Inflation: Causes and Defense Strategy

Financial Post: Bank of Canada Worries about Inflation.

Inflation. How does this impact our projects; our lives? In the above-referenced article, the Bank of Canada signals that the Consumer Price Index (CPI) rising is reason to keep interest rates low. CPI rose 4.7% in October year-over-year, the largest increase since February of 2003 (1). The blame for increases in pricing seems to fall on supply issues, caused by the pandemic and (for Canadians at least) the flood damage in BC. The idea here being that prices are increasing because there is a scarcity of goods, and this drives the price of goods higher. If only the roads were open in BC and the semiconductors in China were being produced at scale, prices would stabilize again; at least that’s the idea.

Imagine if you will a thought experiment. Let’s say there exists a closed economic system with 10 people / economic agents. In this system, everyone starts with $100. Each day, 10 meals are produced through equal effort by the 10 agents. They each pay $1 to each-other to purchase the other’s share of the meal. Therefore, each pays out $9 a day and receives $9 from the others for their work; a balanced system. Now, imagine in this balanced system that there is only enough food produced to make 9 meals per day. Those who are hungriest may be willing to spend more instead of $9 to get a larger share for themselves, but they also slowly lose money each day doing this. Others would gain this extra money, and once hungry enough would use that to out-bid the others so that they can get a greater share. So prices rise, while the distribution of food becomes volatile, swinging greatly. Risky players may even work themselves to starvation trying to stay on the money-making side of the equation. Eventually, one may take it too far and perish, bringing the economy back into balance, but at the cost of life. This is why supply-based inflation is dangerous; it creates undue hardships. If the Bank of Canada and the Financial Post are correct, then we should see prices fall back to normal once supply constraints are alleviated.

However there is likely a second layer to this problem, one that most national banks are not fond of discussing; namely, money supply (2).

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In the above chart (2), you can see the current supply of highly liquid currency created by the Federal Reserve over time (M1). You can spot that in the last year there might be what one could call a historical change. Most other nations, including Canada have played along (3):

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There is another way, therefore, that inflation can be caused. Let’s think back to our experiment. Starting with the balanced economy again, imagine that 1 of the 10 agents is responsible for replacing damaged currency, and who created the initial $100 per person. Let’s call this agent Guv. Guv notices that everyone has a little bit of extra time at the end of each day, and decides to get more value out of them by paying them to do more than just make their share of food each day. Guv uses his money-making skills to add another $1000 to the economy this way. Initially, everyone is happy, Guv gets some extra food, the community pools some of their extra time together and builds some nice new roads, etc. Eventually the economy balances out again, and everyone now has $200. Guv thinks he did a great thing, and considers doing this regularly. However, with more money, each person wants a little more food, so they start to bid up the price. Eventually, everyone pays $2 for food per day per person instead of $1. Once the economy is balanced again, the price of food stays at this new rate, and does not go back down. Eventually, the new roads need maintenance, and Guv misses the old days when he got extra food. Guv decides to print more money again, this time much more, so that more can be accomplished.

Yet, as human history has shown time and again, all this seems to do is create a cycle where Guv gets fat, small improvements are made but not maintained, and prices increase. Although not as intuitively dangerous as sustained supply constraints, if currency supply skyrockets (and purchasing power tanks) too quickly, people at the bottom of the economic flow can’t keep up and lose purchasing power. If one agent takes $9 from the previous day to go buy food for the day, but the price is now $18, his savings now buys half the food it did the day before. If this currency supply / inflation cycle increases too quickly, we enter hyperinflation, whereby people abandon the currency completely. At this point it’s easier for agents to barter or use other more stable forms of value; otherwise they risk losing all of their purchasing power faster than they can replenish it. One recent example is the hyperinflation in Zimbabwe that wiped out much of its citizen’s wealth, plunging the nation into poverty (4). The Dallas Federal Reserve acknowledges this dangerous cycle: “Hyperinflation, which rapidly destroys a currency’s value, is fundamentally a monetary phenomenon. Deprived of conventional means of raising revenue, such as taxation, governments borrow without limit from the central bank” (4).

