Inflation: How We Got Here
Almost every trip the last six months, I’ve ended up discussing the same topic in almost every country: just how expensive everything has gotten. People are tightening belts, and seeing real reductions in their quality of life, and noticing price jumps in essentials.
Strangely though, I’m finding people raraly understand inflation or our current experience with it should have been more avoidable. While it’s not necessarily going to remove the helplessness a lot of people are feeling at the moment, I do find understanding a thing better normalizes it and leads to action. So, helping understand why something like rising interest rates are counter-intuitively used to try to induce price stability is worth knowing.
Also, while the current round of inflation is different from other experiences in the 20th century. While current inflationary presures are partially the fault of global shocks, perhaps the key drive of the extremes we’re seeing, and the difficulty central banks are having in reining it in is predatory profit taking and government agencies asleep at the regulatory wheel.
In sum, an fascinating story pestilence, war, greed, and poor business management, which we’re all suffering through. And one we can take actions on to prevent in the future from happening again.
The Cost of Money
First off, let’s talk about inflation. What it is and isn’t.
Inflation is like air. You don’t really notice it until its oppressive, like when you’re sucking wind post-workout. And for the last decade or so inflation has been easy to ignore as e’ve had one of the longest, sustained periods of low inflation and interest rates (in some cases, negative) in history. But you ignore inflation at your peril, as we’re finding out. Why? Inflation, and its flipside cousin, interest rates, should be thought of as the time cost of money. And ignoring the costs of something so ubiquitous and that you don’t think will change is a bad assumption that has caught everyone flatfooted, causing pain and even bank failures as people are suddenly forced to pay back cheap money with pricier payments.
At its most basic, money is issued by governments which citizens are legally obligated to recognize as payment on debts. Governments use taxes to raise these funds and issue tender to create, “the Money Supply”.
In theory, demand and supply for goods and the relative way people value them lead to fluctuations in prices over time. This is “natural” inflation. So, too the amount of money in circulation to pay for those goods, money supply, sets the value of a particular unit of currency and how much purchasing power it has to purchase the total demand for goods and services. More money circulating means prices are cheaper (the danger of governments printing money making the unit currency “cheaper” in terms of its purchasing power.). The less money in circulation, the more pricey. This aggregate change in these prices in the economy over a set period of time is what we know as… inflation.
$$Inflation = \frac{Prices \space now - Prices \space before}{Prices \space before}$$
So, here’s the practical upshot to take away (as I’m always chocked by my friends who just park money in bank accounts at 1.3%): If your money has always just been sitting around under your mattress like Scrooge McDuck, and inflation is positive, your money is worth less next year than it is right now. You’re losing money. There s a price to letting money sit idle. And that price is inflation.
So, Explain the Interest Rate Increasing Thing?
Interest rates are inflation’s soap opera twin. And again, reflect the time cost of money (and risk).
In this case though, it’s all about lending and lenders than the prices in the economy and the money supply.
Lenders (banks, VCs, Capital funds) are constantly trying to make sure their money is not going down in value and re-allocating it to places of balanced risk versus return.
If you are a lender, having the money you are owed paid back in a year in last year’s with this year’s cheaper money (because of inflation) is a bad deal for you. If you are lending money out to someone that wants it, you need to take into account projected inflation and also put a premium on top of the that in order to take into account your cost of lending, as well as the risk of non-payment. We want to not lose money after all.
Macro-economically, the Nobel-famous Fisher Equation which talks about the direct relation between interest rates and inflation.
$$Interest \space Rate = “real” \space interest \space rate + Inflation$$
So, when inflation goes up, the observed “natural” interest rate goes up. This happens regardless of central bank intervention.
Enter the central bank. The central bank has a number of responsibilites: managing the money supply, keeping prices, stable, and loaning money to commerical banks in need of liquidity.
So, how does the central bank attempt to induce price satbility and low inflation? It attempts to maintain a narrow band where prices go up slightly enough each year to drive investment and lending to keep the wheels of our economy turning but without increasing prices enough to be a drag on spending and the economy. So, the bank raises the central bank lending rate to commerical banks.
Why? Doesn’t raising interest rates make things worse?
When interest rates are very low, as they have been the last decade, money is cheap. It makes sense to borrow as a business or a consumer and move consumption from the future to the present. You borrow and spend - usually in order to get a better return than if you spaced out your investments over time as the net present value of a lump sum now is generally worth more than it would be later..
