Inflation: passing fad, or lingering fancy?

ECCLESHALL, STAFFORDSHIRE – On Monday I asked you if I’d made a grave error in dumping my company pension pot into the gold mining sector.

If you’ve been reading this letter for even a short time, you’ll know I’m very bullish on gold, and have been invested in the sector for many years. I am confident that companies which mine gold have a very bright future ahead of them, and as my retirement (if I ever do retire) is well ahead of me, I’m prepared to wait for a long time if need be before such companies have their day in the sun.

Some readers think I’ve made a wise choice… some believe it reckless… and as we saw in yesterday’s note, some readers think it so stupid as to beggar belief.

One should always interrogate and challenge one’s beliefs – especially when there’s money on the line – and so I welcome critiques of my strategy, which I freely admit is reckless in the extreme. I’ve enjoyed reading all your responses, and I will be printing several in future letters.

One reader in particular has put great effort into telling me I’m making the wrong move. Or at least, to make a contrarian case – for he too is somewhat on the fence. He argues that inflation, the great driver of precious metals prices throughout history, will be a fleeting, fickle friend to gold this time. While we may see a burst now, it will not be sustained – and gold will not shine so bright as I expect.

Inflation ain’t the only reason I’m bullish on gold, but I’ll let him make the case to you below, and then issue my reply…

Re: Sticking your entire pension pot into gold

By Anonymous, in The Capital & Conflict Mailbag

You invited comment, so I am going to make the case for inflation not putting in a sustained appearance. This is a contrarian argument, I admit, and I’m not so confident in it that I don’t own some gold & miners myself, albeit probably as a short term trade – I expect inflation expectations to drive a return, but I suspect it might be a short run, brought to a halt by falling inflation numbers later this year or next year. Assuming our politicians don’t drag out the covid crisis forever, of course.

There is certainly lots of evidence of inflation right now, the question is, is it transient (as central banks claim,) will it disappear as soon as global supply chains recover from the interruptions brought about by covid?

Unlike the fantasy world of neoclassical economics, which assumes that money is ‘neutral,’ i.e. irrelevant, in Realworldistan money (aka capital) is rather important in capitalism. For example, if the national lottery throws free money at theatre groups, we will get more productions of plays, irrespective of whether there is any demand for them. In Realworldistan money has very real effects.

If banks throw cheap money at house buyers they fund an auction that bids up house prices. And boy have we seen that one play out! If the BoE prints money and gives it to financial institutions, well, financial institutions buy financial assets… so they go out and bid up asset prices. Credit-driven house price booms and QE-driven stock market booms are familiar to us all these days.

Most people are now acquainted with the idea that banks create money when they lend; 97% of all money in the UK was created by banks by extending credit. It is also important to understand that where the money flows to also matters. If money flows to buyers of assets, they bid up asset prices. If money flows to consumers, they go out and buy more stuff, so GDP increases until the economy reaches capacity, and at that point any further new money has to feed into [higher] prices. But if banks lend to businesses, those businesses will invest in producing more goods and services, and the amount of goods traded in the economy rises at the same time as the money supply, and you get inflation-neutral growth.

This is known as the Disaggregated Theory of Credit. It follows, therefore, that we should prioritise lending to productive firms. But sadly, banks don’t do that because that’s hard, whereas even a child could run a mortgage book – it takes a bank to screw that up! Unlike most economic theories, this one is empirically derived, and we owe it to Professor Richard Werner, who analysed the Japanese post-war economic miracle when he was in Japan. (His book “Princes of the Yen” is a must-read, it taught me more than 3 years of economics at Oxford.)

So a necessary condition for inflation to occur is not just that we print money, but that it ends up in the hands of consumers, and that this happens when the economy is at full capacity. This explains why inflation has been so elusive for so long – there’s been no sign of reaching full employment (and there won’t be until the immigration numbers come down.) So, it doesn’t matter how much money the bank of England prints, inflation is very unlikely, if not impossible, until the economy hits capacity constraints, i.e. full employment.

