Alternative solutions to inflation

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Inflation is all the rage at the moment – and policy makers are increasing interest rates in am aim to reduce this – but are there any other ways to solve this problem beyond rate hikes? This episode is mostly theoretical – as I don’t believe the discussion points will ever be implemented – but it is all about focusing on helping to increase supply to meet demand – rather than trying to reduce demand in an effort to reduce prices – bit of a longer episode as there is a lot to unpack

There is no doubt that the money supply increase has impacted inflation rate – but I think this has had a smaller impact than the supply chain when it comes to inflation – so why I think increasing interest rates won’t help inflation –

1. The price for anything in a free market is the point where demand and supply meet – we won’t go too deeply in the theory here –
   1. But when it comes to demand there is a thing called elasticity – something can be elastic or inelastic – if it is inelastic – small price changes won’t have much of an impact in on the quantity of a good that is demanded – if it is elastic then a small price change will really affect demand –
   2. Think about a bag of chips versus a Ferrari – chips are very elastic – if the price of a bag of chips were to increase by $3 – this may essentially double their prices and demand would suffer massively – if the price of a Ferrari goes up by $3, it isn’t going to matter at all and the same demand would continue – that is because of alternatives – you can buy potatoes and cook these instead – but it is hard to buy another car as an alternative to a Ferrari if you are after the badge and prestige that comes along with this
2. The issue is that inflation affects demand massively in elastic goods – as smaller price increases impact the demand for that good –
   1. When what most people purchase in life are elastic goods – such as consumer staples – like food, petrol, housing, etc – high levels of inflation can really impact demand for these goods – people may drive less, buy different goods, or reduce their spending on consumer discretionary goods – like eating out or entertainment – but if inflation is occurring in elastic goods across the board, where the alternatives are also more expensive – then this really impacts consumption
3. Two quick examples of extreme price increases in goods – lettuce and bananas –
   1. At the moment – there is a shortage of spinach and lettuce – haven’t seen it personally but heard lettuce is $10 – but I do remember around a decade ago when bananas were also $12 a kg – why was this? Was it the money supply growth? It was a severe shortage in goods leading to an increase in price
4. The issue with increasing interest rates – if increases in prices on consumer staples comes from a lack of supply of these goods – then increasing interest rates will have little effect in bringing the prices down sustainably
   1. In a truly competitive market – companies won’t charge you more if you have more money in your pocket – they will each be aiming to get the best good to you at the price that still allows them to make a profit – this is a little flawed as there are monopoly businesses that exist, which can just increase prices due to a lack of competition – but this point aside – lets hypothesise about how the money supply increase has contributed to inflation under demand side theory – as this states that the more the money supply increases, the more people will spend leading to increases in inflation – so simply looking at the money supply levels –
      1. When measured by M1 – in the past 2 years this has gone from $900bn in Australia to $1.77tn – almost doubled – M3 has gone from $2.1tn to 2.7tn – In both cases, this is an increase of 97% and 29% respectively in two years – this is a massive jump – but did it lead to out inflation?
      2. Going back to the point of the money base growing impacting inflation due to people having more money to spend – has your net income increased by the in between of 50%% in the past 2 years? Have you seen any of this growth in money supply? Has your annual spending gone from $50,000 to $100k?
   2. You might have received some of this money growth through borrowing – but this is going to cost your cashflow – where if interest rates increase, your capacity to spend will decline – meaning that with increases in prices, less will be able to be demanded – this can impact the amount being spent and business revenues – which means they may need to lay people off – which reduces the total amount that is available to be spent
      1. Inflation certainly exists – property prices are a great example – $1 is not worth on average $0.8 when purchasing a property when compared to 18 months ago – this is inflation – but not how the government measures it –
   3. So how does the increases in interest rate help to reduce inflations? People might be spending less – and central banks can create a recession – but if the stemming problem comes from supply issues with elastic goods – then interest rates may have little to do with this – which is why I think the solution to the problem long term lies outside of monetary policy, but in fiscal policy – where it is the government’s responsibility to get out of the way and in an ideal world – try to stimulate supply growth by incentivising private enterprise

Where I think the long-term solution lies – in Supply Side economics – this isn’t an overnight solution – It is something markets need to work out in the long term and it comes back to governments helping to facilitate supply rather than trying to dampen demand through interest rate increases – and this is why I think it will never be fully implemented – as it requires governments to take a step back and give up some control

