Diving deeper into inflation, deflation & our future — Part 2

This is part 2 of a series on understanding inflation. For part 1, see here

Global Inflation Rates Soar, Squeezing Household Budgets Worldwide

Rising Food Prices Push Millions More Into Food Insecurity, UN Warns

Central Banks Hike Interest Rates in Bid to Tame Inflation, Sparking Recession Fears

Understanding how inflation fits in

The headlines above are made up, but I’m sure they feel familiar to you. Or to anyone who has been reading the news for the past few years. Talk of inflation is a regular occurrence in our news and rightly so. The concept has the power to bring about changes in governments and even rule of law (as happened in Zimbabwe’s economic collapse).

It’s clearly an important concept, and because we hear so much about it, it seems simple enough to understand: things tend to get expensive over time. But is that interpretation accurate and expected to hold forever? And what about the common answer to why this happens: as people get richer, demand outpaces supply, leading to increased prices. Is that a good enough explanation or can it change completely?

Given that technological & scientific progress seems to lead to greater ability to supply goods (remember our discussion on mirrors and more complex apple pies), we expect technology to push us to relative abundance — i.e., increase supply faster than demand. So why is it that this supply-demand mismatch continues to occur, even as we make technological leaps?

There seem to be two reasons to this. The first one has to do with the concept of money itself, while the other has to do with demand. Let’s review them both.

First let’s deal with money. When we say supply and demand, we usually think of supply & demand for a particular good. However, since this good is traded using money, the supply and demand for money becomes an important part of the story. In fact, one could say that inflation is when a consumable resource (say a kilo of rice) becomes relatively more scarce than the medium of exchange facilitating it (money).

This definition explains how inflation could occur in countries where there may not be any significant changes to underlying demand or supply. For example, by printing money indiscriminately a central bank would make the medium of exchange (money) very abundant. If money becomes much more abundant than the goods (rice), then inflation is going to follow. Notice that in the absence of central bank’s monetary actions there shouldn’t have been any changes in the economy’s supply and demand of underlying goods. This can happen for multiple reasons, and one of the most common ones is bad economic policy. Modern history is replete with governments increasing abundance velocity of money without any other consideration — predictably leading to inflation

The second reason is demand itself. Sure, supply is growing through technological innovations, but could demand outstrip even that? The answer is “yes, when things are just right”. Specifically, there seem to be three things that can super-charge demand to higher levels than supply can keep up with. Firstly, by making people live longer and/or increasing the number of people on Earth, we grow the population. This will lead to an increase in number of consumers, each contributing to the demand for goods and services.

The second way economic demand could grow is through consolidation of markets. Imagine two micro-economies, each having a GDP of $100. Now imagine a scenario where these micro-economies merge and lead to a larger $200 economy. This new economy will have a richer elite because 5% (the share of the pie that an elite could capture) of $200 is greater than 5% of $100.

Finally, demand can also grow without growing the number of consumers. This can happen as consumer appetites and preferences change. The meat industry is a good example — World Bank and Food and Agriculture Organization (FAO) have observed that global meat production has tripled over the last four decades, far outpacing the population growth — which hasn’t even doubled. This represents a case of the market demand growing without necessarily increasing the number of consumers.

Is inflation sacred?

The above investigation leads us to a conclusion: there isn’t really any structural reason to believe inflation is a good thing. In fact, we’ve had no change in prices for long stretches of human history (I’m talking on time scale of centuries not years). A situation brought about by the fact that for many centuries (a) technological progress was slow enough to not lead to noticeable increases in supply, (b) market sizes & demand remained relatively consistent and (c ) governments didn’t mess around with monetary policy too much.

Going even further, and being a bit provocative, there is no reason to believe that ‘deflation’ is automatically a bad thing (something one hears about quite often) — especially if the conditions are just right.

To help understand how deflation could be good, let’s consider the following thought-experiment. Say an alien species came and gave us 50 disks, each labelled a specific number between 1 and 50. Each disk was coded with breakthroughs & innovations that would represent a 100% jump in productivity from the previous disk. So Disk 5 would be 100% better than Disk 4.

However, they had one condition — only one disk could be accessed per year. In essence, these aliens have basically set a floor for the technological progress that can happen at the goods and services layer. What would happen to inflation in such a scenario?

For inflation to occur in such a scenario, one option would be that the government would have to print money like there was no tomorrow. Alternatively, the demand would have to grow, but it is unlikely that human demand would almost double every single year for 50 years.

In fact, in this thought experiment it is very likely that the supply of goods/services will grow faster than the demand for the same; and deflation would occur. But that won’t necessarily be a bad thing. Most people would be observably better off every year — being able to do more and more things due to technological progress. In addition, everything would cost less money — in fact at some point, theoretically the costs would tend to go to zero.

This thought experiment uses aliens & magical disks, but these were simply stand-ins for extreme technological progress. Basically, in the absence of central banks, inflation and deflation are natural outcomes of a race between technological progress (growth of supply) and growth of demand.

Thinking about the future

Given that we now understand who the competitors are, can we predict what the future holds? Let’s attempt a basic version.

On one side of the match we have Team DD (Demand Drivers) which is composed of (a) population growth, (b) consolidation of markets, and © increases in appetites. Facing them, we have the Team SD (Supply Drivers), this is a solo-team of Technological Innovation & Progress. The question is which team will win in the future.

Let’s take Team DD first. Firstly, we have population growth, and while there’s no set limit for it — population growth does seem to go down as a market becomes more developed. Japan, Germany, Singapore and South Korea illustrate this inverse relationship best — these are countries that have witnessed drastic reduction in population growth rates as they’ve modernized and become richer.

The second member of Team DD is consolidation of markets. There is an obvious natural limit to this lever. Once markets are consolidated, they can’t consolidate further.

Finally, there is an increase in appetite that each consumer in a market might have (either for existing goods or even newer goods/services). This is the only member of Team DD that doesn’t seem to have any upward limitations. Having said that, this increase in appetite is tempered by the fact that humans are slow to change. So while this will continue to drive demand towards (potentially) infinity, the growth will become slow as humans take time to adjust preferences & try new products/services.

When we compare this to team SD, we encounter a side which has no foreseeable upward limit. Barring limits set by our universe’s laws of physics, technological progress ought to be able to continue forever. And do so in an ever increasing way.

Therefore, given long enough time, the race between Team DD vs Team SD ought to lead to a clear winner — supply should beat demand. In this case, even though many central bankers signal their deep-seated love for 2% inflation target, we will get into deflation at some point. In fact, technological progress can move to the point where deflation is so extreme that everything is almost free.

If that’s hard to visualize, think of the following scenario: humans (perhaps through AI) finally crack cold fusion and nanotech. If that were to happen, we could inhabit a world where ALL demand could be satisfied instantly by nano-bots that had access to near-unlimited energy (through cold fusion). You want a computer? No problem, nano-bots can make one for you by following an open-source laptop design and converting your house’s waste product into a laptop (by manipulating molecular structures of waste to resemble silicon).

Even though it might sound far-fetched, it may become a reality sooner than we expect — that is the ever accelerating nature of technological progress after all.

The real question is when economists & politicians will feel comfortable with deflation & technological progress, and not remain beholden to outdated ideas about size of economy and demand for goods and services. But that’s a question that’s much harder to answer.