One of the big debates of 2020 (if you move in circles boring enough to debate this kind of thing) is whether the future will be inflationary or deflationary.
In favour of inflation: money-printing on a scale never seen before.
In favour of deflation: technology, supply-side and demand-side shocks, ageing populations, trendy minimalists with big Instagram followings (maybe not that last one).
The clearest thinking I’ve heard on the subject is from Jeff Booth, whose book “The Price Of Tomorrow” has had a lot of attention over the last few months. This interview is a good brief overview of his thesis, but in this article I’ll make my own attempt at explaining it – as much for clarifying my own thinking as anything else.
In a nutshell: Governments are pursuing policies to create inflation, while technology is exponentially creating deflation. There will be a struggle between the two, and deflation will inevitably win.
What is inflation, really?
People tend to think of inflation as being the price of goods going up, but actually it’s the value of currency going down.
Say a pint of milk is 30% more expensive than it was 10 years ago (which is roughly true). Has milk got more expensive to produce or transport? Have the farmers got more greedy? Have the cows unionised? No – nothing much has changed with regard to the milk.
What’s happened is the currency is worth less, so you need to exchange more units of the currency to obtain the same amount of milk. If instead of paying for milk with Pounds Sterling you were swapping it for some other type of product – say eggs – would you need to hand over 30% more eggs than you would have done 10 years ago? No – nothing would have changed in the milk:eggs exchange ratio.
Everyone intuitively understands supply and demand as it relates to goods, but we tend not to think of it applying to money. Because we think about everything in terms of how many pounds it costs, we think of the pound itself as being constant: the pound stays the same, and everything else shifts in relation to it.
In reality though, the value of the pound is shifting too. So when we’re looking at the price of milk over time, any change in the price we see could have been caused by a change in the milk or the currency – or both.
Why do we have inflation?
Why is the currency worth less than it was in the past? Very simply, because there’s more of it. This is basic supply and demand: if the demand for money stays constant and more of it is created, the price of money will fall.
The extra money is created by the Bank of England in the UK, and the Federal Reserve in the US. The mechanism by which they do it is complicated and not important for our purposes right now. The reason they do it is threefold:
1: Inflation avoids deflation
If inflation is the price of goods going up (in relation to the value of the currency), obviously deflation is the price of goods falling. Governments are terrified of deflation, because it can end up in a “deflationary spiral”: if you think the new car you want to buy will cost less next month than this month, you won’t buy it now and the economy will suffer as a result.
2: Inflation stimulates the economy
If the economy is struggling – lots of people are unemployed, or output is falling – the government will want the central bank to take action to give it a boost.
Printing money isn’t the bank’s first choice of action for doing this. They’d prefer to reduce the “base rate” of interest in the economy, which stimulates the economy by encouraging investment and making borrowing cheaper. But they’ve already done just about all they can there: in 2009 the base rate was reduced close to 0% and never increased again, so the usefulness of that tool has been exhausted.
That leaves them with printing money as their only option. How much? A lot. In the UK in June 2020 alone, they printed £100bn. The previous month, it was £200bn.
(Fun fact: in just the single month of May 2020, as much new money was created as there was in the Bank of England’s entire response to the last financial crisis.)
So in two months alone, 300 billion extra pounds now exist that didn’t before. The supply/demand argument tells us that the supply of extra money should reduce its value, so it’ll take more pounds to buy the same amount of goods. In other words, prices of goods (as denominated in pounds) will go up.
3: Inflation makes it easier for governments to pay back their debts
The UK government is currently in debt to the tune of £2 trillion. They borrowed that money in pounds and they need to pay it back in pounds…so if each pound becomes worth less, it makes it easier for them to pay back the debt.
What is deflation?
If money-printing and monkeying around with interest rates is creating inflation, why are the prices of many goods actually getting cheaper? For example, I can now buy a quality pair of wireless headphones for under £30 that just a few years ago would have cost more than £200.
The answer is that technology is deflationary. In other words, technology makes goods and services cheaper to produce over time.
I mean “technology” very broadly. For example, when humans worked out how to plough a field by attaching a device to an ox, they could plough the field far more quickly and with fewer people being involved. That naturally brought down the price of what was grown in that field: the labour cost involved in producing a single potato was suddenly much lower, so the farmer was willing to accept less money in exchange for one.
