(Date: 1998/2004 By: Ian Runge)
Note: Article updated mid-2004 - ICR
Through the 70s and early 80s business in the western world had to contend with serious inflation. In the 90s we were facing deflation. Now (2004), with huge deficits in the USA there is the spectre of inflation returning once again. What difference does inflation/deflation make to decisions?
Let’s understand the difference between inflation and rising prices (or deflation and falling prices). Prices rise and fall all the time in response to changing demands and changing costs of production. Inflation is when all prices rise in money terms because the value of the money is less. It was the distortions caused by these monetary changes that lead us astray in the 70s and 80s. Often prices appeared to be rising, or holding constant, when in fact they were declining in real terms.
For example in the early 80s large investments in new mines, power stations and processing facilities were entered into in many western nations. The justification for these investments was built on at least two factors:
1) the investment would have been even-more-expensive later, so anyone who got in early had an advantage over competitors who come along later, and
2) with inflation at say 9% and (tax-deductible) interest rates at say 12%, the after-tax real cost of borrowed money was negative. “Someone” (who?) was subsidizing the investment.
Of course, all of this was unsustainable. We over-invested. The price rises or demand never materialized.
What about a deflationary environment? With the collapse in their currencies in the late 1990s, the price of goods produced in many Asian economies reduced—at least in US dollar or other-hard-currency terms. These Asian economies experienced substantial inflation but hard-currency economies faced deflation. Imports into the USA from these economies, for example, lead to substantially lower costs in the USA. Now (2004) with the recent decline in the US$ compared to the Euro, the same sort of thing is happening between these economies, at least amongst commodities that are freely traded.
With deflation, when things you want to buy will be cheaper tomorrow, getting in early puts you at a disadvantage over competitors who come along later. The incentive is to delay. And with prices declining, and assuming world interest rates don’t go negative (could they?) the real cost of borrowed money goes up. This too doesn’t sound like much of a recipe for world advancement.
Well, let’s not get too concerned (yet!). But a declining price scenario does require a significant change in strategy—a strategy that amongst other things puts much more emphasis on management responsiveness.
Consider for example how you choose a computer for your own use, spending your own money. How do you make this choice when you know that if you delay the purchase until tomorrow you will be able to buy an even-better-one then, and even-cheaper. The incentive certainly is to delay—but only until you are sure that you can put it to use straight away. The value you will get out of the computer between now and next month has to be more than the price reduction you expect between now and next month. This seems to me to be a very honest reason to invest! Certainly more honest than the inflationary-distortions in the previous era that made it look attractive to buy now even if you didn’t really need it now.
Decisions about things that you put to use straight away are not much affected/distorted by inflationary or deflationary environments. Consumer goods markets are the classic case. It is the long life goods—capital investment choices—that are most subject to these distortions and most prone to malinvestment decisions.
What lessons does this example offer for investment strategy? If you are investing in capital, then in a deflationary world it is rational to delay the purchase ... and then when you do proceed you must move quickly. Companies that can reduce the lead time between evaluation, approval, and implementation will win in this environment. If you are in the business of supplying capital goods, then faster delivery times, and shorter product life cycles—new products at lower cost than your competitors—will win in this environment. It goes without saying that strong customer communication is an important ingredient to achieving this.
The declining-prices scenario might be a tough environment, but if the personal computer market is anything to go by, it is not one that is necessarily lacking in demand or profitability! Deflation means other changes too. For example, if inflation introduces a bias towards debt finance, does deflation suggest higher proportions of equity finance? [Some economists have suggested this, but it is not necessarily the case …. See below].
These issues cannot be understood from case studies, and few economists understand the issues from a business decision-making perspective. If you are pondering your strategy to handle this new era, please give me a call!. Ian Runge
The inflation/deflation question (revisited)
If inflation introduces a bias towards debt finance, does deflation suggest higher proportions of equity finance?
It is a trick question! The problem is in the question not in the answer. The observed trend to use debt in inflationary times is an artifact of unanticipated inflation, not inflation per se. If inflation is higher than anticipated, then chances are the real interest rate will be negative. If real interest rates are negative (and you can find something to investment borrowed money in that will even just keep up to inflation) then it is surely a good deal to use more debt finance. But if inflation is happening at the same rate as everyone anticipates, then real interest rates won’t be negative! In business there is a perennial problem of sorting out whether observed effects in the economy are artificial or real, the symptoms or the disease. If you think you are caught in some trap, not being able to sort out the symptoms from the disease, then please give me a call! ICR
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