Background effects
There is only one difference between a bad economist and a good one: the bad economist confines himself to the visible effect; the good economist takes into account both the effect that can be seen and those effects that must be foreseen.
Frederic Bastiat
When scientists try to measure something, they always need to be wary of the background effects. Are you measuring the radiation from the item you want to measure, or the background radiation in the room?
This is a fascinating concept to me. It can have quirky consequences, notably, there is a semi-black market for metals forged before 1945, as all steel made since is slightly radioactive from nuclear bombs blown into the atmosphere. Non-radioactive steel is a vital component for Geiger counters (the irony…) and medical apparatus.
I believe economics have similar background effects that are hard to notice. They fly under the radar of the news stream, as they are so slow-moving and unimpressive at first. Even if they are measured, they are mistaken as part of another signal. But when they start to matter, it overwhelms the other temporary factors.
For now decades, no matter what monetary policy did, inflation stayed stubbornly low, to the frustration of central bankers. This was still true less than a year ago
The reason for this was partly that the “money printing” poorly made its way into the “real” economy. Instead, it stayed into stocks and assets like real estate, pumping up no less than 3 successive bubbles in 25 years (dot-com, subprime, and the current everything-bubble).
Background deflation
Another factor that kept inflation in check was what I would call background deflation. There were plenty of real forces at play helping to keep the price down:
Cheap labor, from globalization + digitalization
2 billions+ Asians living subsistence farming and entering the global economy
Conversion to the capitalism of the USSR/Eastern Europe highly educated labor force
Globalization/offshoring using said cheap Asian/Eastern labor
Cheap trade/transportation/communication
Containers ships.
Information technology.
Mass air travel.
High-speed electric trains.
Cheap energy in abundant supply.
Nuclear energy.
Massive worldwide hydropower construction (especially in China and South America) on previously untapped sites.
Consistently growing supply of coal/gas/oil.
Cheap food
Green revolution (cheap energy = cheap fertilizer).
Industrial farming (eroding topsoil, but appearing “efficient” for a few decades).
Deforestation (Brazil, Indonesia, …).
Cheap capital costs
Central bank providing liquidity
Declining interest rates and consequence-free rising debt
Just in time manufacturing (low inventory costs)
The dominance of capital-light growth business models, aka tech
Background Inflation
Ultimately, all background deflation causes came from the American-led world order. Starting from Nixon's pact with China and Japan rise, accelerating with the fall of the USSR and heading for a peak after China entry into the WTO.
I argued previously that the last 12 months have officialized the entry in a multipolar era. This will revert most of the background deflation effects. In addition, additional background inflation effects are growing. Some of those are temporary (5-10 years to fix) like infrastructure shortcomings. Some of them are going to last for many decades.
Cost of labor:
de-globalization, re-shoring
international sanctions
No large pool of qualified labor is left untapped (no, Africa doesn’t count)
Rising Asian salaries
Unionization
Welfare state / UBI (Universal Basic Income) = decline labor participation rate
Cost of trade/transportation/communication
Insufficient infrastructure built (harbor backlog, not enough ships, …)
Insufficient maintenance of infrastructures, especially bridges and railroads
Rising utility grid costs (aging pipes, electric grid, etc…)
Unionization (French-style strikes getting more common worldwide)
Expensive energy
Stubborn ideological oppositions to nuclear
Phasing out coal in most countries
Green transition miscalculation the cost of intermittency
No large and cheap Oil&Gas deposit left untapped, except maybe in Brazil/Guyana (the Arctic is never cheap, nor is ultradeep water drilling)
Expensive (rare?) food
Soil erosion from industrial farming + declining fertility
Deforestation = weakened ecosystem, altered rainfall patterns
Climate change
Rising capital costs
Central bank removing liquidity (unlikely to last tho…)
Rising interest rates, still deep below inflation
Just-in-case hoarding/stockpilling replace just-in-time (high inventory costs)
Debt load becomes an issue
Takeaway
No matter what happens in the supply chain, the Ukraine war outcome, or how many solar panels we install this year, the regime change to background inflation is now a given.
The changes were in the air for already 2-3 years to the astute observer, but they really hit the ground last December.
Russia will stay a pariah state for the West.
China will keep getting more assertive, provoking deglobalization.
Shell-shocked companies will rebuild inventory.
Infrastructure budgets will stay up and up.
10 years of insufficient exploration and capex will keep oil&gas in short supply
New nuclear stations take 10 years at least to get started
Topsoil erosion will take decades to be corrected, and is barely discussed at all yet
I would however have to admit the deflationists still have a few aces up their sleeve. I don’t think that will be enough, but we can hope it will limit the damages.
Declining/aging demography worldwide, out of Middle-East / Africa.
Rise of remote work and other IT-driven boosters of productivity and better use of human capital.
Robotics and automation, keeping some pressure on labor costs.
In the long run
In the long run, I expect inflation to subside in 10-15 years. Deglobalization will reach a new equilibrium. Nuclear power will experiment a renaissance.
I hope farming practice will incorporate more regenerative agriculture practices. Vertical farming or artificial starch production might be part of the solution as well.
Robotics, automation, and self-driving might take longer to go to scale, but they will get there.
Who knows, maybe SpaceX will bring orbital flight so cheap that space-based solar power or asteroid mining are viable. Or nuclear fusion will be commercially viable.
So this should not be a doomsday inflation forecast. It will be rough but should get better after a while. At least as long as government refrains from even more massive money printing to buy votes/appease the mob (a long shot?).
Nevertheless, the heating up will burn most investors, as anybody with less than 40 years of investing behind him has never experienced firsthand background inflation. This will have radical consequences when applied to inflexible strategies.
Bonds might fall in tandem with stock in the traditional 60/40 portfolio.
Long-lasting, low-maintenance, expensive assets (for example, hydropower dams) might become a lot more valuable.
Business models based on cheap capital and constantly spending more money (Uber, Twitter, Netflix, etc…) might discover that refinancing can turn deadly.
Historically, stagflation periods like the 70s were good for commodities, energy and gold, and little else. It was terrible for tech or anything overvalued really. And not great for the rest either
Consumers squeezed by the rising price of basic necessities tend to cut spending everywhere else. So even if the re-opening trade might mask it for a while, I will stay away from tourism, hospitality, luxury, streaming, expensive gadgets, etc… When facing the risk of stagflation, this feels like picking pennies in front of a steamroller.