Most of the time technology improvements are incremental, but at a few points in history there have been huge technological shifts that have made its deflationary impact exponential. The agricultural revolution was one. The industrial revolution was another. And right now, we have a revolution that we don’t have a catchy name for yet – but let’s call it the digital revolution.
Let’s just pick a few obvious examples:
- 10 years ago it cost £10+ for a single CD. Now you can access all the music ever recorded (pretty much) for £10 per month.
- International phone calls used to cost pounds per minute. Now they’re effectively free.
- When we get to the point of self-driving cars being mainstream (surely within the next 10 years), instead of having a car parked outside that you only use 5% of the time, you can use an app to summon a car that’s being used 80% of the time – so the cost of personal transport will plummet.
In all these cases – and thousands more – technology has resulted in goods and services being cheaper to produce. This is deflationary: it costs less money to buy the same stuff.
The tension between inflation and deflation
So we’ve got a tension here. You can imagine it like a tug of war.
On one side, central banks are actively trying to produce inflation for the three reasons we saw earlier.
Pulling against it on the other side, technology is naturally producing deflation – and because of the digital revolution we’re currently living through, it’s now producing deflation at an exponential rate.
So if we look at prices now and they don’t seem to be moving much, that’s not because nothing is happening – it’s because there are two extremely powerful forces pulling in opposite directions.
The question is…which will ultimately win?
The answer is clear: deflation.
Because the ability of governments to devalue their currencies will run out before human ingenuity stops producing new technological advances.
How currencies end
As we’ve seen, central banks are having to take more and more extreme measures to produce inflation and stimulate their economies: from lowering interest rates to printing money to printing yet more money. In the tug of war, they’re having to pull harder and harder.
Eventually, one of two things will happen.
They might lose: everyone will look at the trillions of pounds/dollars being created, and completely lose faith in the currency. Why would you accept pounds in exchange for your hard-produced goods if you know trillions more pounds are being created out of thin air every year? People will switch to using a different currency, and it’s game over.
Or they might win – they might manage to produce inflation – and by winning, they’ll lose. Trying to create “just the right amount” of inflation is almost impossible. Because they’re pulling so hard against deflation, they’ll keep taking more and more extreme measures until eventually they over-correct and create hyperinflation. It’s a bit like winning a tug of war and immediately falling over backwards because the opposing force suddenly isn’t there.
If you see the value of the pound falling rapidly (which is what hyperinflation is), why would you accept pounds for your goods? Again, everyone will switch to a new currency and it’s game over.
This isn’t theoretical: in recent years we’ve seen the effective collapse of the currency in Zimbabwe, Argentina and Venezuela, among others. In these countries, it got to a point where people basically stopped using the currencies because they didn’t trust them: a thriving black market for US Dollars was created, because (for the moment at least) people trusted it more.
There’s an argument that the US Dollar will be able to withstand a lot of monetary abuse because it’s the world’s reserve currency, and maybe that’s true. But the Pound Sterling used to be the reserve currency, and the Dutch Guilder before that, and both lost their status eventually.
Countries can’t keep printing new money ever-faster forever and things just carry on as normal. There will come a point where it goes too far and the currency becomes worthless. It’s impossible to know when that point will come…we just know it will in the end.
What should you do?
The pound or the dollar might fail within the next decade, or it might not happen in our lifetimes. Regardless, before getting to the deflationary future we’re inevitably going to have a period of significant inflation.
Unfortunately, again, we have no way of knowing when this inflation will really kick in. But if you believe it’ll happen sooner rather than later, there are some investment decisions you can make that are likely to do well in an inflationary environment.
Own real assets
An unhappy side-effect of inflation is that it increases the gap between the already wealthy and everyone else. Anyone who owns assets will see the value of those assets increase, and anyone who doesn’t will be left behind.
What assets should you own? Anything that’s scarce and has value.
Property is a good choice because it has real utility – people will want to live in it – so it’s likely to hold its value. Gold is a decent choice too because it’s consistently been valued for thousands of years, but the drawback is it doesn’t pay you anything in the meantime.
In theory the shares of high-quality companies should work too, because (as we’ve seen in 2020) money flows into the stock market when rates are low and monetary policy is loose.