So, what is the cause of CPI increase and overall inflation to cost of living? Supply shortages can certainly cause what we are seeing at the gas pumps and grocery stores. But so can national bank monetary policy. If supply shortages are our only concern, we should see projects delayed and a temporary rise in prices in our daily lives. If the cause is flooding the world economy with currency, then we should see a surge in project investment, and prices that don’t seem to want to come down once supply chain issues are resolved. Although it’s hard to ignore the drastic changes in money supply that national banks are generating, supply chain issues also play a role. That said, there are strategies you can take as a business, and as an individual to protect yourself in both scenarios.

To protect your business during supply shortages, it’s best to hoard cash and other (fairly-priced) assets and delay projects. This protects you from overpaying for labour and materials, and it also prevents mining and manufacturing companies from generating inventory they can’t bring to market due to supply chain issues. However, if the cause of inflation includes currency-flooding, then hoarding cash is counter-productive. To protect your business from monetary inflation, you should initiate fixed-price contracts and turn as much cash as you can into assets as quickly as you can. This helps make product generated at today’s costs and sold at tomorrow’s prices help you climb the inflationary mountain. If you are unsure as to the cause of inflation, or if you suspect it is a mix of the two, you may seek to obtain assets that increase along with inflation. Historically, this has been real estate, and healthy stocks. Although stocks are liquidated during hyperinflation, so this strategy should be monitored very closely.

To protect you and your family from supply-shortage inflation, you really don’t have as much of an option; if you need to buy food and heat your home, you have to pay the higher cost. You can restrict luxury purchases to compensate, however on a macro scale, this will contract the economy. The best way to counter this situation is to prepare before such a scenario; build up an inventory of durable necessities. This can help offset temporary supply-side price hikes. Also, removing dependence on essentials can help too. Geothermal home heating, solar power combined with an EV, greenhouses and gardens; these can all help insulate you from price swings in your essential cost items. If monetary inflation is the worry, similar to business strategies, you don’t want to be holding cash or cash-based assets. Monetary inflation has been described as a way governments extract wealth from your savings (5). It does this by reducing the purchasing power of your savings faster than the interest it generates can compensate. When governments spend “new” currency, they do so in an economy calibrated to the previous amount of currency. By the time prices increase to compensate, your savings have not increased at the same rate. You may consider investing in assets that inflate in value along with (or faster than) monetary changes. Historically, real estate and precious metals have been seen as hedges against monetary inflation. Real estate does seem to inflate along with the money supply, but as 2008 reminds us, it also can crash now that banks have found ways to exploit that market. Precious metals too have a history of manipulation by the same centralized banks that benefit from such inflation (6). You may, therefore, consider newer and decentralized inflationary assets like Bitcoin or other decentralized limited digital assets. Although nobody knows for sure what the best option is, it’s likely better to investigate your options rather than relying on luck alone.

In closing, drastic inflationary monetary policy combined with supply chain constraints have put the economy at risk, and the economic agents within that economy are thereby at risk by definition. Businesses, projects, families, and individuals are all being affected. However, we don’t have to be passive observers. History tells us how we can defend against these pressures. The difficultly this time is that supply-side protections of hoarding currency run counter to the monetary inflation protection of dumping currency for assets. Deciding for yourself which causal factor is the dominant one will help guide your defensive strategy. One benefit that historical economic agents did not have that we do is information. We have access to economic data without being filtered through politicians and bankers. We also have a new asset class in decentralized limited digital assets. More on those assets in a future article, and why I do not refer to them as “crypto-currencies”; there is a pivotal difference between those classifications.

Take care, and feel good knowing you are at least considering these issues; being a passive economic entity is a surefire way to lose out, especially in times of drastic inflation.








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