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The danger of circular thinking

Year-on-year price rises continue here in the UK, driven almost entirely by broken supply chains, rising energy costs and fertiliser shortages (which cause the rise in food prices).  For journalists, politicians and central bankers (trapped in the neoliberal belief that inflation is the greatest economic evil) the solution is simple – lower the amount of currency in circulation so as to create widespread business failures and unemployment in order to crush demand.  This is achieved by central banks raising the cost of new currency via interest rate rises, and by governments cutting public spending and/or raising taxes… sounds like yet another treatment that is worse than the disease.

The worse thing about this though, is that it is based on a false premise that uses tautologous logic.  A tautology is defined as “a statement that is true by virtue of its logical form alone.”  That is, a circular logic – “why is it round?  Because it’s a ball.  How do you know it’s a ball?  Because it’s round.”  For a real-world example of tautology in action, consider this piece of genial reasoning from this morning’s BBC business pages:

“As we’re talking about inflation this morning, let’s remind you how it all works. Inflation is the increase in price of something over time.”

In other words, what is inflation? Rising prices.  What are rising prices?  Inflation.”

It is not clear when, exactly, this circular definition of inflation took hold.  But it was some time in the 1990s, when central bankers started talking about how they were “the masters of the universe” who had tamed the great inflation dragon.  Crucially, prior to that time, inflation was defined more specifically as an increase in the stock and/or velocity of a currency resulting in increased prices.  As Milton Friedman famously put it, “Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.” (my emphasis).

This does not preclude prices rising for other reasons – such as one or more inputs to production suddenly being unavailable in the quantities required.  But these are not inflation because they are not a monetary problem.  In the case of recent oil price rises, for example, Frank Shostak from the Mises Institute explains:

“If the price of oil goes up and if people continue to use the same amount of oil as before then this means that people are now forced to allocate more money for oil. If people’s money stock remains unchanged then this means that less money is available for other goods and services, all other things being equal. This of course implies that the average price of other goods and services must come off.

“Note that the overall money spent on goods does not change. Only the composition of spending has altered here, with more on oil and less on other goods. Hence, the average price of goods or money per unit of good remains unchanged.”

This said, governments can – and often do – have a knee-jerk inflationary reflex when faced with supply-side shortages, generating more currency in an attempt to pull forward new supply.  But so long as governments refrain from such foolishness, “the solution to high prices is high prices.”  That is, in the face of supply-side price increases, consumers cut their spending while investors fund more supply-side production.

An alternative way of looking at the problem would be to consider the opposite of inflation – deflation – as Jeff Snider does in this Eurodollar University vlog.  Just as not all price increases are the result of too much currency, so not all price decreases are the result of too little currency.  Snider uses the example of the development of smartphones which, through efficiencies and economies of scale fell in price over time.  Indeed, in the 1990s and early 2000s, a whole host of discretionary consumer goods fell in price, offsetting the increased cost of essentials – not just because of efficiencies and economies of scale, but because the western economies offshored production to parts of the world with cheap labour and little in the way of labour or environmental regulation – notably using cheap coal as a power source eschewed by the western states:

Nevertheless, the point stands – nobody in their right mind would argue that the western economies suffered a widespread deflation through the 1990s and early 2000s… one of those few periods in our history in which ordinary people enjoyed a brief – albeit debt-based – uptick in our standard of living.  Indeed, deflation is as devastating to an economy as inflation… just in a different direction.

The problem with inflation is that the economy enters a spiral because, if households and businesses know that items will be more expensive tomorrow than they are today, they will bring forward spending.  This raises demand even further, causing prices to rise even faster.  In a deflation, in contrast, businesses and households know that prices are going to be lower tomorrow than they were today.  And so, they put off spending for as long as they can.  But the collective result of this is to take even more currency out of the economy, causing prices to fall even further.

There is a huge risk then, that if we mistake rising prices for inflation when in fact, they are being driven by something different – such as supply-side shortages – that the actions taken to try to remedy the situation will make matters worse.  To understand this, consider that there are several things which can pull prices upward or push them down:

In the event that there is too much currency – and/or that the velocity is too high – then we must somehow reduce the supply.  In practice, this means slowing the rate at which currency enters the economy while increasing the rate at which it leaves.  So how does currency circulate through the economy? Broadly, there are two circuits.  The first begins with the state spending currency – which it borrows, but which it could just print – on things like public services, pensions, and infrastructure, and ends with the government recovering the currency through taxation.  The second – and much larger – circuit begins with commercial banks creating interest-bearing currency when they make loans and ends when businesses and households repay their debts (of course the two currencies are indistinguishable once in circulation).

