How do you create inflation in an era of austerity?

On July 25, 2012 we wrote to you with our reasons why inflation would not be an issue in an increasing expansionary monetary scenario, but why deflation would be the market’s bug bear. When I re-read our summary I still feel that the argument that we put remains in place. 

What deflation also causes is profit warnings as consumers simply either keep their hands in their pockets or save any funds they feel would be helpful in a downturn or if they lost their job. See below, then read it again, please.

As governments around the world continue to print money in an effort to create some sort of inflation the deflationary impact of the internet pushes back just as hard as the accelerating rate of change continues. This makes the tasks of governments attempting to “reflate” economies even more difficult.

The individuals and companies who are economic disruptors continue to prosper at the expense of the “deer in the headlights” old company management who seem continually paralysed by change and unable to evolve their business models.

It is not yet measurable in real terms but the economic effect when we look back in the next few years will be seen as profound, global pricing transparency and falling margins are guaranteed to continue across a broad spectrum of products and economies.

As “creative destruction” continues and infuses itself into a wider and wider swath of our lives it speeds up the rate of change in complacently stagnant industries that never thought technology could affect them. 

In Australia alone think of some of the now listed disruptors that include Real Estate.com, Seek, Car Sales.com and Webjet to name just a few. These “new” businesses have blown existing companies that have been firmly entrenched for decades to bits. 

On a global scale Amazon, Google, Facebook, EBay and Skype have forever altered the landscape. Silicon Valley continues to be “ground zero” for creative destruction, and complacent industries thousands of miles away are falling like dominos.

Most high-tech companies have a business model that is completely the opposite of what old-economy companies operate under:

  • The price of the products sold by a high-tech company decreases over time. Remember how much your first mobile phone cost compared to now.
  • Cloud computing will accelerate these changes on a more rapid-fire basis. Old school companies manage inventory, pricing, and forecasts under an assumption of inflationary price increases, but a technology company exists under the reality that all inventory depreciates very quickly as the real cost is in the first one produced and the cost of each extra one then falls. Price drops will then shrink revenues unless unit sales raise enough to offset it (and assuming that enough unit inventory was even produced). The new methods of distribution decrease the costs of pushing these products into the economy. By way of example look at the iTunes model where anything that can be downloaded will continue to take market share from businesses that sell the physical product. 
  • Go into a JB HiFi store and note the walls and racks of DVDs and CDs that currently occupy space. As internet download capacity increases these products will simply just disappear, as will the turnover and profits of businesses that fail to adapt to the model of distribution.
  • This results in the constant pressure to create new and improved products every few months just to occupy prime price points, without which revenues would plunge within just a year. Yet high-tech companies have built hugely profitable businesses around these peculiar challenges, and at least a dozen such US companies have market capitalisations over $100 Billion and many are headquartered in Silicon Valley. 
  • Think Apple, iPhone, iPad and how these recent inventions have seemingly taken over the world, as we know it.
  • The huge amount of liquidity that was created by the Federal Reserve is cycling through technology companies and increasing their earnings. 
  • The products they sell, in turn, increase productivity and promptly push inflation back down. 
  • Every uptick in inflation merely guarantees its own pushback and creates a form of “good” deflation via increased affordability and price reductions in the goods and services that people consume. There are of course exceptions such as Agriculture, which is affected by external events such as weather.
  • By way of example just observe how flat screen televisions have become thinner, clearer, lighter and much cheaper on an accelerated curve.
  • So if the US prints another $1 trillion, that may merely halt deflation, and possibly there will be no hint of inflation at all despite the efforts to inflate our way out of this crisis. In fact, the demographics of the US, with baby boomers continually aging are highly deflationary (and this is the bad type of deflation), so the US would have to print another $1 Trillion every year for the next 10 years just to offset demographic deflation.


As a result, the US economy might be mired in a long-term situation where vanishing industries force many laid off workers to start in new industries at the entry level, for half of their previous compensation, even as new fortunes created by the new industries cause net wealth increases.  

The US could see a continuation of high unemployment combined with high productivity gains and corporate earnings growth for several years to come. Big paydays for entrepreneurs will make the headlines frequently right alongside stories of people who have to accept permanent 50 per cent pay reductions. This would be the new normal. 

Stay tuned, this is just the beginning. Expect to see ongoing and continued stimulus measures not just in Europe but the UK.