Take on debt
I know, sounds like a weird suggestion. But remember that one of the reasons governments like inflation is it makes it easier for them to pay their debts back. You can benefit in the same way.
If you take out a loan in pounds and you’re required to repay in pounds, it works out in your favour if each pound is worth less by the time you have to pay it back.
Get in early on the next currency
Remember that there’s supply and demand for currency just like there’s supply and demand for anything else. If it’s suddenly decided that something else is going to be the new major currency that’s used to trade goods, everyone will rush to buy it because they’ll need it to transact. This will push the price up, so if you’re ahead of the game and you already own it, you’ll benefit.
The challenge, of course, is that the next currency could be absolutely anything – including something not invented yet – so getting in early isn’t easy.
If you had to bet right now, the smart money would be on either something pegged to gold (not ideal in many ways, but has had value for a long time) or Bitcoin (newer and far less widely adopted, but more suitable in some important ways). Both are attractive because governments can’t inflate them: Bitcoin has a known fixed quantity that can’t be altered, and you can’t dramatically increase the amount of gold you pull out of the ground all of a sudden.
The reward of getting in early is huge, but the risk is you’re wrong and it turns out to be worthless. I’ll be writing another article explaining why some people believe Bitcoin stands a good chance of being the next world currency.
Learning to love deflation
Jeff Booth puts it well: as an individual, deflation is good. Being able to buy the things you want more cheaply is a cause for celebration. So why is deflation bad when you zoom out and consider everyone collectively?
There’s no need to be scared of deflation. The thing to be scared of is the point at which, in their attempts to prevent it, governments destroy their currencies – with all the messy fall-out that goes along with the transition to a new kind of money. You might also be scared of the social pressures that result from inflation making asset-owners richer and everyone else poorer.
There’s not a lot you can do about any of this. But by understanding it, you can at least make better investment decisions on a personal level.
4 thoughts on “Our inevitable deflationary future”
Brilliant article Rob, I find your site very informative. Just one point to raise…
“if you think the new car you want to buy will cost less next month than this month, you won’t buy it now and the economy will suffer as a result.”
I listen to Peter Schiff and he argues that if you can afford to buy the car now you will do. Everyone knows the latest iPhone will fall in price, but it doesn’t stop people queuing up to buy them on release.
I hope to hear your perspective on Peter Schiff’s true capitalist approach one day in your articles. Thanks for all you do Rob, your books have helped me massively.
Agreed – it’s a stated reason for why the government aims for slight inflation, but I don’t know if it’s actually true in practice.
I’m working on a lot more economics-y stuff which is going to include Peter Schiff kind of territory, so keep an eye out for that. Thanks for reading!
This is a good explanation and insight. One of the elements which is unique to our current global situation is that most major currencies and countries are in the same boat of having increased debt to GDP ratios and are now in parallel printing money and causing inflation pressures. If this is done individually its dangerous for a government as people lose confidence in the currency, its obvious that its value is falling in comparison to other currencies, people and businesses switch to using other currencies etc….but when they all inflate together its quite a unique scenario which may break some of the conventional wisdom.
I wonder how inflation impacts the development of technology which is that strong deflationary driver, if due to inflation and economic stagnation the wages, and hardware costs increase regularly will businesses be willing to spend significant sums of money on R&D to push for the next innovation, risk bringing a new product to market or will they be focusing on buying up stock and components ahead of supplier price hikes, cutting their operational costs.
I have been listening to some interviews on YouTube with Russell Napier where he digs into some of the changes which have happened with governments taking over the creation of money from central banks, and the future potential that credit availability will be more controlled by the government than by the free the market. I think you would find them very interesting.
Great comment, thanks Murray! Agreed on all currencies inflating in parallel. It’s why I don’t think the US Dollar Index tells you much, because it’s just measuring USD against a basket of others that are doing exactly the same thing.
Good point on whether an inflationary environment will reduce innovation. You could argue that there’ll be more willingness to invest in automation if wages are going up, but I really don’t know.
I’ve heard Russell Napier on the power-shift away from central banks and he makes great points. This is an excellent interview with him: https://themarket.ch/interview/russell-napier-we-are-entering-a-time-of-financial-repression-ld.4628