May 27, 2014
Santiago, Chile
In 113 BC, a major scandal erupted across the Roman Republic as three sacred vestal virgins stood accused of incestum– violations of their sexual purity.
The special prosecutor brought out of retirement to try the case was Lucius Cassius Longinus Ravilla, a famous judge and former consul whose principle form of investigation was asking the question– cui bono? Who benefits?
It remains a great standard to apply today, especially with respect to one of the most spirited debates in modern economics.
Granted, economists typically aren’t a colorful bunch. It’s a dismal pseudo-science, after all, supposedly driven by data and not by passion.
But the inflation vs. deflation argument is something special… it is the ‘tastes great / less filling’ argument of our time that sparks all sorts of controversy and heated discussion.
A lot of folks hold an almost fanatical view of their side.
Economists led by Nobel Prize laureate Paul Krugman tell us that falling prices (led by a contraction in money and credit) make people “less willing to spend, and in particular less willing to borrow.”
And with a steep drop in consumer spending, severe economic stagnation results, including declining wages and a rise in joblessness.
Many in this camp conclude that central banks are warding off deflation by expanding the money supply, and hence doing the right thing.
‘Inflationists,’ on the other hand, hold the view that money printing is inherently dangerous because it drives retail and asset prices much higher.
This results in a vast erosion in most people’s standards of living.
Now, monetary policy really isn’t such a difficult thing to understand, especially when applying Cassius’ standard. Cui bono?
People who are severely in debt benefit substantially from inflation. Inflation erodes the principle value of a loan until eventually the entire debt simply inflates away.
Imagine taking out a bank loan in Zimbabwe right before hyperinflation struck. Within a few months, you’d be able to pay off the balance with your pocket change.
So who benefits the most these days from having their debts inflated away? Governments.
They hold the most debt, and being able to borrow money at interest rates which are below the rate of inflation is of tremendous benefit.
Banks also stand to gain from inflation. When the money supply is expanding and interest rates are low, bank profits increase dramatically.
Neither of these players wants to see deflation. They hold the keys to the castle, and they’ll do everything they can to ensure that inflation wins out.
But here’s the thing that I think a lot of folks fail to understand– it’s not necessarily a binary choice between inflation and deflation. It’s possible to have BOTH. And it ain’t pretty.
This is precisely what happened across Asia during their financial crisis in the late 1990s. And here in Chile, it’s starting to unfold right now.
On one hand, price inflation in Chile is on the rise. Data released earlier this month showed that Chile’s retail price inflation surged in April to a five-year high.
You can see it on the ground. Fuel prices are much higher. Food prices are much higher (it’s a great time to own a farm…). Etc.
But at the same time, many asset prices are falling.
Farmland is quickly coming off its highs, and my phone is ringing off the hook now with distressed property owners looking to sell. We’re seeing more properties go to auction than ever before.
In the residential market, prices are also getting much softer.
Meanwhile businesses that sell heavy equipment and capital goods are struggling amid the slowing economy.
The symptoms are mild right now, but Chile is in the very early stages of this phenomenon. I expect I’ll see even more signs in the coming months.
This real world example that effectively settles the argument: it’s possible to have elements of inflation and deflation simultaneously.
And with the right mindset, this can be a golden opportunity for investors. More on that in a future letter.
