The folks at the Federal Reserve keep telling us that rising prices are “transitory,” the product of a robust and fast-moving post-pandemic economic recovery.
One of the reasons often given for rising prices is “supply chain bottlenecks” caused by the sudden recovery in demand. But a dive into the data reveals that most commodity prices have risen in tandem in an environment of wide levels of spare capacity, and in some cases, even overcapacity. The supply chain isn’t the problem. The money is the problem.
Economist Daniel Lacalle analyzed the numbers for an article published by the Mises Wire and found the “supply chain” excuse doesn’t hold up under scrutiny.
Lacalle looked at the utilization ratio of industrial and manufacturing productive capacity. Russia is at 61%. India is at 66%. Lacalle called this “a clear level of structural overcapacity.” In China, capacity utilization is at 77%, still below pre-pandemic levels. In fact, no G-20 country’s capacity utilization is above 85%.
So, what is this telling us? As Lacalle put it, “There is ample available capacity all over the world.”
Loose monetary policy exacerbates overcapacity by prolonging the survival of “zombie companies.” Empirical studies by the Bank for International Settlements (BIS) have documented this phenomenon. A zombie company is a firm that can’t service its debt with operating profits. The availability of low-interest debt refinancing along with government stimulus allows these companies to survive far longer than they otherwise would. This short-circuits the process of “creative destruction” in the economy and leads to the perpetuation of overcapacity. According to Lacalle, “Low interest rates and high liquidity have perpetuated or increased global installed excess capacity in aluminum, iron ore, oil, natural gas, soybeans and many other commodities.”
But what about the transportation chain? Lacalle says there’s no evident problem there either.
The excess capacity in the shipping and transport sector is more than documented and in 2020 new capacity was added in both freights and air transport. Ships delivered in 2020 added 1.2 million twenty-foot equivalent units (TEUs) of capacity, with 569,000 TEUs of capacity on ultra-large container vessels (ULCV), ships with capacity for more than 18,000 TEUs, according to Drewry, a shipping consulting firm. International Air Transport Association (IATA) chief economist Brian Pearce also warned that the problem of capacity was increasing in calendar year 2020.
Lacalle boils it down to the key question: why does inflation rise if overcapacity is perpetuated and there is enough transport capacity?
In a nutshell, it’s the money, stupid.
As Milton Friedman once put it, “Inflation is always and everywhere a monetary phenomenon.”
An increasing money supply means more dollars chasing roughly the same amount of stuff. As a result, prices rise. As Lacalle put it, “More supply of money directed towards scarce assets, be it real estate or raw materials. The purchasing power of money goes down.”
Part of the problem is confusion about the definition of inflation. Defined correctly, inflation is an increase in the supply of money. Rising consumer prices are just one symptom of inflation. It also shows up in rising asset prices. We see it in stock market and real estate bubbles. That fact is we’ve gotten inflation in spades with or withing rising CPI. The Federal Reserve increased the money supply at a record pace over the past year.
Of course, the money supply was increasing before COVID-19. Lacalle said there is a difference between 2020 and previous years.
“Previously, the Federal Reserve or the ECB increased money supply at or below the levels of demand for money (measured as demand for credit and use of currency). For example, the increase in the money supply of the United States was close to 6 percent with a global demand for dollars that grew between 7 and 9 percent. In fact, the world maintains a dollar shortage of about $ 17 trillion, according to Luke Gromen of Forest for the Trees. This keeps the dollar or euro relatively stable and a perception that inflation is low. However, there were red flags before covid-19. There were protests all over the world, including Europe, against the rising cost of living. The world’s reserve currencies export inflation to other countries.”
So, what happened last year?
“For the first time in decades, the Federal Reserve, and the main central banks increased money supply well above demand. The response to the forced shutdown of activity with massive money printing generated an unprecedented inflationary wave. The economy did not collapse due to lack of liquidity or a credit crunch, but due to the lockdowns.”
Lacalle pinpoints three consequences of this “monetary tsunami.”
- Emerging market currencies plummeted against the dollar because their central banks “copied” the US policy without the global demand that the US dollar enjoys.
- A disproportionate amount of money flowing to risky assets joined by more flows to take overweight positions in scarce assets. That excess money made investors move from being underweight in commodities to overweight, generating a synchronized and abrupt rally.
- Extraordinary measures typical of a financial or demand crisis were taken to mitigate a supply shock, generating an unprecedented rise in money with no added credit demand. More money in scarce assets is not a price increase, but a decrease in the purchasing power of money.
This phenomenon has repeated itself throughout history.
‘The history of money since the Roman Empire always tells us the same thing. First, money is aggressively printed with the excuse that ‘there is no inflation.’ When inflation rises, central banks and governments tell us that it is ‘transitory’ or due to ‘multicausal’ effects. And when it shoots up, governments present themselves as the ‘solution’ imposing price controls and restrictive measures on exports. It is not a theory. All of us who have lived in the seventies know it.”
Lacalle warns that the risk of stagflation “is not small.”
Only a drastic shift in central bank monetary policy can change the inflationary dynamic. But Lacalle asks the operative question: will central banks tighten policy when government deficits are soaring and even a small increase in sovereign yields can generate a debt crisis?
You would be wise to consider the answer to that question and plan accordingly.
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