What does Thomas Edison have to do with bonds and gold?

In these times of economic upheaval, divergent opinions regarding future inflation exist side by side:  Either Grand-scale inflation or deflation, take your pick.  The differences are actually not side by side but at either tail of a subjective probably distribution of inflation expectations.  This is economic jargon for the simple idea that there two opposing stories being told as to how future inflation will play out.

This cleavage in expectations exists not just among economists, but opinions also divide Fed policymakers and financial market participants alike who simultaneously assign, for example, very high prices to both fixed income debt that benefits from deflation and inflation-adjusting debt (a la the Treasury TIPs) that benefits from inflation.

There was a time in my life when I was involved in the development of inflation adjusting financial products that ultimately earned a U. S. patent.  In what was an education in investor behavior, I was surprised to find both buyers and sellers projecting 30 years of future inflation solely based on the last monthly CPI report extrapolated forward for 30 year.  So today’s bimodal inflation expectations are a notable exception to the usual normal distribution of expectations squarely centered on the most recent past.

So what is at the heart of the cleavage in inflation expectation?  Obviously, there are two visions of the eventual outcome of the financial crisis and the Great Recession whose repercussions continues to morph and plague the economy.  It has resulted in extremism in government financial needs and monetary policies never before seen in the developed world to contain the recession and aid and abet the refinancing of consumer debt and the financing of government deficits.

But also on the minds of inflation watchers is the implication of the baby boomer entitlement boom which is now booming.  For example, the Social Security Trust Fund, the only entitlement with a trust fund of any significance, is expected to be depleted in only 3 years. Thereafter the financing of the boomer entitlement packages will create leaps in government financing stains and further central bank co-opting to make an inflation outlier possible.

Whatever the historical model or the free floating paranoia cited by the Grand-scale inflationist, it all follows from the pressure on governments to raise funds by selling bonds either to support the economy or support the entitlements and for their central banks in turn to purchase a large portion of that debt as central banks do with printing money.  That is made necessary because private saving both domestic and/or foreign are insufficient to finance the government’s debt lust. To most Grand-scalars the process comes down to the single catchword: “printing.”

Since much ink has been devoted to Grand-scale inflationist arguments, likely as much ink as needed to print their feared currency explosion and I won’t add to it here but rather review the deflationist’s positions which are less well known and are subject to recent qualifications.

The deflationist views are almost as radical a departure from our historical norms at least among the living. Deflation is associated with depression which to the deflationists arises from the idea that servicing both the consumer debt load and the government debt load, both present and future, will deplete income streams leaving very soft goods markets demand and hence soft pricing.

Other deflationists point to the possibility of a sovereign default which is not likely with the printing press within reach of our government.  If it were to be a sovereign default generated deflation it would likely be delivered as the result of contagion from a depressed European default.

But deflationists still find falling prices a likely outcome even without a default as a result of the fiscal restraint to prevent one.  That is, the upcoming fiscal cliff is not seen as a one-off exception but as the forerunner of generalized austerity for a long time to come that will be sufficient to soften demand in goods markets so as not to put upward pressure on goods prices, despite the “printing” they observe.

So to today’s highly influential deflationists and bond devotees, the soft demand creates excess supply in goods markets is seen as an insulation from inflation if not the driver of absolute deflation. In this case, the asset of choice is fixed income, the longer the maturity the better, general stated as a strategy of safety and income at a reasonable price (SIRP) championed by David Rosenberg and other very notable financial economists.

The supply insulation from inflation is measured by the excess productive capability relative to aggregate demand and is shown in the accompanying graph as the difference between Potential GDP (the supply side) and Actual GDP (the demand side) for the past dozen years.  When the Great Recession arrived, the demand side (Actual GDP) plummeted well below Potential creating what is known as a deflationary gap.  Deflationary gaps have been seen before but never of this magnitude in the post WWII period.

What could eliminate the inflation safety margin would be successful government attempts to spur Actual GDP upward and onward to approach the path of Potential GDP.  However, the massive fiscal and monetary stimulus during the Great Recession years has only put an end to the GDP free fall and thereafter GDP demand has only been able to track below and in parallel with Potential GDP target leaving what appears to be a substantial margin of inflation insurance.

But alas, the deflationary gap comfort margin for fixed income also depends on the growth path of Potential GDP.   The estimates of Potential supply are made by the Congressional Budget Office from projections of increases in capital (plant and equipment), the labor force and the productivity of the combined labor and capital inputs.  For much of the post WWII era we lived in the heady bubble of steady state growth with relatively minor and short recessions which made steady state, trend extrapolation easy and more reliable.

But, we are now finding that without the pressure of demand growth, a lot of things change including the incentives to add new plant capacity when excess capacity exists and labor is cheap.  An additional slowdown of Potential occurs as new plant and equipment generally embodies the latest technology and makes a productivity contribution to Potential as well. That is, the engine of Potential Supply runs through the Thomas Edisons in the laboratory, to venture start-ups and through the IPO process but it has downshifted and reduced not just the level of Potential GDP but its growth rate as well.

As a result, at year end 2011 the deflationary gap would have been a very large 11.3% of GDP had the estimated Potential Supply growth made at the onset of the Great Recession been realized.  However about half of the inflation insurance provided by the deflationary gap has disappeared based on the 2011 Potential GDP revision, leaving a deflationary Gap of 5.6%.   If one were to examine the graph and extrapolate both Actual and Potential GDP it would not be many years before they cross.

Further concerns for the supply side exists when we find that when Plant and Equipment spending slows down, its average age is getting older hence both labor and capital should be comforting each other as they grow old together.

Moreover the general negative view of the outlook for productivity growth has been expressed by Robert Gordon the well-known productivity expert and is well summarized by Martin Wolf in “Is Unlimited Growth a Thing of the Past?”

While the Deflationary Gap is still substantial, we can see where things appear to be headed. The logic is clear: Necessity is the mother of invention, and without pressure to produce more, there is little sense in building a capital stock that imbeds productivity gains. This idea is consistent with recent data revisions.

With an economy that is trapped into long term sluggishness and consolidation on the demand side from fiscal austerity pressures, it will also slow the Potential Supply side. This means it takes a lot less growth on the demand side to generate inflation.  And add to that the commodity supply shortfalls which keep upward pressure on food, energy and raw materials prices.

Indeed, even with a Great Recession when, other than in the cascading shrinkage of 2009, deflation has not been forthcoming as suggested by theory.

While the Tomas Edisons of the world are still out there tinkering, fewer of the fruits of their research are benefitting productivity.  The implication is more inflationary sensitivity than one would expect from a relatively slow growth economy which provides comfort to the value of the investment categories favored by the Grand-scalers such as gold and real assets.


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