The Answer is Yes

I remember many years ago, when people first started having their cholesterol checked, the result was just one number, the total cholesterol number. People talked about their “cholesterol” (the total) as if it were just one monolithic reading. But as time went on people realized that this was misleading. They learned that to really understand what was going on they needed to look deeper to the “HDL” and “LDL” components of total cholesterol, because those are two very different things that function in very different ways with very different effects.

We learned our lesson on cholesterol, but not inflation. The financial press is full of debates on inflation vs. deflation. Are QE, ZIRP (zero interest rate policy) and deficit spending sowing the seeds of future inflation? Or will excess capacity and unemployment drive deflation? Is core inflation near zero the correct measure? Or should we fret over record price rises for food, oil, gold and other commodities? The entire debate treats inflation like one monolithic reading that is either “high” or “low”, “good” or “bad”. But like total cholesterol, it is not that simple. The proper way to look at inflation is by looking at its main components.

Prices are driven by the cost of their labor, material, and capital inputs. To make something in a factory you have to have investors and lenders provide the money (capital input) to build the factory, and you need the material and labor inputs to run the factory and make the products. Looking at each of these components separately, it is easy to see that labor costs will remain constrained by unemployment in the developed world and by huge pools of cheap labor in emerging markets. Capital costs will remain constrained because industrial utilization is low and emerging markets have overbuilt industrial capacity in their export industries, particularly in China (just like Japan in the 80’s). Prices for materials, on the other hand, will continue to be supported by physical capacity limitations (there is only so much oil, copper, molybdenum, etc. in the ground), emerging market populations moving to cities (where, for example, they eat more meat, which requires a lot of grain to produce, and use more plastics, oil and gas), and by lousy yields on most investments (which makes gold, copper, etc. more attractive as alternative investments).

So in the debate over inflation vs. deflation… the answer is yes. Labor and capital deflation. Materials inflation. Until… material inflation forms a bubble that gets bad enough that it chokes off all economic growth, at which point the bubble collapses and then everything is deflationary. When this happens it will be a very difficult time for the world economy. When will it happen? Maybe this year, maybe next, maybe even the year after (but I really doubt it). My best guess is that it happens before the end of this year. Oil at $100, Chinese real estate priced like Japan in the 80’s, Facebook worth $50 billion – these are all signs of a developing bubble. The end of QE2 and impending (I hope!) reductions in government deficits (fiscal tightening) could be the pins that prick the bubble. Or maybe not. Maybe the economy is strong enough to continue growing into next year without stimulus, but this will simply drive up materials prices more, making the inevitable bust that much more painful.

Recognizing a developing bubble is easy. Predicting it will end badly is easy. Predicting when it will end, or how high it will go before it ends, is very hard. Caveat emptor.