Inflation & Deflation - Heads I Win, Tails You Lose

Introduction

People rent out their time to employers in exchange for money, and businesses invest money to potentially get more of it back in the future. The use of money is so prevalent it's easy to forget that it's just a made up concept meant to facilitate exchange and act as a store of value. What your money buys you today will very likely not be what it buys you in the future, and you have less control over it than you think. This is a story about Cris and Leo and how a fluctuating value of money changed the trajectory of their lives and exacerbated the inequality between them and across the world.

Chapter 1 - Oblivion

Cris and Leo grew up in New York. Cris's father owned a small furniture business in Brooklyn and his mother worked at a local factory. Cris grew up spending most of his free time helping his father in their wood shop. Leo's parents were both partners at major law firms in Manhattan and lived in a penthouse overlooking Central Park. During summers Leo could be found vacationing in exotic destinations.

Cris and Leo ended up going to Lehigh University for their undergraduate degrees and struck a friendship while there. After graduation they both took up jobs as analysts at an investment bank based in Manhattan and rented an apartment together. They were living their dreams. Cris was delighted to be on a six figure salary and used his signing bonus to buy his father a new piece of equipment for the wood shop. Leo was just glad to have his own apartment in the city away from his parents' oversight.

The world was bustling with optimism. The stock market was rallying and the media was filled with reports of stocks that had doubled or tripled. Those on the sidelines had a fear of missing out in the rally and piled into the markets. Company executives all had rosy business projections and were ramping up hiring to prepare for the inevitable growth. What could possibly go wrong?

Chapter 2 - Nosedive

Amidst the wave of optimism that had spread through the country, businesses were overzealous in their spending and when the growth they had assumed didn't materialize many faltered and even fell behind on their debt payments. The stock market crashed and engulfed the entire country in a panic. Most people's retirement accounts and at least a portion of their savings are invested in an index fund that tracks the stock market so a crash is felt by the masses. Even the banks took losses as they were left holding a bunch of bad loans businesses defaulted on. If it weren't for the government guaranteeing people's deposits (up to a certain amount), everyone would have withdrawn their money at the same time, leaving banks insolvent as they only hold a portion of deposits in reserves.

Cris and Leo were both laid off as the investment bank they worked for took massive losses and had to cut costs. Without a job Cris could no longer afford to renew his lease in Manhattan and was forced to move back home to Brooklyn. Leo, on the other hand, was able to leverage his parents' corporate network to find a new job relatively easily.

Now back home, Cris was helping out his father but their furniture business was struggling as people could either no longer afford to spend money or delayed their spending. In a widespread panic fear usually sets in as people don't know what the future will look like and start planning for the worst and hoard whatever resources they can. Cris's mother had her wages essentially cut in half as the factory scaled back on production hours. The rosy business projections turned apocalyptic and there were mass layoffs all over the country causing people to lose their source of income. One person's expense is another person's income, so when people no longer had money to spend the effect rippled through the entire economy. The media was filled with reports of turbulent years ahead which added to the panic and the economy came to a stand still. This is when the Central Bank of the country should have intervened, but didn't.

Facing declining demand, Cris and his father had no choice but to cut prices in a last ditch effort to entice customers. Businesses all over the country faced similar issues and were forced to cut prices as customers, many having lost their jobs, simply weren't able or willing to spend as much as before. The market was flooded with excess unsold inventory which put a further downward pressure on prices and the economy was stuck in a deflationary spiral.

To make things worse, payment on a sizable business loan that Cris's father had taken out a few years ago was due soon. Old debt is especially problematic once deflation sets in as the payments become even more burdensome once the prevailing wages and prices are lower (i.e. when prices are lower each unit of currency can buy more so the fixed debt amount that doesn't adjust downward with deflation is effectively a higher payment than one had planned for). Everyone with old debt faced a similar issue and was forced to take desperate measures. Cris's family, like many across the country, were left with no choice but to sell their financial assets in order to pay their debts. Unfortunately, this was at a time when the stock market was still reeling from the crash and people were forced to sell out of their positions at massive losses. The widespread selling put further downward pressure on stock prices and the markets fell even further.

Every transaction has two sides, and at a time when many were forced into selling there were others who could afford to be opportunistic. Leo was in a much better position to weather the storm. Not only did Leo have a consistent paycheck coming in, his family had more than enough savings to meet their obligations. Instead of being forced into selling in a market downturn, Leo's family was able to take advantage of the situation and put more money into stocks at low prices.

Chapter 3 - Printing Money

Years went by and the country fell deeper into a depression. Eventually the Central Bank decided to intervene to try and halt the economy's self perpetuating deflationary spiral. A Central Bank has the power to stimulate or cool down the economy and largely does so by adjusting the money supply and the interest rate at which banks lend among themselves (which in turn flows through the economy as it drives what rates banks charge people). Seeing the falling prices and a lack of spending / investment, the Central Bank announced lower interest rates hoping it'd induce businesses to take advantage of lower borrowing costs and resume investment. Investment creates jobs which in turn increase spending as people have more disposable income. The media started reporting a rebound in economic activity and the narrative turned hopeful.

Armed with the belief that people will have the money to buy the goods being produced, factories ramped up production and Cris's mother was back to making a full shift's wage. Furthermore, to push prices higher and combat deflation, the Central Bank bought securities from the market to increase the economy's money supply. This is known as quantitative easing and the Central Bank essentially 'prints money' that it then introduces into the economy with the idea that more money would compete for the same level of goods and services thereby pushing prices higher.

