From the April 2006 issue of Wealth Manager Web • Subscribe!

More Is Less

Malcolm Forbes once compared inflation to dandruff, saying both were problems without solutions. For investors who would like to give inflation the brush-off, it might help to look at what makes the economic scalp itch.

Theorists have long argued about what causes prices to fluctuate. In 1936, legendary British economist John Maynard Keynes linked inflation (and its evil twin, deflation) to imbalances between savings and investment, a gap he suggested could be bridged by adroit shifts in government spending. The Keynesian view became popular given the widespread perception that tightfisted fiscal policy had caused the Great Depression.

In the 1960s, however, Milton Friedman argued that inflation and deflation were related to the amount of money coursing through a nation's financial system. Though similar theories had enjoyed brief spurts of popularity going back to 16th century mercantilism, monetarism was decidedly out of favor in post-World War II America. One critic compared Friedman's resurrection of monetarist theory to "beating a decomposing horse."

Apparently, the horse was only snoozing. In fact, most experts now consider inflation to be some form of monetary event. Translation: Prices rise when too much money chases too few goods.

Monetarism passed its first real-world exam after President Carter replaced Arthur Burns at the Federal Reserve with Paul Volcker, a towering, cigar-chomping economist with a reputation as a fierce monetarist. The reputation proved accurate: With inflation running out of control in 1980, Volcker abruptly applied the monetary squeeze, jacking up benchmark interest rates to 20 percent.

As the economy gasped for air, investors anxiously awaited the weekly release of money supply data for signs that Volcker might finally loosen his grip. "Those were the glory days of monetarism, when people focused on the raw money supply numbers," recalled professor Timothy Taylor, an economic historian at Macalester College. "At the time, what Volcker did was considered crazy. But it was the acid test that proved Freidman's theories were right." Within three years, inflation had fallen from over 13 percent to under 3 percent.

Despite the success of Volcker's "tough love" monetarism, the debate about the root causes of inflation goes on.

Changes to the ways that money is saved and invested since the 1980s have muddied the theoretical waters. "Financial innovations have caused the relationship between the money supply and the real economy to be fluid and changing," says Taylor. "The most recent version of monetarism holds that the Fed should just look at the inflation rate, and that will tell them everything they need to know. Ben Bernanke is associated with this inflation-targeting argument."

Judging from the bond market's skittish reaction to strong January employment data, some fixed-income investors embrace a competing theory of inflation known as NAIRU (Non-Accelerating Inflation Rate of Unemployment). In that view, inflation becomes problematic when unemployment falls below a certain "natural rate."

Yet over the last 40 years there has been virtually no correlation between inflation and full employment -- whatever that rate actually is. "Both monetarism and NAIRU fail miserably," asserts Lakshman Achuthan, managing director of the Economic Cycle Research Institute (ECRI). "If you made decisions based on either one of those theories, you would be out of work." Notably, ECRI's Future Inflation Gauge--a proprietary index with a good record of forecasting turning points--may be showing tentative signs of peaking. "The measure of wages in the jobs report isn't a great leading indicator of inflation," Achuthan says.

Another theory, known as the output gap, posits that prices rise when an economy grows faster than its ability to produce goods and services. During the 1990s, however, inflation remained comatose even as the U.S. economy shifted into overdrive.

Clearly, the causes of inflation go beyond the rate of growth and the supply of money and labor.

Thanks to the info-tech revolution, productivity gains over the last decade allowed employers to grant annual wage and benefit increases of nearly 3 percent without passing along higher costs to consumers. Improved energy efficiency also has played a role in damping inflationary pressures. Between 1970 and 2004, the energy required to produce a dollar of GDP declined by 49 percent. Finally, the addition of billions of low-wage workers in Asia has kept domestic labor costs subdued.

Identifying the causes of inflation is much more than academic gimcrackery. The three great long-term bull markets of the 20th century (1921-1929, 1942-1966, and 1982-2000) occurred during periods when consumer prices were usually rising only slowly. Conversely, the two secular bear markets (1929-1942 and 1966-1982) each unfolded as prices were either falling or rising too quickly.

Price instability also has ignited monumental political upheaval. The severe deflation of the 1930s led to Franklin Roosevelt's New Deal while the double-digit inflations of the 1970s paved the way for the Reagan Revolution. In Germany, the hyper-inflation of the Weimar Republic (wholesale prices rose by over 1 trillion percent between 1919 and 1923) contributed to the rise of Adolph Hitler.

The ECRI's Achuthan notes that while economic conditions have become less variable over time, investors now take heightened notice of even the tiniest outbreaks of inflation.

Just like dandruff on your favorite black suit.

Thomas D. Saler is a financial journalist, author, and longtime contributor to Wealth Manager.

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