Here is what I wrote about it last year.
May 5, 2009
Will the current stimulus spending and increase in money supply start a massive run of inflation in the economy? In my opinion, the reason this question continues to come up is that most economists and pundits share the same line of thinking and regularly espouse their fears of a hyper-inflationary economy. I have created this market update to answer some of your questions.
The economist’s line of thinking is not surprising. The last time we had significant inflation and a major economic downturn was in the 1970’s. This was during the most formidable years of the majority of today’s academia and economist’s lifetime. So, inflation seems like the natural and familiar result for many of that era and generation. That being said, it is my opinion that DEFLATION is more likely to occur first in our future than a big jump in inflation. This paper will discuss the reasons for my conclusion and provide the data and information that has helped form this opinion.
I will begin with a review of what I believe caused most of the inflation of the 1970’s and early 1980’s.
In order to properly understand the inflation of the 70’s, we need to have an understanding of the general public’s spending patterns and trends that exist during the lifecycle process. Modern academia views all individuals, from a demographic standpoint, as identical. All non-employed persons including children, a stay-at-home parent or retiree, is viewed as though they are interchangeable parts. Of the groups mentioned above, none “produce” in an economic sense, yet all consume.
The major flaw I see in this way of thinking is to assume that these “non-producing” individuals do not contribute to the economy. Although a stay-at-home parent and their children may not contribute to GDP, they most assuredly do consume…A LOT. Children get progressively more expensive until they leave the nest. Their parents will cover the expenses for everything from piano lessons to football helmets. Not to mention the endless need for clothing, food, and trips to the doctor. A new family or growing household also requires investments in furniture, appliances, cars and possibly an upgrade to a bigger house.
In contrast, retirees make comparatively much less impact on the economy. Whereas children progressively require more money to be spent with each year of their life, the elderly progressively require less on virtually everything but healthcare. How many new washing machines, entertainment systems or furniture does an elderly couple need for their home?
After the age of fifty or thereabouts, the vast majority of people markedly decrease their spending and become more fiscally conservative. An elderly couple may still enjoy a nice dinner in a restaurant or a decent bottle of wine. However, their large credit-financed purchases have already been made. Once you reach a certain age, you have enough bass boats and living room sets to keep you occupied.
This brings us to inflation. If academia believes that all people are equal in their spending patterns, then they must also believe that each person contributes equally to the causes of inflation. It is my belief that this theory is also flawed. This flaw was exposed during the 70’s and early 80’s.
The “Baby Boom” started in 1946 and continued through 1961
[i]. During this period, almost every baby boomer lived at home with their families. The economy grew as these families bought homes, furnished their homes and lived the American Dream. Throughout this period inflation was low. From 1950-1965 inflation averaged 1.78%. and from 1959-1965 the average was 1.26%. In 1966 the inflation rate almost doubled to 3.01% and then continued to increase through 1980 when the inflation rate hit 13.58%.
[ii]
Generally, when someone turns 18, they either go off to school or enter the work force. In 1966 we saw a huge jump in the work force as the boomers started to get jobs. This trend increased throughout the 70’s with an annual average labor force growth rate of 2.6%.
[iii]
This is an important factor in the cause of inflation. When an 18 year old moves out of his or her parents’ house they now have their own needs and necessities. They must first find a place to live, then purchase furniture, appliances and have the energy to keep all the new gadgets running. The number of housing units available skyrocketed from the mid 1960’s through 1980.
[iv] All of these units had to be built from the ground up in the 1970’s. This alone was inflationary. Since the 70’s the rate of housing unit growth has declined significantly
In order for these young adults to pay for their new places and to buy their furniture, lava lamps and beads, they needed a job. The building of new offices, factories, and shopping centers, was also inflationary.
Additionally, the need to get to and from those new jobs created the need for more transportation. That need created additional demands on resources, which in turn lead to higher prices. All forms of transportation require fuel. Add the growing demand in fuel to an artificial supply crunch created by OPEC and you get more inflation.
During the last half of the 70’s the Fed increased interest rates to try and lower the money supply and in turn lower demand. Since the common definition of inflation is “too much money chasing too few goods”, they thought that, by squelching demand, they could keep inflation low. Even with these attempts by the Fed, the money supply did not decrease. This was caused by the increasing number of people entering the work force, making money and living their family formation cycle. With the increase in demand for goods and services, the velocity of money increased.
[v] It is very difficult to lower demand when people are just living their lives. Consumers were spending their money on wicker chairs, macramé plant holders and 8-track players, on top of their general necessities.
