Inflation, Deflation and Globalization Arbitrage

There is a debate raging amongst economists and market participants about whether the US is about to suffer inflation or deflation.  It is an area of great discussion and there is no clear consensus.  I think that, as with most areas of this dismal science, people are too short term focused here to see clearly what is going on.  We will get both.

My first problem is that when people address the subject they are generally talking about price levels reflected in changes to the Consumer Price Index (CPI).  The CPI is flawed, however, as a measure of price levels.  It does not measure inflation that real people suffer in part because it is an average of an average and in part because it is manipulated down (by reasonable adjustments) so that government payments that are indexed to it are lower than they would be else wise.   CPI will, therefore, tend to underestimate inflation and overestimate deflation.

To get a better understanding of the inflationary and deflationary pressures we are facing I think that we have to look at the drivers of price levels and see what thematic forces are at work here.  Deflation and inflation are the results of larger thematic forces at work.  As a long-term investor in private equity I have to be thematically driven, but I think that it also gives you a good framework for understanding shorter term phenomena.

The themes that I think are most relevant here are Moore’s Law, democracy/capitalism, and globalization:

• Moore’s Law for processors (and its sister Nielsen’s Law of Internet Bandwidth) point to us being able to do more for less resources, be it processing or communicating.  This is pushing communication costs to/near zero and allowing new disruptive business models to be built at ever lower costs.  If I have a business that sells or services widgets for $10, and someone comes along with a new service at $5, it it at its core deflationary.  Moore’s Law is a massive deflation driver, especially for businesses that involve end-to-end communication and can be disrupted by moving from analogue to digital foundations; think newspapers, music, finance, education, etc.
• Democracy and capitalism go hand in hand in many places in the world today.  It is possible to have capitalism without democracy (such as in China or Saudi Arabia), but I cannot think of an example where we have democracy without capitalism.  They are powerful interlinked forces and they are forces where the driver for change is decentralized to the people and not centrally controlled and conceived.  The result is that the best ideas can percolate to the top and they facilitate the adoption of new idea, disruptive ways of doing things and, like Moore’s Law, are inherently a deflationary enabler.
• Globalization is both deflationary and inflationary.  Simply put the Indian outsource model is a huge arbitrage of wages in the West vs. wages in India.  It keeps a lid on wage inflation as there is someone the other side of the world able and willing to do the same job for less.  Today I can hire a programmer in the US for $5,000 -$10,000 a month here or $1,000 a month in India.  Moore’s law has reduced the cost and technology barriers, democracy and capitalism has facilitated the formation of such industries in India and the reduced political and tariff barriers from globalization makes this all possible.  Thus for the West globalization is deflationary – we make these goods in China because the end result is cheaper goods.  For China, India and the service centers and factories of the wold it is inflationary, especially for wages.  I would say that this is a good thing; rising wages in developing nations has a trickle down effect for their economy, raising living standards, raising availability of health care and lifting people out of abject poverty.

There is another theme here that combines all three (and other) themes; rising expectations in the developing economies.  Though America receives a bad press around the world, everyone wants to live like an American.  Everyone would love to consume as an American; drive a car, live in a big house, be rich.  Now I know that is not how many live here, but the American Dream is the World’s Dream.  The problem is that it is not possible, not in the short term, and even if we approach it it will seem to be more of a nightmare than a dream.  The world is resource constrained.

The speed of the growth of expectations and realization of those expectations in the developing economy is unprecedented in world history.  Never before have so many people been lifted from utter poverty to mild poverty, mild poverty to working class, working class to middle class.  This is amazing, it is magnificent and it has significant repercussions.  Some of these are good and some are not.  I remember reading in 2006 that the number of obese people in the world now exceed the number malnourished.  Forbes in 2007 published a table with 88 countries that have over 50% of their population with a BMI over 25.   There is not enough basis materials and resources available to meet the expectations of the newly enabled people from the developing world.  Advances in technology will ultimately bring us new and novel solutions, but in the short term these demands will lead to shortages that are resolved through price.  Commodity prices are going higher, agricultural product prices are going higher.  This demand driven inflation is required to lower demand.  It is basic economics.

Thus my expectation is that we see commodity based inflation combined with services and manufacturing based deflation.  I expect both.  We can expect a relative wealth transfer from the West to emerging economies, especially those that have an abundance of resources or cheap labor.  The recent economic crisis has only exacerbated the deflation aspects here as the cheap money led to a build up of excess manufacturing capacity, and a desire to increase productivity in the downturn that will reduce the need for labor going forward.  It also has led to a fall in commodity prices that I expect will prove to be temporary.  The end game is that the globalization arbitrage will continue, that living standards will move closer between emerging and developed economies, but that they will meet more in the middle than either expects.

Shanghai Rising

I see this a a natural outcome of policies and processes that are in place, have momentum and are tough to dislodge.  This is not all bad for those in developed economies.  There will be an unprecedented increase in the ranks of the middle classes globally, and this will stimulate massive new markets that can be addressed with new products that will benefit all of mankind.  For example there will be more people willing to pay for drugs and therapies for diseases that today are too “rare” to have research funded.  This will not just be limited to healthcare but extend to investment in consumer products, entertainment, and all aspects of life.  There will be change and disruption, but overall we will all benefit from this brave new world.