It follows then, that the most effective way of lowering the amount of currency in circulation would be to lower the rate of new borrowing while increasing the rate at which debt is being repaid.  And the easiest way of doing this is to raise interest rates.  Governments may also aid the process by increasing taxes and cutting public spending.  And so long as the problem really is inflation, then the currency in circulation should fall back to where it should be.  But what if the problem isn’t inflation?

In the event that supply-side shortages – and less obviously, the rising energy cost of energy – are driving world prices up – as has been happening to fossil fuels since the western lockdowns ended – the theoretically correct response would be to increase production in order to bring supply up to meet demand.  Indeed, if this could be accompanied with efficiency and economy-of-scale gains, so much the better.  What would happen though, if a government and central bank were to try to tackle a supply shortage by sucking currency out of the economy (bottom right of the diagram):

We see this playing out in the real world in the shape of increasing prices of essentials even as discretionary prices are on the verge of collapse.  The process, however, unfolds over time.

The initial – temporary – pent-up demand brought about by people saving during lockdown ran into broken supply chains the moment economies attempted to reopen… remember the spike in the cost of shipping containers and the shortage of computer chips two years ago?  This though, was merely the warm-up act before the massive loss of oil and – especially – gas production – due to wells being closed and refineries shut down – sent prices spiking to eye-watering levels last autumn.  That shock, of course, is playing out at different timescales.  For example, the price of fuel at the pumps hit home almost immediately.  Food prices, on the other hand, have only spiked more recently as last year’s fertiliser shortages have taken their toll on this year’s harvest – which has hit animal feed as well, which is why the price of basics like milk and eggs are currently driving prices up.

Following a brief consumer spending binge immediately after lockdowns were lifted, retail sales flattened out.  This left retail businesses with two key problems.  The first was that many over-ordered stock in the belief that the temporary binge was going to be a sustained growth in sales.  The second was that they feared passing rising input costs on to consumers in case this drove people to their competitors.

Labour shortages complicated the issue, however.  One of the – many – unforeseen consequences of lockdown was a massive movement of people, particularly away from the expensive metropolitan cities.  In London, for example, there was the immediate loss of tens of thousands of the Eastern European workers who used to provide the service backbone which allows that city to survive.  Those UK workers with the wherewithal to move out, and the ability to work remotely, also left.  And later, that part of the 50-65 age group with enough of a private pension to opt for an – albeit lower paid than they had expected – early retirement, also downed tools.

The establishment media – whose editors and journalists tend to be metropolitan liberals who live in the areas from which people had fled – reported this as a labour shortage without considering the geographical mismatch involved.  Britain is a grossly unequal economy in which almost all of the high-paying employment is located in London and an archipelago of districts around the top-tier universities.  One consequence of this is that, while London is – or at least was before lockdown – the richest place in northwest Europe, the remainder of Britain contains nine of the ten poorest places:

Unemployment, and particularly underemployment has persisted across ex-industrial, rundown seaside and smalltown Britain throughout the so-called labour shortage.  Meanwhile, the main reason why places like London are unable to fill what are mostly low-paying service and routine white-collar positions is because the far higher cost-of-living than the rest of the UK.  Indeed, even young professionals working in London before the lockdowns faced a choice between expensive and time-consuming commuting or renting – at exorbitant rates – a room in a shared house in one of the less desirable districts.  Eastern European service workers fared much worse, often not only sharing the one room, but in many cases sharing the bed that they slept in.  Little wonder that they – or at least the ones who registered as British residents prior to Brexit – are in no hurry to return.

Central banks and government also failed to see the nuanced picture; and treated the labour market mismatch as the first stage in a 1970s-style wage price spiral.  And so, the process of rapid interest rate rises began.  As the railway workers have apparently discovered though, trade unions are a ghostly shadow of the once-powerful industrial armies of yesteryear.  Indeed, with energy costs hitting profits, many businesses – particularly energy-intensive ones like railways – are more than happy to not have to pay the workforce while they are off on strike.  Indeed, when the rail union called off a series of strikes earlier this month, the rail companies effectively had them anyway, only running the kind of skeleton service usually reserved for winter Sundays.

