Understanding inflation, by looking at inflation and deflation together
This is what’s called macro – it’s to do with wealth in a country, a continent, the world, and within that macro environment we all exist, earn and pay our bills. The macro measures big ticket items, like the price of everything at the factory gate.
We, as individuals, don’t buy (normally) from factory gates, we are highly individual in putting together our own basket of goods for our expenditure. I don’t buy gaming handsets, I do buy French wine; my adult children do buy the handsets and prefer to buy local craft beers, so their personal inflation is going to be different to mine.
Inflation affects our spending power, not our spending – unless it is for utilities like water or power. If the price of fresh meat jumps, we simply tilt towards fish and pasta. If the price of fuel jumps, we simply skip that weekend’s trip to the coast.
We tend to describe to investors that inflation is good for equities, based on the simplistic summary that inflation is the rise in the price of ‘stuff’, stuff is sold by companies, so higher prices will lead to higher revenue and higher profits. This applies to the nominal prices and revenues, where it is the same price as before but with inflation added on top.
This is explained most simply by Irving Fisher in his book ‘Money Illusion’. He was an American professor of economics at Yale, followed by Milton Friedman, and this is from a hundred years ago, published in his book in 1928.
“To illustrate how, as between stockholders and bondholders, this lottery works, consider a company which, say, before the War in 1913 had outstanding a hundred million dollars of bonded debt and a hundred million dollars of stock.
Each yields five per cent, five million dollars, so that, before the War, the corporation distributed between these two classes of investors, bondholders and stockholders, ten million dollars. This, for convenience, will be called profit.
Let us now see what happens if the buying power of the dollar is cut in two, that is, if the price level doubles (which it actually did between 1913 and 1919).
Suppose then, that this company did the same physical volume of business after the War as it did before, but at the doubled price level. It would then have doubled the profit—in dollars.
For, if the expenses double and the receipts double, the difference between the two must also double. The profit would thus be twenty million dollars instead of ten million dollars. But while nominally this twenty million of profit would be double the original ten million, in real value it of course would merely be its equivalent.
Now this twenty million dollars would not be distributed evenly between bondholders and stockholders, as the ten million had been! Why? Because the bondholders are restricted by contract to their five per cent. They will get, out of the twenty million, the same five million as before—the same, that is, nominally, but in real value only half. What is left out of the twenty million (fifteen million dollars) will now go to the stockholders.
Nominally, then, the stockholders will get three times what they did before the War, but when we allow for the dollar having been depreciated one-half, what they really get is one and one-half times as much value. Thus the stockholders get more real value than before the War, while the bondholders get correspondingly less.
Inflation, quite impersonally, if you please, has picked the pockets of the bondholders and put the value into the stockholders’ pockets, simply by the change in the value of the dollar.
Suppose, now, that the wind blows the other way. Then the exact opposite happens. Prices are, let us say, cut in two by deflation and the company’s expenses and receipts are both cut in two. It follows that the profits will also be halved. Hence the company will distribute not $10,000,000 but $5,000,000. (Of course, the $5,000,000, at this lower price level, is worth just as much as the $10,000,000 before.)
But this $5,000,000 will not be evenly divided between stockholders and bondholders; for, under their contracts, the bondholders are entitled to five per cent. They will therefore take the entire $5,000,000, leaving nothing at all for the stockholders.
The company is on the verge of bankruptcy. If the process goes much further a receivership follows. The blame would be attributed to the management; but it would be the robber dollar that had done the harm. Like the stockholder is the farmer, already discussed, who mortgaged his farm, while his creditor is like the bondholder. When, as in 1919, there is inflation, the farmer gains at the expense of his creditor. When as in 1921, there is deflation, his creditor gains at the expense of the farmer. “
Irving Fisher, The Money Illusion
The term ‘money illusion’ is the name for the natural bias people give to thinking about money in current (nominal) terms, as opposed to real values, adjusted by inflation. This influences our perception of outcomes, and has been empirically measured and assessed by leading behavioural economists including Amos Tversky.
People generally view a 2% cut in their current income with a fall in prices by 2% at the same time, as unfair, but they see a 2% rise in their current income when there is 4% price inflation as fair.
This is why we use the term rational investing in regard to our strategy with client investments; people simply are not consistently rational (that’s a human characteristic), and financial decisions are no different, so we seek to nudge people down the prudent (rational) path. The money to pay your bills today, this month, this year, is very easy to identify – you know what you’ve got and where it is. Our job as your planners (not investors) is to ensure the money is just as reliable for the you in ten years time – you will either need it then when it is even more important to have income reliability as you are older, or you’ll be dead. We’ll help with the former scenario.