emphasis mine)

Not to mention that Freddie Mac and Fannie Mae (F&F) officials spent $170 billion during the last decade in lobbying to the US Congress to maintain such privileges. Corruption-free First World Economies? You must be joking.

The “too big to fail” rational has likewise been used as justification to shore up the ailing GSEs. This from CBS Marketwatch, ``[Treasury Secretary] Paulson said the global reach of Fannie and Freddie necessitated unprecedented action.” (highlight ours) Figure 2 from US Global funds shows of the extent of foreign ownership of Agency (F&F) Bonds.

Again this lends credence to our view that the US government’s continues to rely heavily on foreign financing and trade to buttress their economy even under today’s depressed post-bubble conditions. The problem is sustainability.

As CFA’s Brad Setser warns, ``The costs of a system that channeled huge sums of emerging market savings into the US real estate market — contributing to a bubble in US housing that is now collapsing, at a significant cost to all involved (private market players who bet that housing would only go up, the US government, and emerging market governments who bet on the dollar) and now a surge in inflation in the emerging world — are now quite apparent. It has produced a massive misallocation of resources on a global scale…And it now seems that this game will break down on the US end before it breaks on the emerging market end. The Agencies will run out of equity before central banks lose their willingness to buy Agency paper.” So will deflationary pressures in the US financial system cause a run in the US dollar?

The third beneficiary will be debtors over creditors. Creditors will be paid with depreciated currency. The public’s incentive will be to save less and consume more and consume today by borrowing more. In effect, inflation is a redistributive process of transferring real wealth from creditors to debtors. And once inflation begins to bite, people will call on government demanding compensation, aid and safety nets as we are seeing today.

Of course, the biggest beneficiary of inflation should be the biggest debtor, to quote Austrian economist Hans Senhholz in 2005, ``The biggest debtor also is the biggest inflation profiteer. With some eight trillion dollars in debt [$9,521,842,618,777.96 as of July 20, 2008 from brillig.com-mine], the Federal Government is by far the biggest winner. In fact, it gains not only from debt depreciation, which at just three percent amounts to some $240 billion every year, but also from Federal Reserve money and credit creation that enables the U.S. Treasury to suffer annual budget deficits of some $500 billion a year.”

In addition, liabilities from Medicare, Medicaid and Social Security and other welfare promises add up to $59 trillion (wikipedia.org) or $85.6 trillion (Federal Bank of Dallas President Richard Fisher).

Whereas foreign ownership of US debts have swelled over the years, this from wikipedia.org (emphasis mine), ``The US debt in the hands of foreign governments is 25% of the total, virtually double the 1988 figure of 13%. Despite the declining willingness of foreign investors to continue investing in US-dollar–denominated instruments as the US Dollar has fallen in 2007, the U.S. Treasury statistics indicate that, at the end of 2006, foreigners held 44% of federal debt held by the public. About 66% of that 44% was held by the central banks of other countries, in particular the central banks of Japan and China.”

So the likely path for the US government, as the biggest debtor, is to inflate its way out of its debts. And this we believe is functional seen via the transmission mechanism of currency pegs and US dollar links which aims to transmit stimulative policies to emerging markets see Reverse Coupling, Inflation From The Core and Current Account Deficits.

The fourth beneficiary are the industries that benefit from cross price elasticity of demand (about.com), ``the rate of response of quantity demanded of one good, due to a price change of another good. If two goods are substitutes, we should expect to see consumers purchase more of one good when the price of its substitute increases. Similarly if the two goods are complements, we should see a price rise in one good cause the demand for both goods to fall.” In short, substitution dynamics on the demand side arising from prices changes.

For instance, under high oil prices scenario, the tendency is for people to go for fuel efficient cars or bicycles or use more of public transportation as the preferred mode for transit.

This means that sales of big SUVs could be expected to decline (as it has been in the US) while smaller fuel efficient car industry sales, bicycle industry sales or public transportation revenues can be expected to rise.

But a caveat here, mainstream media suggests that the Philippines have met the threshold level of pain from energy prices enough to tilt the balance of car sales.

