Inflation. Ask not for whom the bell tolls; it tolls for thee.
Every worthy investor learns much that he or she need know in a crisis. Little can be learned from the press and social media though: when you stand at the pinnacle of free financial journalism, you’re standing at sea level.
There are exceptions to the rule. Walter Bagehot, editor of The Economist, was one. John Chamberlain, Garet Garrett, were others. James Grant remains one. Each adds something different to the prosaic business of financial and economic reporting.
Each waged a battle against inflation.
Inflation is often reduced to the phrase, “too much money chasing too few goods.” It is too narrow a definition. Inflation is too much money. What the redundant increment of purchasing power chooses to chase is variable, but always dangerous. It varies from cycle to cycle.
In one cyclical interval, dollars may chase skirts — or avocado or electric cars. This is inflation at the checkout counter, the familiar CPI variety. Or the dollars may chase shares — or bonds or real estate. In the city, this is the kind of inflation known as a bull market. We, in the city, cheer a bull market. Mostly.
This type of inflation — the inflation of asset values — is the kind of inflation that is prevalent today.
A fifth of all the dollars in existence were created last year. In the past year, the world’s central banks have materialised — net — over $4 trillion. Conjured, on their computer keyboards. It is a lot of money, even if you say it quickly. It may help to grasp the meaning of this number to know that if you counted to just one-million at one number per second — with no breaks — it would take 12 days of continuous counting. To do the same for two trillion, it would take 62,000 years.
Deflation, too, is a perennially misunderstood term. It is not — as one so often hears it defined — a simple decline in aggregate prices. If you lived in a time of material and technological wonder: of digital technology that sets robots to work; makes universally accessible the complete breadth and depth of human knowledge; and coordinates the world’s far-flung labour markets, as it costs less to make things, so it should cost less to buy them.
Would you call this happy state of affairs deflation — or would you call it progress? Governments hold up the threat of deflation to justify ultra-low interest rates. Central banks have their thumb on the scales of finance.
When interest rates are kept arbitrarily low by government policy, the effect must be inflationary. In the first place, interest rates cannot be kept artificially low, except by inflation. The real or natural rate of interest is the rate that would be established if the supply and demand for real capital were in equilibrium.
The actual money interest rate can only be kept below the natural rate by pumping new money into the economic system. This new money and new credit add to the apparent supply of new capital just as the judicious addition of water adds to the apparent supply of real milk.
The money rate of interest can be kept below the real rate of interest only as long as the supply of new money exceeds the supply of new real capital. Excessively low-interest rates are inflationary in the second place because they give excessive stimulation to the volume of borrowing.
There is a doctrine in finance called the dividend discount model. It says that the price of common shares is the present value of its future cash flows discounted by a suitable rate of interest. What would happen to the calculation of the value of those shares if the rate of interest were unsuitable — if it were artificial?
Excessively low interest rates are inflationary because they mean that bonds, shares, real estate and unincorporated businesses are capitalised at excessively high rates. They will fall in value even though the annual income they pay remains the same if interest rates rise.
If interest rates were artificially low, it would follow that prevailing investment values are artificially high. And they are. We live in a valuation hall of mirrors. We don’t exactly know where our markets should trade, because we don’t know where interest rates would be in the absence of central-bank manipulation.
Natural interest rates — free-range, organic, sustainable — are what we need. Hot-house interest rates — the government’s puny, genetically modified kind — are the ones we have.
