An astute observer of longer-term trends, Fred Demers, Director, Multi-Asset Solutions Team, helps institutional investors avoid recency bias by drawing insights from the history of inflation.  

“Inflation is when you pay fifteen dollars for the ten-dollar haircut you used to get for five dollars when you had hair.” – Sam Ewing

A Bird’s Eye View of History

Anyone who studies the roughly 2,500 years of modern human history will find a surprising number of inflationary periods that have occurred across the world. The Roman Empire, for example, tried to fool its citizens by reducing the amount of copper used in their coinage. But merchants were smart enough to notice the minting value had diminished, which led to an increase in prices for a bushel of wheat and other staple goods. France had a similar experience in the 18^th century when Napoleon Bonaparte used huge fiscal deficits to finance his expansionary wars. And, of course, it famously took a wheelbarrow filled with deutsche marks to buy a loaf of bread in Germany under the Weimar Republic.

In the case of Napoleonic France, economists like Adam Smith had only begun to understand the relationship between borrowing and inflation, the consequences of government debt, and the impacts on real economic growth. We learned then that you cannot create wealth out of thin air. Of course, if a tangible commodity were to be newly discovered, such as when Spanish explorers uncovered gold inventories in North America, the intrinsic value of those physical assets could indeed expand a country’s wealth. But with fiat currencies, it’s a zero-sum game. Every dollar you borrow to spend today comes at the expense of consumption tomorrow. That’s why for many institutional investors the word “inflation” rhymes with monetary policy.

The Quest to Tame Inflation

During the Great Depression of the 1930s, we saw an outright deterioration in living standards as price growth consistently outpaced GDP. It was a massive destruction of wealth that, among other things, contributed to the outbreak of World War II. However, the post-war economics looked extremely different—there was a massive capital drain from the U.S. to Europe as money flowed across the Atlantic as part of the Marshall Plan to rebuild the continent. Exchange rates were carefully managed such that Germany’s deutsche mark, France’s franc and Italy’s lira did not surge on the capital influx. The countries needed policy controls in order to maintain a competitive position and rebuild their manufacturing capacity to satisfy the growing appetite of U.S. consumers.   

Later on, in the 1970s, policy makers embarked on a 50-year crusade to solve the business cycle. In addition to managing the money supply, central bankers believed it was possible to control the risk-free lending rate with enough dexterity to smooth out the business cycle. I would argue their track record has been disappointing.

“Inflation is taxation without legislation.” – Milton Friedman

There is no natural law saying central banks should control the overnight rate—it is a modern concept. However, one policy innovation that’s beyond debate is the establishment of central banks as the lenders of last resort. There’s no debate on that front. Having an independent entity to provide liquidity without any concern for profits has been incredible for the stability of markets. A private bank must, by nature, turn off the credit tap when the future becomes uncertain, but a central bank can afford to interject as much as is needed for the system to resume normal functioning.  

Many investors worry that the current environment is reminiscent of the 1970s and early 1980s when inflation peaked at 14.8%. The comparison is understandable: the current standoff over Russian energy production has echoes of the OPEC oil embargo, and rises in the Consumer Price Index (CPI) are at levels not seen in more than 40 years. However, the underlying demographics are entirely different. Back then, Baby Boomers were moving into the cohort of workers and increasing their wages, whereas now the situation is reversed in many Western countries (and Japan) given that the same generation is actually leaving the workforce. This aging dynamic creates deflationary pressures that should ultimately prevent the U.S. economy from sliding into another decade of 1970s-style stagflation.

Central banks’ strategies for crisis management have also changed significantly. In the past, former U.S. Federal Reserve Chairman Paul Volcker used to favour hard medicine—raising the overnight interest rate to nearly 20%—to “kill the beast” of inflation. His aggressive and decisive policy actions kickstarted back-to-back recessions. By contrast, it’s become apparent in the past year that Chairman Jerome Powell’s Fed was behind the curve on inflation, hesitating to raise interest rates until the CPI was already well beyond the Fed’s target range. They unfortunately waited too long to cool down the economy and, as a result, we’re now seeing a resurgence of runaway inflation.

“I do not think it is an exaggeration to say history is largely a history of inflation, usually inflations engineered by governments for the gain of governments.” – Friedrich Hayek

The Politics of Inflation

There’s a saying that inflation is always a political choice. The argument is that elected officials who try to engineer higher living standards without any real gains in productivity are the original driver of inflation. Case in point: if workers suddenly experienced 10% productivity growth, then a corresponding rise in wages would be validated by their increased contribution to the company or economy. But to increase those wages without a comparable gain in output is to effectively re-distribute income from the most productive areas of the economy to the least. It’s a subtle balancing act. But policy makers must ultimately remember that spending money, especially printed money, is not a purely additive process.

Inflation is a reflection of the extra dollars that are in the system—money that cannot be matched by our capacity to produce goods and services. And our capacity is limited by finite resources, whether it’s oil and gas, land or hours of human labour. This is accepted wisdom. Yet in 2020, we saw governments initiate enormous spending programs as our capacity to produce was constrained by COVID-related lockdowns. Are we surprised this resulted in inflation? We know interest rates can impact demand and asset prices through an indirect transmission process. So, if you send cheques in the mail using the direct linkages of fiscal policy, that money is deposited into real bank accounts and then spent.

People have a propensity to consume. Politicians have a propensity to spend. And policy makers, despite their best of intentions, have a propensity to forget that their actions can have dire consequences for the rest of the economy.