Inflation, money, things & people

"Inflations is always and everywhere a monetary phenomenon".

Increasing money supply
Let's play monopoly. Only this time with a twist. We have one board, one set of properties, hotels, cards etc. However we have two sets of monopoly money. Here's how we play. For the first hour we play one set of properties, one set of money. At the end of the first hour add the second set of money, shared amongst all the players. What do we notice? We would notice a step change (increase) in the general level of prices as players bought and sold properties. Such a step change would be immediately obvious and would (rightly) be attributed to the extra cash added to the game.

Now let's be sneaky. Again we start play with one board, one set of properties, hotels, cards etc, and one set of money. However in this game, every time a player passes GO we secretively give him extra cash to the tune of 2% of his current position (cash + properties). After 35 rounds (about 4 hours), there is twice as much money circulating as before (1.02^32 = 1.99), except the players are not aware of this fact.

So what do the player notice? Fabulous returns on property!! "I bought Mayfair for $400, and sold it 2 hours later for $600. I then bought all the utilities for $800 and had them at the end worth $1600. How clever am I!!" What else would we observe? Well the fines and rents seemed increasingly trivial as the game went on (hint, they're not indexed to inflation).

Welcome to life. In reality we have more than just property as an asset class. With inflation we see the prices of bonds, property, commodities, equities all rise, though not necessarily in synch. The central banks can add money, but they can't say where it will go. So what happened? Bonds rose, equities rose (and peaked 2000), real estate rose (and peaked ~2006), commodities rose (and possibly peaked 2008).

Money supply versus physical goods

So let's play monopoly again. This time after the first hour let's double the board (properties, hotels, players), but keep just one set of monopoly money. What would we notice? Sharp property price falls as the same amount of money was shared by more player bidding on more properties. Oh my goodness, we'd have massive deflation, a monopoly depression!!

Okay, let's try a different game. Play with one board and one set of money, but after 1 hour we remove half of the money by making players hand it over. If need be they have to sell their assets to do so. Again we have falling prices and a monopoly depression.

Money supply growth, population growth and productivity

It's all relative in a growing economy. If we double the monopoly board and double the money, we won't see different prices, just a bigger game. In the real world increasing the 'board' is achieved through population growth (birth rate, immigration, death rate); while increasing physical stuff is achieved through productivity growth (more with less, technology, science, innovation etc). Globalisation also plays a part as production and services are procured from overseas workers. Increasing the amount of money is achieved by increasing central bank money (M0), and commercial bank money (M1-M3).

Price stability - balancing growth in money, people, stuff
So here's my theory. Assuming stable population, innovation and productivity, inflation (general price levels) are always and everywhere a monetary phenomenon. The more correct general theory would be that inflation is function of money, population and goods growth.

The boom years 1980-2000
In a previous post I discussed asset price appreciation and reducing inflation (the great moderation). Following this thought further I believe we can see macroeconomic factors in light of money supply, population and goods growth.

Global Money Supply
Total money supply growth has clearly been at high levels since the 1980s. In recent times we have seen extensive money growth in many nations as they try to competitively devalue their currencies. See the chart at left based on data 2007 money supply from Wikipedia. This is clearly inflationary, but what has happened to population growth?

Global Population Growth
Well nothing abnormal in an absolute sense, but in a productive capacity we have added 3 billion Chinese, Indians, Brazilians, Thai's, Malaysians, Vietnamese and so on. That is clearly deflationary.

Global Productive Growth
Three things have impacted productive capacity. First, industrial/digital inventions such as computers, internet, biotec, agri-tec and so on. Second, business management techniques have improved (lean six sigma, just in time manufacture, ERM, CRM and so), and are more standardised through global companies. Thirdly, more countries are now moving into manufacturing so more 'stuff' is being made.

From the mid 1980's I belive that productive growth + population growth exceeded money supply in the financial economy. That's why inflation moderated with all the benefits associated with price stability.

In the current situation (2008), money supply is contracting due to the credit crisis (banks have lost too much money) whilst population and productive growth is stable. This calls for general price deflation according to my model. Of course the (asset) price reductions won't be even. We have already had trillion dollar real estate and equity losses. So it is not unsurprising to see some rises in bond and commodity prices. Look for more of the same over the medium term.