Slowly things turned around. Businesses across the country were doing well and, largely due to the low borrowing costs, made a nice return on their investments. Cris and his father saw old customers return and things were starting to feel like normal again. Life continued on an upward trajectory and the world soon forgot about the tough times. The stock market rebounded and while Cris's family was just grateful to be out of the depression, Leo's family found themselves sitting on a handsome profit as they were able to invest in the depths of the depression. The wealth gap between the families thus grew wider. In times of severe market shocks it is often the case that ones with resources to hold onto and even buy more financial assets get richer and ones with limited resources are forced to sell at market lows causing a widening of the wealth gap. Moreover, while the increase in money supply was stimulating, the way it flowed through the economy further widened the wealth gap.

When the Central Bank was buying securities from the market using newly created money the holders of said securities were mostly large corporations and wealthy individuals who were thus the first ones to access the new money supply. Additionally, the same corporations and individuals were the first ones to see their borrowing costs decrease when interest rates were lowered. Therefore, large corporations and wealthy individuals gained the most as they were able to invest new money at low rates before everyone else in the country and before prices started rising. This is known as the Cantillon Effect.

All was well in the world for a while, and while the Central Bank's policies were helpful in combating deflation, we'll see next that there's no such thing as a free lunch.

Chapter 4 - Too Much Ink

Cris had grown to like working with his father and was eager to grow their furniture business. One day as they were driving to their store's landlord to discuss a lease renewal, Cris was trying to convince his father to expand the store and move to a bigger workshop. Cris's father, memories of the depression years holding him back, was hesitant but eventually agreed to see what was out there. Unfortunately, they were in for a surprise as the landlord informed them of a massive rent hike they could barely afford. Cris's father asked around to see if others were seeing similar increases and was shocked to learn they were widespread and that there were a lot more potential tenants in the market flush with cash. To make things worse, Cris's father soon had suppliers calling him informing of higher prices citing a rise in their own cost of operations. The sudden and sharp increase in prices reverberated through the economy as wage earners across the country felt the pinch every time they bought groceries.

It turns out that the Central Bank printed too much money and kept interest rates low for too long causing prices to rise uncontrollably. The increase in the amount of goods and services produced in the economy wasn't enough to keep up with the much higher increase in money supply and led to a sharp increase in prices. Moreover, persistently lower interest rates meant that an increasing number of businesses took out loans to finance spending which further caused demand to increase beyond what production could keep up with, thereby pushing prices even higher.

Cris's mother was still making the same wage at the factory but soon found herself being able to afford less and less as prices kept rising. Such was the experience of wage earners throughout the country as their earnings did not keep up with the rising cost of living. Most businesses, facing rising input costs, kept wages flat since the alternatives were either lower profitability or risking losing customers by passing on all the cost increases to them. Some businesses even started outsourcing their needs to countries with lower labor costs.

Cris's family were no longer able to afford the things they were used to and saw their bank savings' buying power greatly diminish. On the other side, Leo's family who had made a windfall in the stock market rally following the depression and were able to diversify their portfolio by investing in real estate and gold, were able to withstand inflation better; while their bank savings lost purchasing power, the gold and real estate they owned increased in value along with the rising prices. Again, the wealth gap increased.

Chapter 5 - Salvage

The Central Bank knew it had to act, as left unchecked, inflation has the power to destroy a currency as people lose confidence in it as a store of value and, in extreme cases (hyperinflation), can abandon it and switch to foreign currencies that are more stable. To combat the sharp price rises and cool down the economy, the Central Bank raised interest rates making continued investment more expensive and reduced the money in circulation by selling securities to the market. Higher rates and lower money supply then combined to put a downward pressure on prices, but it was a long process that took years to materialize.

It's important to remember that the cumulative effect of inflationary periods never goes away. Once high inflation had occurred, even though it was subsequently brought under control, the purchasing power of people's savings remained significantly reduced and the damage to families like Cris's was largely irreversible.

Cris and his family accepted their new reality, not that they had any choice in the matter, and went back to playing the hand they were dealt. Years ago Cris and Leo had been in the same job with the same college education behind them, but their lives unfolded in more disparate ways than either of them could have imagined.

Conclusion

While Cris and Leo are fictional characters, their experiences are rooted in true events that have transpired over the past century. The United States fell into a deflationary spiral in 1929 that lasted nearly a decade, and Germany and Zimbabwe both experienced hyperinflation in the 1920s and 2000s, respectively. As I write this, the United States's Central Bank (Federal Reserve) is in an ongoing battle to bring down inflation.

The perils of both deflation and high inflation outlined in this story are the reason why central banks of several currencies now aim for a 2% inflation rate. They hope this will be a manageable level of price increase that people can reasonably plan for, a sustainable economic growth target, and provide a much-needed buffer against deflation.

Common people bear the brunt of the negative consequences of deflation and high inflation, and it is up to the elected officials to conduct monetary policy in a way that safeguards the masses. Wealthy individuals and sophisticated investors have the means to sidestep and even benefit from crises, and without effective policy, inequality will continue to exacerbate.

If only there was a form of currency not controlled by a central bank...

Disclaimer: All content is for informational purposes only and should not be construed as legal, tax, investment, or financial advice. All opinions expressed are strictly my own and do not represent those of any company or third party.