Wages have increased in nominal terms but have lagged well behind prices, so that in real terms the workforce has taken a sizable decrease in spending power.  This has come on top of a decade between the crash and the covid during which the real incomes of the bottom half of the workforce had fallen steadily – albeit less dramatically.  One result is that people have behaved in a manner which makes absolute sense to them but presents serious dangers for the wider economy.  For example, in September, as Britain was recovering from the hottest temperatures on record, retailers selling winter clothing experienced a temporary boom – not because we were suddenly flush with cash, but because we could see which way energy prices were going to go, and we had no intention of paying them.  This, I suspect, is why the one part of Kwasi Kwarteng’s ill-fated budget to survive – paying the energy companies to lower our bills (a little) – is still in place.  The sheer weight of numbers of us who intend getting through the coming winter without turning on the heating – along with those at the bottom who can’t pay anyway – would have resulted in a bloodbath across the energy supply companies.  Incidentally, the scale of this self-disconnection is now creating concerns among the public health technocracy, as reflected in establishment media stories about the dangers of black mould in unheated homes… yet another thing we’re going to have to get used to.

For businesses, the dam broke earlier this year as rising costs could no longer be absorbed.  But, as we saw in the retail figures last month, Britain’s consumer base cannot afford to pay.  While consumers had been cutting the volume of purchases, until the summer they had at least been maintaining the value.  This turned downward in the third quarter and is likely plummeting now.  We have already seen the canaries in the coal mine in the shape of losses and bankruptcies.  Indeed, the Royal Mail – which I argued was reflecting the state of both the retail and wholesale sectors – is now seeking to cease deliveries on Saturdays – a means of cutting the wage bill without having to fire workers.  More worryingly though, the six weeks prior to Christmas would normally be the busiest time for Royal Mail, so that if all was well in the economy, they would be increasing deliveries and employing additional temporary staff.

At this point, it is likely that a large number of employers are hoping for a decent uptick in Christmas trade to prevent widespread job losses.  This, I fear, is going to be a forlorn hope – people wrapped up indoors in winter clothing, whose chilly homes are infested with black mould, are unlikely to be rushing out to the shops for a seasonal spending spree.  Indeed, if retail spending continues to fall as it has throughout the autumn, then widespread lay-offs may well begin as soon as the New Year is ushered in.

Looming in the shadows, behind the businesses and households which are the immediate victims of lockdowns, supply shocks and inappropriate government responses, is a bloated international banking and financial system which has been permitted to generate quadrillions of dollars of derivatives on the back of a mountain of debt – private and state – which will never be repaid.  And for all of the optimism of government and central bank officials, that financial sector has bet the house on something much, much worse than the controlled economic demolition being attempted via rate rises, tax increases and austerity cuts.  Financial markets are pointing to a massive drop in interest rates, even as central bankers insist that they will continue to rise.  The question we need to ask here, is whether multi-trillion-dollar hedge funds and banks might have access to real-time proprietary data which is telling a very different story to the backward-looking public data used by central banks and governments?  Because the story the money markets across the world are telling is that something big is about to break, and that when it does, we can expect a massive wave of debt defaults – private and state – and a collapse in the value of assets.

The question which follows, is whether an alternative policy response might be better?    As Tim Morgan argued earlier this year, it is unlikely that those with the power of decision will recognise the need to alter course:

“Where markets are concerned, there are limits to how long the downside in discretionary sectors can be ignored by equity investors, and to how long the bond markets can dismiss rate pressures as nothing more than a short-term irritant. The relentless compression of affordability, and the inevitability of a rise at least in nominal rates, have unmistakable implications for property.

“Politically, too, there are limits to quite how much hardship voters will accept without putting some tough questions to TINA [there is no alternative]. The tax base is being squeezed, because the only part of the economy that can really be taxed in a net-positive way is the margin that exists between top-line prosperity and the cost of necessities. There really is no practical mileage in taxing people to the point where hardship requires the hand-back of taxes through welfare…

“It might seem almost heartening that, in the absence of logic and evidence, TINA has become the sole prop retained by the consensus ‘narrative’…

“As the soldier is supposed to have said in the First World War, ‘if you know a better fox-hole, go to it!’…

“We need to beware, though, that TINA may have a far less forgiving sibling, with the confusingly-similar acronym TINAR – There Is No Acceptable Reality.”

As I have written elsewhere, the underlying forces that are causing economies to shrink are both structural and existential.  This is no longer an arcane discussion of the relationship between prices and the supply of currency.  Economic growth and prosperity are caused by the efficient use of energy… energy whose cost is now rising remorselessly.  Barring some leap forward in our understanding of applied physics, the energy available to us to power the economy is in terminal decline.  Ergo, irrespective of what governments and central banks do, we are all going to get poorer with each passing year.  And whatever else this implies, it means that one way or another, the financial economy is going to shrink back into line with the real economy.  Whether governments and central banks choose to create a wave of debt defaults or – more likely under popular pressure from electorates – print currency in an attempt to inflate the debt away, depression and decline are built-in.

As you made it to the end…

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