1. Supply side states that the more supply is increased – the more this helps to meet demand – which helps to reduce the prices/CPI – which allows more to be demanded at the same nominal dollar value – in other words – you can not buy two bags of chips for $4 rather than one for $4
   1. demand and ability to demand are two different things – as humans, we all have the capacity to have unlimited wants (demand) – when compared to our ability to meet these demands
      1. This is the Economic problem – how to solve our unlimited wants with finite resources
      2. Finite resources – being income, wealth, as well as goods/services available for us to purchase – But one major step in solving this problem is to have what we demand cost less – i.e. If our wants cost less we can demand more
   2. But wait – Doesn’t demand create supply? Companies wouldn’t exist if people didn’t pay them money for a good or service – But How can you demand anything if there is no supply?
      1. This is where demand side economics comes in – this is the prevailing school of thought amongst policy makers – but supply vs demand is like the Chicken and the egg situation – what comes first – demand or supply – What should be the focus – Giving people more money to spend – or producing more in an economy to meet demand and lower prices?
   3. Both sort of right – have the same desired goal – Increase GDP – Mainly consumption – which is demand – but there can be no demand without the supply as we are seeing now
      1. if the increased spending comes at the cost of increasing inflation, it is not a long term solution – plus, there is no free lunch – for government to try and increase individual spending – this money either comes in the form of taxes or debt – which means there is a cost to this
   4. Demand side thinking is that the best way to stimulate an economy is by increasing the demand potential – but what is forgotten or ignored in this theory is that this relies on boosting supply first to help meet demand – otherwise inflation would materialize
      1. If the government tries to stimulate demand through something like UBI – then there may be less people working – so the demand for employees goes up, increasing wages – this then means that these costs get passed on and goods cost more – so what people can purchase in terms of their purchasing power parity has declined
      2. It is no good to increase your income by $10k per year if your cost of living increases by $10k per year – all this has achieved is giving governments more control
         1. Also demand side ignores how wealth is created – rather, it focuses on redistribution to try and max short term demand
      3. If wealth creation is really demand driven – i.e. through redistribution of income – well there can be no real wealth created – simply passed back and forward (minus gov cut)
   5. Demand side is favoured by policy makers because it increases their control over the economy – supply side requires that the relinquish control – which they really don’t want to do
      1. Supply side states that it is better to grow the pie than to increase everyone’s share of consumption as a %
         1. i.e. better to have 10% of $1,000 than 50% of $100 ($100 vs $50)
      2. What has caused the greatest improvement in our living conditions over time? An increase in supply, reducing prices
      3. Looking back over the last 200 years shows the constant improvement in standards of living by supply – taking the majority of the worlds population out of poverty – plus making our lives easier through innovation and production of goods given to the masses
         1. Did people in 1800’s demand the newest car, demand faster PCs in 1920s, or demand better smart phones in the 1980s?
         2. No! Because they weren’t around – people only getting used to brick cell phones in 80s – people didn’t know what to demand because these products were not available – it was the free market with individuals like Henry Ford, or Steve Jobs who introduced products to the market – this is the fallacy of the demand side – innovators (being the supply side) create products to meet demand 

Benefits of Supply side – aims and outcomes of the policies through less regulation, and lower taxation

1. Improves our lives – Increase supply – Not just more of the same stuff – but new stuff – innovation – also grows the economy and helps to reduce the price of goods
   1. Doesn’t aim to just fuel existing supply – but increase new options for supply to be demanded – goes back to elasticity of goods – through providing substitutes to demand
   2. Today we have running water, aircon, talking to you through 1’s and 0’s – Never been easier or better to live
      1. Improvements in healthcare/medicine, transport, communication – quality of life goes up
   3. All from inventions – innovators make our lives much better – gone a long way since the invention of the wheel –
2. Provides Economic Growth – Helps to stimulate more employment & economic activity which further fuels supply by increased demand – one of the major drivers of economic growth
3. how else does it help the economy grow and reduce inflation?
   1. Theory – As the supply of goods and services increases – The economy grows – people have higher levels of income and prices decline as more goods are people produced – Question: who employs you?
   2. The more things that are being produced – the more the economy does well – the more income we have – the more we can spend – the more companies are able to provide that service – the lower the price of goods become – consumer technology when adjusted for inflation was cheaper 2 years ago than it was 50 years ago – think about TVs
   3. Other side – As technology gets better, wont AI replace humans – maybe – if we stop innovating
      1. That is where supply comes in – even in the quest to create the best AI technology – how many jobs and products have been created? What about whole industries?
      2. Look at the 10s of thousand jobs the iphone directly and indirectly has created – that replaced a lot of people being employed – camera shops, landline companies, music players – mp3
   4. There is always creative destruction – and it takes time – Only under demand theory does this come true – Increase regulations, licensing/Bus rego costs, taxes and the number of new industries and innovations are hamstrung by an increase barrier to entry – established companies can survive
      1. the pie can’t grow to feed the now unemployed due to no innovation or increased production in the economy
      2. Fallacy of Demand Side Economics –predominant theory of macro-econ that Governments currently use
         1. About providing more to those with limited demand potentials (incomes) – helping to boost GDP through demand
            1. hopes that the economy improves through increased consumption – but to redistribute more tax is needed or lower costs in interest rates
            2. The issue comes in when supply shrinks – prices go up

In summary – Supply side four core desired outcomes – what true supply side policies aim to achieve  

1. Generation of wealth – Cut taxes to allow people to spend more of their own money
   1. Increases economic activity through more products and services
      1. Lower costs and regulations = higher productivity >higher revenues, more employment capacity
   2. Over time companies push Wage growth – supply and demand
      1. Limited number of companies – large number of potential employees = low wage growth – as they don’t have to pay much to retain them – who is currently doing a lot of lobbing for kids to learn to code?
         1. Tech companies – more employment pool in the future
      2. Heaps of companies competing for employees = Wage growth – have to pay more to keep people – creates competition amongst employers – but have to be a lot of them
   3. Economic growth – GDP – Have to hire people for more supply
      1. You need people with large amounts of money – How do you start a business? Borrow money in a lot of cases
   4. Increase rate of supply – Completed through lowering taxes and regulations
      1. Without increase of supply – standards of living drops decline over time – Countries with lowest levels of supply also have lowest standards of living
   5. This helps to reduce the inflation in the economy – the inflation we are experiencing at the moment has come from government policy – in the US shutting down gas and fuel production which the markets internationally have priced in –

Summary – Better to make the pie bigger – not to split it up

We have cheaper stuff and increased living standards through supply – these are wins for us