The largest Baby Boom cohort was from 1957-1961. The year with the most births was 1961. After 1961 births started dropping and eventually plummeted from 1965-1976. This decline is one of the reasons that the velocity of money plummeted during the recession of 1982. Just as the Fed was able to raise rates high enough to reduce demand, the actual demand started to go down naturally as fewer people started to enter the labor force. We were producing a lot of goods in the late 70’s. When demand went down, so did the economy.
At this stage we had the bulk of the baby boomers in the work force and the economy was able to have enough productivity to create the supply for the demands of the growing family. Lower tax rates also helped to fuel entrepreneurship and innovation, so more businesses were being created and expanded.
Most economists and many in academia look at the increase in money supply and other indicators as suggesting that we are heading back to the inflationary days of the 70’s. Those indicators were symptoms, not the cause of inflation. As I outlined above, inflation increased due to a rapid increase in demand. Today we have the opposite of that type of demand.
According to the Consumer Expenditure Survey
[vi], the age range in which people spend the most money annually is 46-48. From their 30’s on, people spend more and more as they age, peaking out at the 46-48 age range. Since the mid 1990’s we have had more people entering their 30’s and 40’s every year. This was very good for the economy. Now we are seeing the reverse of this trend.
To give you an idea of how quick the drop of 40 something’s will be, take a look at the following numbers. We had 4,268,000 births in 1961. In 1973 we only had 3,136,000 births. This is a 26% drop. Many people will ask, “what about immigration?. When you factor immigration into the mix, the peak birth year was 1957, with only a minor drop to 1961.
[vii]But there was an equally massive drop into 1975. It is no surprise that when we hit the current credit induced crisis, the demand for goods dried up and spending decreased. Now and going forward, there will be fewer and fewer people in the 30 and 40 year age range to pick up the spending pace. Additionally, with retirement looming, the boomers are saving more than they are spending.
The inflation crowd is saying that, with the increase in money supply and pent up demand, we will see a huge burst in inflation as the economy starts to recover. The inflation crowd believes that since the Fed is keeping interest rates low, banks will be more willing to start lending. Then, when the “consumer” starts to feel better about their financial situation, they will run to the banks to borrow more money and start buying cars and houses again. This massive increase in demand will in turn cause a huge bout of inflation.
I see several flaws with that thinking.
First, the largest percentages of “consumers” are ages 48 and older. They are now in their downward spiral of natural consumer spending. The oldest of the boomers are age 62 and the youngest boomer is 48. They are either in retirement or near retirement. Many have recently lost 30-60% of their retirement accounts and 20-40% of their home value in the current market downturn. They are not in the mood or financial position to start on another debt fueled consumer spending binge. They already have their big TV’s, furniture, stainless steel remodeled kitchens and Harleys. If their kids are still at home, they already have their IPODs, cell phones, laptops, Wii’s and Playstations. In this modern era, cell phone and high bandwidth internet connections are at 90% household saturation, there is not a lot of growth left in many areas.
Another interesting effect the aging of America is having is in the “total miles driven” in the US annually. Except for a drop in 1980 and a couple of small drops in the 70’s, the trend has been more miles driven year after year. In 2008 we saw a significant drop in total miles driven in the US.
[viii]This was in part due to the rapid increase in gas prices. But even as prices have dropped, the trend has continued. As of January 2009, on a rolling 12-month period, we have driven fewer miles than we did in 2005. We have also seen car sales plunge since 2005, so a drop in miles driven is not a surprise. As people age, we drive less.
Another flaw in thinking by academia is that they look at all consumers through the same filter. They give equal weighting to all consumers regardless of age. They talk about the increase in private wealth over the past 30 years as a positive sign for future economic growth. While this is true, who has this wealth? Our current household net worth (total assets minus total household liabilities) is now $51 Trillion. While this number is large, it is over $12 Trillion less than what it was in late 2007. What hasn't dropped much is our total liabilities. Household debt is near record highs at $14.2 trillion.
[ix]
This is important to the inflation question for the following reason.
Even though the boomers have debt, they are past their peak age for spending. Any additional money they receive from government stimulus or wage increases will go to paying down debt or building up savings. The personal savings rate shot up in 2008. Considering that consumer spending accounts for $10 trillion of GDP, a 3.7% savings rates means $370 billion fewer dollars spent in the economy.
