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Generational Dynamics Web Log for 25-Apr-2011
25-Apr-11 News -- Skyrocketing food and fuel prices spur inflation fears

Web Log - April, 2011

25-Apr-11 News -- Skyrocketing food and fuel prices spur inflation fears

The inflation versus deflation debate

Skyrocketing food and fuel prices spur inflation fears

Global wheat prices are "on fire," according to Barrons, because of a relentless drought in Europe, Oklahoma and Texas. Wheat futures are now approaching $10 per bushel, up from around $4 just a few years ago, and the fear is that wheat prices will go even higher as the May harvest approaches.

Trees that were once mostly submerged are now high and dry (Texas Tribune)

Trees that were once mostly submerged are now high and dry (Texas Tribune)

All of Texas is extremely dry, and since the beginning of October, barely one-tenth of an inch of rain has fallen on Midland, according to the Texas Tribune. It's hoped that the La Niña weather pattern that has contributed to the severe drought will be weak or gone by summer, but that will be too late for the next wheat harvest.

Europe is experiencing the worst drought for a century, with almost no rainfall in April, according to AFP. The wheat harvest is at risk, and there's fear of widespread, devastating wild fires.

Oil and food prices, 2000 to present (Seeking Alpha)

Oil and food prices, 2000 to present (Seeking Alpha)

The world food price index is now larger than it was during the food crisis of 2008, when there were widespread food riots, especially in developing countries. However, the price of rice, a staple in many developing countries, has remained fairly stable, and so developing countries are not being as badly hit this time, according to an analysis by Carnegie’s International Economics Program appearing in Seeking Alpha.

Inflation versus Deflation

Many politicians and mainstream analysts are pointing to the rise in oil and food prices as proof that the dollar is weakening and (hyper)inflation is setting in, even though the consumer price index (CPI) has remained low. The price rise in these commodities does not necessarily indicate inflation, especially since wages have remained flat. With wages flat, high food/fuel prices simply mean that consumers have less money to spend on other goods, pushing those prices down, canceling the rising prices on food and fuel.

As I wrote in 2004 (see "CPI data points to deflation trend"), a Law of Mean Reversion analysis on the CPI indicates that it will fall. I still expect the CPI to fall 30% in three years after the real financial crisis occurs, just as it rose 30% in three years from 1977-80.

The inflation versus deflation debated has been extremely animated in the Generational Dynamics forum for several years. It's worthwhile repeating here a few recent postings.

Member "richard5za," an investor in South Africa, expects a great deal of inflation in the U.S. dollar. He said that investors would soon begin to "flee from the dollar." I asked him what investors would flee the dollar into. He wrote,

"You would flee the dollar into what is called "inflation hedges" as we did in the 70s with pounds and rands etc to protect the value of our money. That was a period of little economic growth and quite high inflation, which came to be called stagflation.
Real estate is a favourite inflation hedge especially that in prime positions; when all is settled at the end of the economic abberation, whether that is 5, 10 or 15 years, its still worth what it was in real terms. Zimbabwe had massive inflation, but using google go onto a website selling houses in Harare and you will see respectable dollar prices for the houses. The value has been retained for the owners across the period of inflation devastation.
Gold is another inflation hedge but can be risky; for instance in the early eighties when it was clear that the inflationary period was over, the gold price dropped sharply. Also some commodities and precious stones e.g. diamonds. ...
Rare antiques are another favourite - there's a world shortage and they'll get their value back in times of stability."

Richard explained further by telling some of his personal history:

"I finished all my studies in 1968 and secured employment with a successful British multinational group. In 1971 the "big boss" said to me "Boy, do you own a house?" I said "No, Sir"
He said "Well, I think inflation may increase and I am strongly advising you to buy a house. If you need to borrow money for the deposit then the company will help you." "Thank you very much, Sir." So I bought a middle class house on 1000 sq m of ground.
In 1973 the "big boss" said to me "Richard (I had graduated from boy to Richard) I am very worried about inflation and I am organising for all management the opportunity to buy good quality antiques as an inflation hedge."
I bought the most magnificient 1695 long case clock (grandfather) It was a London maker and the case was exquisite. it was a business matter with business disciplines so when I sold it in 1987 for 12 times what I paid I told myself to be very grateful for the 14 years of wonderful stewardship."

Richard says that he made a great deal of money investing further in real estate, and also made money in stocks in the 1980s. He concluded,

"I was now very busy with my career, having become CEO, and my funds were being handled by a finacial advisor. In 2006 I retired (for the first time) and took over my personal finacial management again, and in 2007 I sold all my stocks except for 5% which I put into gold and gold miners. That amount has done well and doubled.
So what I am trying to say is that it doesn't matter what the economic circumstances may be, you can flee what ever currency you want, put your money into hedges. commodities, property, whatever is the right decision for the circumstances."

From the point of view of Generational Dynamics analysis, this 1970s inflation hedging strategy wouldn't work today. I explained by telling my own 1970s story.

