In January of 1970, crude oil sold for $3.18 per barrel. Over the subsequent eleven years, the price of oil surged 10-fold to $31.77. Cumulative inflation over that eleven-year stretch was 124%. Because of the pervasiveness of oil in the global economy and the concurrence of the increases in oil prices and inflation, many conclude that oil prices caused inflation in the 1970s. We believe that conclusion is wrong and leads to misconceptions about the global inflation central banks are battling today.
A groundhog’s heart beats about four times every minute during hibernation. Its body temperature drops to just above freezing. A hibernating bear takes one breathe about every 6 minutes. Its body recycles urine so it literally goes without peeing for three or four months at a stretch.
In the spectrum of life, hibernation seems just this side of dead.
Let’s assume for a moment that the entire global economy consists of just ten people. Each member of the group produces goods and trades with other members of the group. They have a currency to facilitate trade; let’s call it the U.S. Dollar (USD). Prices in this ten-person world are expressed in USDs.
There are three basic ways prices can increase.
First, the supply of a particular item could somehow become more restricted. If a drought reduces the supply of corn in our community, the price of corn increases.
Second, the preferences of the people in the group could change. If one member of the group changed his preference from beef to chicken, the price of chicken would increase while the price of beef would decrease.
We call these first two drivers of price “product-related drivers” because they each affect price through the supply and demand of the actual product. The important feature of product-related price changes is people adjust their behaviors based on the changing price.
When a drought causes corn prices to escalate, people adjust their consumption of corn. Corn lovers might maintain their consumption of corn, but to do so they would have to reduce their consumption somewhere else. Others might do without corn and consume a close substitute like wheat instead.
The corn shortage has secondary ripple effects in other markets. Some ripple effects would have a positive effect on the prices of those other products, such as when consumers of one product flock to a close substitute. Other ripple effects would have a negative effect on the prices of those other products, such as when corn lovers sacrifice their consumption of other products to maintain their consumption of the higher-priced corn.
In the simplest of cases, corn lovers would cut back their consumption of wheat and those doing without corn would buy more wheat. One would offset the other. The price of wheat would not change appreciably.
Usually, of course, the ripple effects are more complicated and might affect many markets, but the main conclusion is that the ripple effects offset one another. Some ripples affect prices positively. Others affect prices negatively.
The notion of a product-related price increase in one product rippling through the entire economy and driving up the prices of all products is a faulty one. It ignores the offsets of the consumers that must cut back. A product-related price spike for a specific product cannot create a general price escalation across all products. The math doesn’t work that way. Everyone in our ten-person community cannot just magically spend more money on everything. Those that want to maintain corn consumption must cut back somewhere else, which negatively affects prices in those other areas.
If we could magically remove the need for the corn lovers to cut back elsewhere in the face of higher corn prices, the story would be different. We would then remove the offset. But that is not possible with product-related price increases.
That of course brings us to the third driver of price, which is monetary. If somebody secretly gave each member of our ten-person community extra money, the corn lovers faced with an escalation in corn prices could spend more money on corn while at the same time maintain their spending in other areas. The extra money, in short, allows all members of our ten-person community to spend more money on everything. It can accomplish what a product-related price driver cannot.
A hibernating animal, of course, isn’t really dead, it only appears dead. There is lots happening just below the surface. The gestation period of a black bear is about seven months. Much of that seven months occurs when the mother bear is hibernating. Cubs are born in January or February, right in the middle of the hibernation period. The cubs nurse on the mother for the first few months after birth while she drifts in and out of hibernation. Biologists say the mother doesn’t actually hibernate right through the whole process; she exists in a semi-conscious state drifting in and out of hibernation. Appearances can be deceiving. A hibernating animal is very much alive.
Let’s assume the people in our ten-person community receive extra money from the secret donor, but don’t spend it. The extra money is warehoused in peoples’ bank accounts or under their mattresses. Since the extra money sits idle, it doesn’t affect prices. No incremental demand is created anywhere, with the possible exception of banking services.
It is when people start using that extra money to buy goods and services that prices are affected. The money is created first. Its effect on prices comes when people spend it.
The hoarding of the extra money once it is created generates a lag between when the extra money is introduced into the economy and when that extra money affects prices. The longer people hoard the extra money, the longer the lag.
In many instances of money creation, people spend the extra money very quickly after receiving it. In those cases, the lag is short or non-existent. When paper money was created to help finance the U.S. Civil War in the 1860s, for instance, the recipients of the new money spent it almost immediately. Broad-based price inflation arrived almost immediately.
The same is true when the U.S. Government created paper currency to finance the Revolutionary War and when Zimbabwe created paper money in the first decade of this century. Broad-based inflation came quickly after money creation in these instances.
In other cases, the hoarding of newly-created money creates significant time lags between the creation of money and its effect on prices. The U.S. Government embarked on spending programs in the 1960s, including expensive social programs and the Vietnam War. The U.S. Government, with the help of the U.S. Federal Reserve, funded those programs with newly-created money. People initially built up their cash balances, effectively hoarding the newly-created money; this delayed the effects that extra money had on prices.
Oil prices nearly tripled in 1973. What began as a product-related price increase associated with the Arab Oil Embargo turned into broad-based inflation across all products as consumers of oil spent their cash balances in order to maintain their lifestyles. The existence of the cash balances created in the 1960s and hoarded until the 1970s made that possible. The oil price spike associated with the Arab Oil Embargo triggered the broad inflation of the 1970s, but did not cause it. The root cause was the money created in the 1960s.
A trigger versus a root cause is a distinction with massive implications. If we somehow solve the root cause, we avoid the inflation. If we solve the trigger and ignore the root cause, the root cause lies in hibernation awaiting the next trigger.
Incorrectly identifying the oil price spike in the 1970s as the cause of the 1970s inflation leads to the erroneous conclusion that if we would have solved the supply constraint of oil we could have prevented the inflation. We don’t believe that. The root cause of the increased money supply would have remained in hibernation awaiting the next trigger.
Since the 2008 Global Financial Crisis, the U.S. Government and the U.S. Federal Reserve have created an amount of money that dwarfs all other money creation episodes in the history of the USD combined. We believe that money today is lying in hibernation awaiting a trigger.
Inflation, in our view, is not dead; it is hibernating. Spring will come.