Further, it’s not the 1970s any more, we live in a globalised world and many of our goods are made in China and elsewhere, so hitting our economy’s capacity constraints also means tapping out those global supply chains. That can happen, but it’s not obvious that it will, absent lockdowns.

People fret about rising material prices, but they cause temporary inflation: a one-off increase in input prices has a one-off effect on goods prices. If input prices go up 10% this period, then prices of finished goods go up 10% in the next period, but there is no feedback loop, so it is a one-off effect.

To get real inflation we need sustained wage inflation, for that feeds into prices, and prices then feed back into wage demands. And for that to occur we need workers to be emboldened to demand wage increases by full employment. With the coming automation/AI storm, that seems unlikely… Could it happen in the short term? Watch those employment numbers and those global supply chains. But this matters less in a globalised world – an increasing RPI in the UK can’t drive up the wages of workers if those workers are in China!

A lot of people have been predicting inflation ever since the first round of QE, they’ve been wrong for going on 10 years. Yes, there’s evidence of inflation now, because global supply chains have been hit by covid, but once we’re past that, it’s possible (probable?) that inflation recedes again.

Long story short: I’ll be looking for signs of normality returning (hopefully coinciding with a nice price reversal in gold) as a signal to ditch my gold & miners. As I type this, I am pondering what signal would tell me this hypothesis is wrong, and to hold on to gold, and I guess that would have to be strong employment numbers coinciding with strong inflation numbers.

Hope you found my thoughts on this interesting. Either way, best of luck!

Thank you! I have indeed found your thoughts interesting.

There are a lot of avenues we could go down here. One thing to consider at the very outset is the supply shocks we’ve witnessed which are causing higher commodity prices and thus higher inflation statistics today. It is assumed in the above argument that the logistics issues which are causing these higher commodity prices will simply revert to their pre-WuFlu state if we give them enough time.

This may be the case (as we explored back in Hot crop) – but I’m not convinced it’s certain, when you consider how the WuFlu has exacerbated existing tensions between countries and across supply chains amid the miserable economic conditions. However, this is small-fry, and not the main response I would make.

Let’s look at the topic of governments putting more money in the hands of the consumer, which they’ve been very keen on through the lockdowns to keep the population quiet – most notably in the US with “stimmy cheques” (a possible forerunner of UBI), and over here with the furlough scheme (though the phenomenon can be found all over the world).

Will such support be totally withdrawn when the economy reopens? I doubt it – and I think it’ll lead to higher wage inflation regardless. What will tempt you back to work when you’ve experienced receiving money for nothing, if not meaningfully higher wages? Do we really need full employment for this to occur? I’m not so sure.

The reader above argues that inflation doesn’t care if the consumer is spending freshly printed money they’ve earned for “free” (even on goods or services that are suffering a supply shock) provided the economy is not yet running on all cylinders.

I am broadly sceptical of this view, as I think it’s perfectly possible for unproductive countries to debase their currencies for extended periods of time. Is the obscenely inflationary Venezuelan economy really running at full capacity? Its oil production certainly isn’t…

In the case above, it’s argued that loans given to businesses don’t affect inflation, for they lead to a rise in goods and services in tandem with the rise in the money supply. However, this assumes that loans will be provided only to productive businesses in the future, and that the bank will care about getting the money back or not. The rise of government-backed bank loans to businesses over the WuFlu period – exemplified here in the UK by the Bounce Back Loan Scheme – changes this dynamic. We explored this subject last June.

With banks lending money to businesses (printing money) which they don’t expect will be repaid because the government has guaranteed the repayment, I don’t believe we can make the assumption that bank loans won’t affect inflation in future. For the expansion in the money supply cannot be relied upon to increase the level of goods and services in the economy – that money could be spent on any old thing

But that’s all I have time for in today’s note – I’ll continue on tomorrow. Don’t go away!

All the best,

Boaz Shoshan
Editor, Capital & Conflict

Category: Investing in Gold

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