The other side of the 1970s

When I was working for Digital Equipment Corp. (may it rest in peace) in the 1970s, there was a girl who had an entry level job as a computer operator. After she'd been there a couple of years, she left DEC and went to Data General (RIP) with a good salary increase. After a few months, she left DG and went to Wang (RIP), with a good salary increase. After a few more months, she left Wang and came back to DEC. The net effect is that in the space of a year she had changed jobs three times and almost doubled her salary at DEC.

There were lots of stories of that kind in the 1970s. It was well known that anyone with good skills and willing to work hard could change jobs and get a good salary increase.

I don't agree with the "stagflation" characterization of the 1970s. There was plenty of inflation, and it's true that the stock market fell during the 1970s (which I believe is why people use the word 'stagnation'), but the economy was extremely vibrant in the 1970s. Everyone knew that people who had bought IBM or DEC or Xerox stocks had made out like bandits (to use a phrase I heard at the time) -- not because speculators had created a stock market bubble, but because these companies had scored some real technological achievements.

In the 1970s, almost every company was still "young". Almost every business had gone bankrupt in the 1930s, and the ones that hadn't had to totally restructure. By the 1970s, all of these businesses were at their peak of robustness and productivity. New products and technologies were coming out all the time. Skilled workers were in high demand, and even unskilled workers had no trouble getting a job. There were plenty of job openings, and not enough workers to fill them. As a result, salaries increased -- based on merit, not based on social skills -- resulting in inflation.

The other thing about the 1970s is that everyone was worried about a new stock market crash. You could walk into a bookstore and find several books on "How to survive the next Great Depression."

Now today, all of those indicators are flipped on their heads. Each job opening gets hundreds of applicants. If you change jobs, then you have to take a salary cut. Jobs in the last decade have fled overseas, seeking low salaries rather than high skills.

Today's businesses are no longer "young." This is something I haven't written about lately, but I used to call it the "crusty old bureaucracy" effect, using a phrase that I'd seen in a description of some company. Lots of employees do little or nothing but sit around. Salaries are increased based on longevity only, with little relationship to skills. There's little innovation going on, with something like the iPad providing a rare exception. Today we have REAL stagnation.

In the 1970s, people worried about a new Great Depression, because that's what they remembered from the 1930s. Today, people are worried about a new Great Inflation, because that's what they remember from the 1970s. A new Great Depression couldn't have occurred in the 1970s because the wrong generational constellation was in place, and a new Great Inflation can't occur today for the same reason.

Everything is in a bubble. Stocks have had historically high valuations since 1995. Real estate has been in a bubble internationally since 1995, and has only partially recovered. Gold's long-trend trend value is about $500/oz, but now it's in a bubble at three times its trend value.

So now assume a hypothetical scenario where there is 10% inflation, and you follow Richard's hedging strategy. You're talking about assets that are already in a bubble, and by the time that 10% inflation is reached (as if that's possible), the bubble would be much bigger. With huge amounts of liquidity flowing into gold, for example, the price would go from 3 times trend to 10 times trend.

And this is where you run into the logical contradiction. The inflation hedge assets are already in a bubble, the bubble would be growing even larger, investors would realize that these hedges are way overpriced, and many would stay in the "safe" dollar rather than risk a bursting bubble.

Of course you can always invest in real estate or gold, knowing that its price will eventually go up. But you could have invested in stocks in 1929, and you would have made money by the mid-1950s.

So now, to close the circle, the businesses with a "crusty old bureaucries" are going to be destroyed or forced to restructure, like similar businesses in the 1930s. With layoffs increasing and salaries decreasing, there's no chance of anything close to 10% inflation. Investors will not flee the dollar.

From the point of view of generational theory, what we're going through now is a generational financial crisis. At it's core, a generational crisis is based on widespread abuse of credit and securitization -- tulip certificates in Tulipomania (1637), South Sea shares in the 1721 South Sea bubble, "assignats" (credit based on lands confiscated from the clergy) in the bankruptcy of the French Monarchy in 1789, railway shares in the Panic of 1857, and stock shares and foreign bonds in 1929. Today we still have tens of trillions of dollars in toxic assets, in the form of CDOs, CDSs, and other synthetic securities.

So you can't have a generational financial crisis that leads to inflation. A generational crisis, at its core, is based on widespread abuse of credit, creating a huge bubble. When the bubble bursts, there must be deflation. It can't happen any other way, as far as I know.

(Comments: For reader comments, questions and discussion, see the 25-Apr-11 News -- Skyrocketing food and fuel prices spur inflation fears thread of the Generational Dynamics forum. Comments may be posted anonymously.) (25-Apr-2011) Permanent Link
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Generational Dynamics Web Log for 25-Apr-2011 25-Apr-11 News -- Skyrocketing food and fuel prices spur inflation fears

Skyrocketing food and fuel prices spur inflation fears

Inflation versus Deflation

The other side of the 1970s

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Generational Dynamics Web Log for 25-Apr-2011
25-Apr-11 News -- Skyrocketing food and fuel prices spur inflation fears