You can’t get something from nothing.
Illustration: Randall Munroe. Source: Wikimedia
It’s the same principle as the conservation of mass, or conservation of energy, or conservation of momentum. In nuclear physics, when deuterium atoms merge to form a helium atom, a teeny-tiny amount of mass is converted into energy, according to Einstein’s famous equation, E = mc2. The result is an intense explosion, as the mass/energy conversion happens so quickly and the detonation creates a shockwave.
In economics, there’s a similar phenomenon at work. Some call it the “free lunch” principle, as in the saying “There’s no such thing as a free lunch” (TANSTAAFL). The government doesn’t create prosperity by simply distributing more of its currency to the citizens. That confuses money with wealth. We don’t become wealthy just because we possess more money. We’re wealthy when we can purchase the goods and services that we want, or when we can enable others to do so.
Similarly, the government doesn’t necessarily make us poor by taking our money, if in exchange we can get what we need. That’s the compact that people in many nations have made regarding healthcare – paying higher taxes and participating in a government-managed healthcare system. And if societies tried to create healthcare or national defense or administrating system simply by printing money, the system would fall apart. Economic activity creates wealth, not the other way around.
Inflation happens when there isn’t enough economic activity to satisfy the demand placed on the system. There are two ways for policymakers to address this. One is by slowing – or delaying – the demand. Paul Volker and Alan Greenspan famously used monetary policy in the early ‘80s and ‘90s to accomplish this, “taking away the punchbowl when the party gets too hot.”
There’s another way to address inflation: increasing supply. The supply-side revolution of the ‘80s and ‘90s did just as much to defeat inflation as the Fed’s monetary policy. And this was accomplished primarily through tax reform, regulatory reform, and a cultural ethos that valorized innovation and enterprise. But that’s a subject for another day.
How can investors protect themselves from an unexpected increase in good prices?
If you pay for goods and services in an inflationary currency, one approach is to hold a non-inflationary currency. For millennia, gold played this role. When the Roman Emperor Nero reduced the amount of gold in the Empire’s coinage – thus debasing the currency – the price of goods and services in Rome rose. Similarly, during the inflationary 70’s and more recently, the price of gold – along with non-inflationary currencies – has risen:
Long-term price of Gold and Swiss Francs. Source: Bloomberg.
Some believe that cryptocurrencies have this non-inflationary potential. And it’s true that no more than 21 million bitcoins can be mined. But investors should keep the Lindy Effect in mind, the notion that things that have been around a long time tend to stay around for a long time. Gold has been around for millennia, the Swiss Franc for centuries, and bitcoin for … a decade? Yes, a decade seems like an eternity in crypto-currency time, but technological disruptions can themselves be disrupted: couriers were replaced by faxes which were replaced by email which will be replaced by something else.
Another approach is to own the goods and services. If rent is rising (and “rent” is just an amalgamation of various shelter costs), you can own your own shelter. If food is getting more expensive you could plant a garden. If services become more expensive, you could perform some of these yourself. During the ‘70s my family bought a set of trimmers to economize on the price haircuts. The quality might have suffered a little, though. So far, price increases in the service-sector of the economy have been modest. Supply chain issues haven’t affected the price of haircuts … yet.
CPI Services (ex-energy). Source: Bloomberg.
So far, the excess reserves that the government created in response to the Coronavirus crisis have mostly sat in savings accounts or have been invested. As this pile of cash bleeds into the economy, so far, it has raised the prices of some goods – especially goods with supply chain issues.
Investing in the stocks of goods providers is one way to hedge against an increase in their costs. But be warned that the goods providers are often subject to cyclical pressures and margin issues. They may be able increase prices, but they face increased prices from their suppliers as well. And miners – the original goods providers – may face increased costs of capital and of labor.
There’s no free lunch. But if we diversify and take modest positions across a host of industries and adjust our lifestyles to accommodate higher prices, we shouldn’t get hurt too badly. And that’s the first rule of investing – try not to get hurt.