Raising the central bank rate makes that more expensive for commerical banks. they borrow less as it gets more expensive, and thus reduce the money supply, which money ore valuable, ostensibly curbing inflation as others cut back on consumption (since the commerical banks pass along their rates at a markup to retail borrowers).
The theory being, since people and businesses cannot afford the new things they want as interest rates go up, spending falls. As demand lessens, but supply remains consistent, prices drop to lower levels. At least in theory, this tames inflation and brings it to heel, stabilizing prices.
But… we’ve all seen that inflation is having trouble being tamed. Multiple rounds of central bank interest rate rises don’t seem to have cooled inflation and if anything, there seems to be ample evidence that many critical prices are increasing faster than the inflation rate as defined via the consumer price index.
Rents, groceries, and energy, three critical factors most peope cannot substitute for, have jumped enormously causing a lot of pain and insecurity for people. So, what gives? Worse still, inflation appears to be increasing much faster than wages are increasing, providing a horrible double whammy of not just money that is worth less, but you having less of it in relation to increasing prices.
And herein lies the beginnings of our tale of pestilence, war, and greed that has stoked inflationary fires, and made our combined lives so much harder the last year. And why the tale is so much different than other inflationary shocks we’ve seen to the end of the 20th century.
Let’s look at the factors:
- Pestilence
- War
- Greed
Pestilence
COVID. A globe-shutting pandemic was an economic shock unprecedented in our modern world. In a world economy, where many countries had shifted to services, rather than goods, the cnotraction to the economy was sharp and sudden.
While governments provided stimulus to insulate citizens and companies, those shocks were blunted, not eliminated, and now the economy has started picking uip and stimuli are ending, the stimuli that artificially buoyed people and companies up over the pandemic period are ending. Creating a gap between what people can pay and what things cost as demand increases for hard goods increase due to demand shocks versus the supplies available.
To say nothing of the companies and jobs lost during the pandemic which led to an economic contraction and less activity in the economy in general.
This was the classic demand shock as the world re-opened. While services were largely curtailed in spending over the lockdowns, the sudden opening up, the lack of inventory and wholesale shift from services to goods purchasing post-covid (and continuing) caused prices to rise and started off the rapid consumer price index increases we saw in 2021.
War
Our second Horseman was the unprovoked attack on Ukraine by Russia.
Few people realize how dependent global food supplies are on Europe’s breadbasket for raw foodstuffs, or how dependent Western European economies were on Russian fossil fuels for energy needs. Supply shocks to both of these with even constant demand has meant that prices for both these raw materials which make up so many other things, have gone up.
Food and energy are also two items for which there are few viable substitutes. Consumers nor businesses cannot simply pivot to alternatives instantly and since these two items are components of almost all production, businesses in most cases had little choice but to pass those price increases along to consumers to prevent deterioration of profit margins, much less bankruptcy.
Though, the energy shock cause by Russia’s invasion does have a small silver lining. It has accelerated Western European adoption of renewables and alternatives and moved up timetables on energy independence and transition from fossil fuels an estimated entire decade. Something numerous COP conferences have failed to do in a timely or climate change effective manner.
Greed
It’s hard to dodge Horsemen, and together they could arguably account for what we could have been seen as normal levels of inflation we should have seen. This inflationary period has been extreme.
Across the board, price hikes we’ve seen in groceries, rent, energy, transportation, and other essentials seem to be cruising at extremes of 30-40%, well above the inflation rates of 10% we’re seeing the general consumer price index. Why?
Sadly, it comes down to good old-fashioned greed.
I’d separate these into three distinct areas all of which are failures in business and govnerment to keep economies and sectors competitive.
- Corporate concentration
- Excuse-flation
- Poor business management
Corporate concentration
Economics believes in competition. Businesses prefer monopolies.
The last two decades in North America and globally have seen an unprecedented increase in the concentration of certain industries into a few (or single) corporations with the power to raise prices with impunity.
Why are we seeing record corporate profits at a time when inflation and ecnomic shocks would seem to indicate companies should be suffering alongside consumers.Simple. These companies can raise prices with impunity because there are few, if any substitutes for their goods. Or the industies they are in have the same pricing power which effectively amounts ot collusive price setting.
