Note the huge returns for timber in the 70s, when the U.S. government printed money with abandon. Hey wait, that sounds exactly like…now. Trees, which are limited by existing acreage and take many years to grow, are by nature limited in supply. When the supply of money increases, trees become scarce relative to dollars, and therefore must rise in price. It’s not very complicated. (One other interesting thing in the graph above is that timber prices seem to anticipate inflation by a year or two.)
I have discussed parts of our inflation thesis in previous letters. We covered how I like the monetarists but that they only worry about the supply of money while they should additionally worry about the supply of goods, and that socialist economies are very much detrimental to the supply of goods. I also discussed how I’m not buying what the Keynesians are selling, which is that too much economic growth is the root of inflation. This month, I’d like to add one more thought, which is that most economists’ views of inflation are too parochial. To predict inflationary trends, a global perspective is now necessary. For instance, over the last 15 years or so, most overestimated inflation because they didn’t properly understand how deflationary the globalization of the labor market would be. China, in particular, has suppressed global inflation through a combination of abundant, inexpensive labor and ample manufacturing capacity. Now, however, I fear what the underestimating is happening in the other direction.
To understand why, consider that much of the current debate about inflation vs. deflation in the U.S.A. has been about domestic indicators such as unemployment and capacity utilization. Conventional economics says that if lots of factories (or people) are sitting idle, then new production should be easy to bring online, and inflation will be negligible. This thinking overlooks a key difference in this economic cycle vs. prior ones: the U.S.A. and the developed world matter much less than they did in the past.
As an illustration of this trend, the graph below shows how the demand for finished steel - one of the key inputs into most infrastructure projects and industrial and consumer goods – has flat lined in the developed world over the past decade. All of the growth has come from developing markets, especially China. The same holds for just about any other commodity you’d care to pick.
In a nutshell, you can’t analyze squat these days (little academic lingo there) without considering what China and India are doing. China, most of all, is becoming a massive net consumer of commodities. And the thing about commodities – as I suggested about trees – is that you can’t gin up the supply quickly. Oil, metals, timber…the supply is highly inflexible. Thus, as China continues to grow, it will put enormous pressure on commodity prices, which flow through to the price of absolutely everything right here at home. We got a sneak preview of this from 2005-2008.
So you see, the fact that a bunch of factories in the U.S. are underutilized is of little consequence. More parochial concerns such as a wanton monetary policy and socialist/bureaucratic bottlenecks will simply add fuel to this simmering fire.
One other thought. Here is the past volume of searches on Google for the words “inflation protection:”
The top graph represents the prevalence of the search term relative to all other search terms. Before the Lehman meltdown, there weren’t enough searches to even register, but things changed in a hurry.
The words “deflation protection” don’t register at all.
(Google Trends, by the way, is a very interesting tool, and I almost feel like one could build a quant model off it, something I plan to give more thought to in the future.)