Look at this seemingly biased headline, “Soaring oil prices pull down June car sales”

From abs-cbnnews.com, ``Series of surges in fuel prices in the country have made their mark on automobile sales as car buyers shift from gas-guzzling and full-sized sport utility vehicles to economical and dual-purpose automobiles, the Chamber of Automotive and Manufacturers of the Philippines, Inc. and the Truck Manufacturers Association said in their joint report.

``The sales report showed that vehicle sales sustained their strength in the first-half of the year despite rising fuel prices, carrying a growth of 13.6 percent with 54,257 units sold to 61,654 units during the same period of 2007. But sales beginning in the month of June 2008 dwindled compared to the month of May, its second monthly decline for the year.

``June 2008 sales accounted to 10,772 units, 1.2 percent lower than the 10,900 sold in May. Sales, however, were still up 10.6 percent compared to the same month last year, which had 9,737 vehicles.”

Why biased? The article seems to give weight to the outcome from the reference point of month-to-month sales rather than from the year-on-year or from first half of the year sales in making such conclusions.

In other words, the article’s headline wants to reinforce the popular view that rising oil prices are having a big NEGATIVE impact on car sales, which is obviously NOT the case!

In nominal terms, June sales compared to May was 128 units lower compared to the 1,035 cars sold more relative to June of 2007. Common sense tells us that 1035 is almost 7 times greater than 128. To add, over the first semester, car sales had been up 7,397 units or an average of 10,275 units per month compared to last year’s 9,043 units per month!

So while the rate of change may be indeed by marginally decelerating, it isn’t enough to justify on the generalization that car sales were being NEGATIVELY impacted by rising oil prices!

But relative to cross price elasticity we see a confirmation of this phenomenon, `` shift from gas-guzzling and full-sized sport utility vehicles to economical and dual-purpose automobiles.”

And it goes the same way with the Philippine economy.

News accounts portray the Philippines in a helpless quagmire given the phenomenon of rising food and fuel prices. For me, such perspectives are politically designed-they are meant to either encourage government intervention or portray the incumbent as inept.

But if we examine the structural composition of the Philippine economy (as previously discussed in A Prospective Boom in Philippine Agriculture!) where agriculture accounts for about 36% of employment, 25% of exports and 16% of GDP, operating under a huge 13 million hectares (Food and Fertilizer Technology Center or agnet.org), booming agricultural prices (a.k.a. inflation) should translate to booming income for the rural farmers (ceteris paribus or all things being equal)!

Stated differently, while food prices are expected to hurt the urban poor, rural folks could be expected to benefit from rising food or agri prices.

Anyway as discussed in Politicking Weighs On Phisix, Inflation Problems Have Been Policy Induced with an accompanying chart from ADB’s Hyun H. Son, while the Poor’s expenditures for food accounts for nearly 50% of income, fuel related expenditures account for about 4% (2.5% for nonpoor), which extrapolates that food prices are having much greater impact to inflation figures more than oil prices.

As we have previously argued it is not high oil prices per se but the accelerated rate of change of oil prices that is having an impact on consumer sentiment or psychology. But overall, food is the most sensitive of all variables.

This also means that the “food inflation” menace looks likely a temporary phenomenon given the sudden shocks arising from the severe policy impelled distortions (e.g. trade prohibitions and subsidies) in the marketplace, as high “food” prices will lead to rising investment expenditures either from the government itself (e.g. nearly $1 billion in subsidies for fertilizer, rehabilitation of irrigation systems and post harvest facilities and high yielding rice varieties) or from the private sector (e.g. San Miguel-Kuok $1 billion venture) to the agricultural industry.

So from the standpoint of the incentives of political survival through government action to economic feasibility projects by the private sector all direction points towards massive investments in the agricultural industry, which should translate to higher supply in the future or lower statistical inflation data.

As aptly quoted by India’s Economic Times, ``"In virtually every country, there’s a recognition that they’ve got to increase investments in agriculture," said Robert Zeigler, director general of the Philippines-based International Rice Research Institute, which helped launch the green revolution.”

Thus while inflation is generally bad for the society because it robs the currency of its purchasing power which effectively depresses economic activities, some sectors actually benefits from the adjustments under such environment.

Hence, investing under such scenario should be selective. The notion that “inflation” is bad for all investments is a cockamamie.