Normally, firms would cut prices in order to assure customers were not stolen by competitors, but the fact is, between greater concentration of market power, and arrangements of market interest, many of these frims can raise prices with impunity because there are simply no effective competitors tbat can steal customers.
And we’re seeing this in industries from eggs to oil, where large conentration of near-monopoly power, that should have been prevented in terms of mergers and acquisitions are now using the cover of natural inflation to rachet up pricing into stratospheric ranges to boost profits and undercut consumers.
Excuse-flation
Hand-in-hand with the above, we’re seeing corporations when called out on this behaviour, spinning reasonable sounding excuses for price increases well beyond those dictated by inflationary or even exceptional pressures.
Pat explanations like avian flu suddenly becoming a reason egg prices have soared, or that chicken is at multiples of what it formerly charged per kilo even though the logic on those increases far away outstrips the price increase that would make sense from simply passing along inflationary price increases.
In fact, where you have just a few oligopolistic firms in a particular segment, you see them both increasing prices in order to keep driving profits. P&G is an excellent example of a company that cited the need to increase prices while recording record profits. As did such companies as PepsiCo and Kinmberley-Clark, often in industries where there are few alterantives (as a more insidious example, P&G and K-C control the vast majority of the diaper market and increased prices there dramatically, despite having record profits in those segements.).
Since people are expecting there to be inflation, firms are using its cover to jacl prices and pad bottom lines with monopolistic profits. Why? Because many firms lack viable competition and regulators have done a poor job of preventing a build up in monopoly power in many of these industries.
So, oligopoly pricing, no viable competition, and maintaining record profits are done at a time of severe hardship for numerous consumers as inflation erodes their purchasing power.
Bad Business Management
When money was cheap, VCs were willing to take some big risks on companies banking on what I’ll call, “the Amazon model.” That is, companies engaging in hyper growth in order to build large, monopolistic, defensible customer bases, that they would then profit from “later”.
The trick here is that most companies were trying to create monopolies or near collusive oligopolies that had fundamentally bad economics. The playbook is:
- Heavily subsidize consiumer behaviour change
- Drive out viable alternatives and/or competitors
- Use monopoly/oligoploy power to increase prices and reduce supplier value
We’ve seen this is a raft of highly fragmented businesses, from ride hailing to food delivery where companies made it cheap, even convenient for us to use these services despite the fact VC econmics subsidizing rides, food, deliveries, or flights were all about growing market dominance to the point they could eliminate alternatives and then driving up the cost of the service and reducing the costs driven by
Even in industries where monopoly power does not exist, VCs have funded creating new monopoly sectors, subsidizing consumoption to drive out rivals in fragmented or unconsolidated industries and attempting to create monopoly power all the better to ten use teir position o raise prices on consumers, reduce payments and surplus to suppliers or providers, and take the excess while providing definitively lower consumer value.
Fin
And basically, that’s where we find ourselves in early 2023. Greed, warm and pestilence have made money more expensive to the point a lot of people are suffering and making some serious changes to their lives. But, mostly greed.
While little can be done about war and pestilence, and most governments have done better than most get credit for at navigating those exogenous shocks, the most disturbing thing affecting the accelerated inflation we’re seeing in areas is pure monopoly profit taking from companies in industries where government has failed to regulate effectively or prevent anti-competitive combines from forming in the last decade.
Worse still, while subsidies and help exist to bolster companies and large institutions, we seem to be getting ever farther into the situation characterized by Martin Luther Kind,
“We all too often have socialism for the rich and rugged free market capitalism for the poor.
where large scale assistance seems to be available to insulate you from your errors and misdeeds if you’re large enough, but the rest of us are expected to go it alone with market forces and our wits and means.
In this case, the only viable option seems to be for an increase and reversal of the deregulation that has led to so much abuse and consumer hostile behaviour. Much like Robert reich I find myself advocating again for some tooth to be added back to agencies responsible for protecting the public trust and the tenets of economics over big business to prevent us from entering another Gilded Age. Increase competition, level playing fields for businesses, and tents of free and competitive markets.
I hope you found this post enlightening. It was a hard one to write. Lemme know if you did via mail or elephant below. Interested in feedback. Feel free to mention or ping me on @awws on mastodon or email me at hola@wakatara.com.