Inflation & Market Performance
August, 1999
Okay, I've resisted saying something impolite every time I've heard the term "wage
inflation" for so long I'm starting to get cranky. What kind of asylum comes up with stuff
like this? Let me try to put this in the most politic and charitable terms I can think of. The
term wage inflation is idiotic, the concept is absurd, and those professionals who use it
should know better. One may as well talk about "broccoli inflation" due to a drought in
Southern California. One first needs to understand inflation, however, because ignorance of what it is by
the vast majority of government and academic employees is the cause of the confusion.
The stock market has recently given back most of its gains for the year. As of 8/9/99, the Russell 2000,
representing the broad market, is up less than 1% for 1999 year-to-date. The reason the market has fallen so
much recently is because the government, in the form of the Federal Reserve and Alan Greenspan, has
convinced people that inflation is coming back, and this will cause a rise in interest rates. The Fed thinks this is
due to prosperity (higher wages and living standards), so they want to raise interest rates to reduce economic
growth and prosperity, and therefore (in their minds, anyway) reduce inflation.
Heaven forbid people should actually make more money. Why, it might cause inflation! I mean, jeepers,
there are too many jobs as it is. Let's stop creating so many! We might actually have to go out and hire
foreigners to fill them, and Congress has already said we don't want to let any more of THEM in! Might take a
job away from a real American, whatever the hell that is (white guy, probably). You know, one of those jobs we
don't have anyone to fill because there aren't enough people who are still unemployed to fill them.
Cripes! Let's kick a million or so people out of work. Quick. I'm sure they will appreciate that it's not
personal, Just doing our job, Ma'am, for the good of society and all that tommyrot. We should all really feel a lot
better when fewer people can afford a home, get a raise or promotion, and we have some real unemployment.
Wow! What a relief that will be! I can tell you, I've just been sweating bullets about all this prosperity. Can't
sleep at night. I mean, I just get so depressed thinking about all that prosperity, I want to dash right out and fire
a few thousand people.
Okay, okay, I'll be serious. The reason inflation causes interest rates to rise is that long term rates (at least
for default risk-free Treasuries) are made up of two components. The first is the cost of renting money, and the
other is an inflation component, to ensure you get back in real, spendable terms what you loaned out in the first
place. So if the "rent" is 4% per year on a 10 year bond, and inflation is expected to run 2.5% over the next 10
years, you will only loan out your money for 6.5%. Thus, expectations for inflation have a large effect on interest
rates, as well as bond and stock prices.
Now for the explanation of why higher wages or broccoli prices do not cause inflation. As Nobel Laureate
Milton Friedman has pointed out until he is old and gray, inflation is always and everywhere purely a monetary
phenomenon. Unfortunately, most government and academic economists seem to have been inoculated at birth
against elementary reasoning. They persist in their loopy, dogmatic confusion of supply/demand imbalances
with true inflation. They do this because in the 1970s, when we really did have true monetary inflation, wages
and broccoli prices went up. That wasn't the only reason they went up, it was just one of many. So they
measured price increases as a proxy for inflation, and didn't take out the contribution to price increases from
other, non-inflationary factors, such as product improvements, changing consumption patterns, increasing
productivity, and many other things.
Let's define inflation first. It is simply a supply/demand imbalance in dollars (or whatever currency you
are concerned with), and nothing else. Most people outside the government seem to get it, that if you have too
much of something, its value drops, and if you have too little of something its value rises. This tends to apply
equally to commodities and intangibles like truth. Like other things, if you have too many dollars, their value
drops, and it takes more of them to buy something. This is called inflation. If you have too few dollars relative to
demand, their value rises (as in the Great Depression of the 1930s). This is called deflation. By its very nature,
inflation due to a supply/demand imbalance in dollars is spread to everything, because dollars are our medium
of exchange.
Here's why "broccoli inflation", or "wage inflation", are silly terms. We don't use broccoli as our medium of
exchange, so a change in its price due to a supply/demand imbalance doesn't spread to everything else. If we did
use broccoli as our currency, then of course inflation could be caused by a drought in Southern California. Be
pretty dumb to have a currency system where inflation is beyond anyone's control.
In a free market, such supply/demand imbalances are self-correcting. When the price of broccoli goes up,
farmers plant more next year and the price goes down again. Same with blue jeans or wages. High wages due to a
shortage of some skill result in a flood of people into that field, or cause the adoption of new technologies that
reduce the need for labor, and this causes a reduction in the rate of wage growth. Even rising wages don't cause
"wage inflation" if the workers' productivity is rising faster than wage increases, or if they are switching to
higher-paying jobs, which is the case today in virtually all sectors.
Furthermore, a substantial part of the rise in wages is simply due to workers entering the much
higher-paying jobs in the new Internet services, software and telecommunications sectors. We should all
understand that job growth in the old, industrial sector of the economy has been zero for a decade. All job
growth has been in the new sectors born of the Internet, and in services, both of which pay more than industrial
sector jobs. Moving from low paying jobs to higher paying jobs is not inflationary, it's simply an improvement in
standard of living. For most people outside government, this is fairly elementary. So wages are going up. Nearly
everything else is going down. That's bad?!
Someone who leaves a job at McDonald's flipping hamburgers (or leaves a buggy maker for one of the
new-fangled, high tech motorcar companies like GM in 1910) while they finish their education or take training in
something new, in order to take a sales job making twice as much money is not experiencing inflation, they are
experiencing a higher standard of living. Sure, they contributed to a rise in wages. Is this "wage inflation"? Golly.
Better raise interest rates and nip that in the bud. Can't have people making more money. That's inflationary!
That most government and academic economists and policy makers don't seem to understand this should make
us all wonder if maybe they need gravity explained to them.
What this means for our management of your Funds is that we don't believe that high interest rates will
continue, because higher rates are caused by inflation, and there isn't any. None. Thus, the market pullback due
to economic concerns should be temporary, even though our government apparatchiks are convinced that
prosperity causes inflation, despite the decades-long record of the U.S., Germany and Japan after WWII. We can
take comfort in the belief that reality eventually reasserts itself - at least in the real world, if not in government
and academia. It's looking like this time around though, it may take awhile.
When I hear that the ignoramuses at the Fed are about to raise interest rates again to prevent inflation, I'm
reminded of the old joke about my friend putting garlic in the refrigerator to keep the elephants out. When my
friend tells me this, I open the refrigerator door and say, "But there aren't any elephants in there! Just look!"
"Right!" he replies. "Works, doesn't it?"
Be patient. Right now, that's all we can do. The loonies are on the loose.
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