[x]
The younger Gen-Xers are hitting their peak age range for spending at this time. However, there are not enough of them, by number or by percentage of the population, to spend the economy back to its high economic growth years. Additionally, they purchased their homes, cars and new technologies at the peak created by the boomers spending. They have a higher proportionate share of the debt to service which means less discretionary spending by this generation. According to demographers Strauss and Howe, Gen-Xers are more likely than boomers (at a like age) to hunker down, downsize, pay off debt and save for a rainy day.
Just as we had one of the highest eras of labor force growth in the 70’s, we are now in an era where our labor force will barely keep ahead of replacements. For the 2010’s, assuming the boomers retire on schedule, the labor force growth rate is due to grow only by .6% a year. If the boomers stick around and work longer, it could make it more difficult for the millennial generation to break into the labor force, causing higher unemployment. However, I can see businesses trying to encourage the boomers to retire since their younger replacements can be employed for a lot less.
With current technology, even if we see a huge increase in demand and spending, it will be easy for our economy to produce goods at much lower prices. For example,
look at flat screen TV’s. During the explosion of buying in the mid 2000’s the prices were very high. A 52 inch TV was in the $5-8,000 range. Today you can get that same TV for about $1,200. This is possible because the infrastructure needed to produce the TV is already in place and productivity levels are very high. If demand takes off again, with the help of our overseas friends, we can easily crank up the supply in no time. This applies to most of the consumer goods we buy. If millions of consumer goods being sold at very high prices didn't kick start inflation, I doubt fewer goods sold at much lower prices will.
With all of these trends in place assets and credit will be destroyed faster than the government can stimulate the economy. We can already see the deflationary impacts of a slowing down in the velocity of money in this cautionary environment. Even though the monetary base has exploded (it has roughly doubled recently), lending and spending have slowed and the velocity, or turnover, of money has crashed. Unless changes occur in response to the stimulus programs, which I feel is unlikely to happen, then deflation will be the trend rather than inflation.
People still believe that, if we can keep mortgage rates low enough and if housing drops far enough, people will start buying houses again. This behavior would then fuel the economy and in turn, fuel inflation.
I also feel that this thinking is incorrect for a few reasons. First, Census numbers show that more than 14 million housing units are vacant. That number does not include an estimated 4.8 million seasonal or vacation homes, most of which are only occupied part of the year. The combined vacancy rate of almost 15% is higher than during previous recessions: 11% in 1991 and 9.4% in 1982.
[xi]
About 3% of owned homes are vacant. In normal times around 1% would be vacant. More than 9% of homes built since 2000 are vacant compared with about 2% for older homes. We currently have more places to live than people to fill them.
Secondly, as some of you may remember from my housing report in 2005, I talked about how the peak age for buying your move up house was age 43. At this time, we are seeing a decline in 43 year olds. In 2005 I believed that housing was at a peak.
Finally, in 2008, USC Professors Dowell Myers and SungHo Ryu, released a study about the crossover age when people become net sellers of houses as opposed to net buyers. Nationally that age has averaged 65. But in several states such as California, the crossover age is 55.
[xii]
After consideration of all these factors, I don’t hold out hope that a new housing boom will save the day or cause inflation.
In conclusion it is my opinion that the inflation of the 70’s was primarily due to the huge baby boom generation entering the labor force and moving out of Mom and Dad’s home. Not by an energy crisis or money supply issues. Currently, we have the massive baby boomers passing their peak age for spending and leaving the labor force with barley enough young people to replace them. This is not a recipe for inflation, no matter how much money “Helicopter Ben” (Bernanke) throws into the system.
[i] The Baby Boom from a demographic point of view was from 1946-1964. The year with the most births was 1961.
[ii] www.inflationdata.com
[iii] http://www.bls.gov/opub/ted/2007/jan/wk1/art02.txt
[iv] http://www.census.gov/hhes/www/housing/hvs/historic/files/histtab13.xls (broken link)
[v] The velocity of money is the average frequency with which a unit of money is spent in a specific period of time.
Velocity of money - Wikipedia, the free encyclopedia
[vi] http://www.bls.gov/cex/2007/Standard/age.pdf
[vii] Research
[viii] Traffic Volume Trends - Travel Monitoring - Policy Information - FHWA
[ix] FRB: Z.1 Release--Flow of Funds Accounts of the United States--June 10, 2010
[x] BEA : Personal Saving Rate
[xi] Housing Vacancies and Homeownership - Quarterly Rates by State and MSA (http://www.census.gov/hhes/www/housing/hvs/rates/index.html - broken link)
[xii] Aging Baby Boomers and the Generational Housing Bubble: Foresight and Mitigation of an Epic Transition - Journal of the American Planning Association
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