Deflationary Locusts
Prices and Innovation
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Note: the below is NOT investment advice. I am sharing my perspective for discussion. All investments involve risk of loss.
“Mark my words, we are getting double digit inflation, like the 70s.”
I was at a Utah ski lodge with my kids. We ate family style, shared tables. The guy speaking at mine was fleshy and loud. This was not long after the 2008 financial crisis and the Federal Reserve was printing a lot of money. In the Middle Ages, this would have been done by pounding gold and silver into coins. These days a central bank created zeroes on a computer.
I looked at other people at the table. Blank faces. My guess was none of them thought much about interest rates or inflation. For many years, these were mystery topics for me as well. My dinner companion turned out to be flat wrong. Inflation over the next decade was about 1.5% a year. Predicting anything with a lot of moving parts is hard.
Inflation impacts you, even if it isn’t something you think about day-to-day. When inflation goes up your own wealth—measured in the ability to buy what you want—goes down. The cost of a loaf of bread was $1.37 in 2008 and $1.52 ten years later. When inflation gets out of control, it creates havoc. Think Weimar Germany and food shortages.
Last week, we found out US prices rose 5% from a year ago, prompting news stories about how the Biden Administration’s aggressive spending will lead to more inflation. But it’s also possible the post-pandemic world will do just the opposite, usher in changes to sectors—like education and healthcare—that have been responsible for most of last decade’s inflation.
First, some background. Inflation is the average price change in the things you buy, composed of thousands of individual prices, each determined by supply and demand. Despite lots of research, no one knows exactly how all these supply/demand interactions work. That was a point made recently by former Treasury Secretary Larry Summers. He noted we have theories about inflation related to how much money is printed, debt stock and the nature of inventiveness but not precise, predictive answers.
We do know one reason you invest money is to outwit inflation. Saving is money for later. Later needs to preserve the ability to buy stuff so you need some investments that can gain value when inflation rises. That’s one reason I have a chunk of savings in real estate and commodities, hard assets that tend to rise in value when inflation rises.
These days, a group I refer to as deflation locusts can have a big impact on prices. Locusts set down on a crop, eviscerate it and leave. The modern economic equivalent of this is what happens when venture capital and the stock market fund software engineers who see a vulnerable industry they can rip apart, restructure and reallocate the profits. The middlemen gets crushed, venture capital and software engineers get rich and the consumer gets cheaper stuff. Uber to taxis, Amazon to retail, Apple to music are all examples of this. If it sounds aggressive it is; no one gives up their cash flow willingly.
Certain industries are more vulnerable than others. If you look at inflation over the last 10 years, the two biggest categories of prices rising are healthcare and education, as shown in the diagram below created by my friends at Rose Technology. Tobacco prices are also up, which I imagine is what happens if your customers are addicts.
Going forward, both healthcare and education seem like appealing targets for the deflation locusts, particularly in the wake of a pandemic that pushed us to break long ingrained habits, like seeing a teacher or doctor on-line as opposed to in person.
One reasons costs keep rising in these areas is because productivity, output per worker, is lagging. This is something known as Baumol’s cost disease, a theorist who pointed out that symphony players are no more productive than they were hundreds of years ago but their salaries keep rising. While symphonies can not innovate, schools can. Constantly rising prices in education and health care suggest the innovation in other sectors is not hitting them or cartel like behavior is limiting supply or perhaps a bit of each. (I write this with plenty of affection for the classical musicians, teachers and doctors I know).
When I think about education, my mind goes to Khan Academy. It’s free, higher quality than much of the instruction I received in school and can scale at almost no cost. Based on 2011 data, there are 500,000 math teachers in the US. How many of them are better than Khan Academy? Obviously there would be resistance from unions and others. But there is always resistance to change. Maybe some universities will be more amenable. Georgia Tech’s Zvi Galil is a case study. How many introductory calculus and engineering teachers do we need? Will the locusts make higher education better, cheaper and more meritocratic?
Medical care seems similarly vulnerable to the locusts though perhaps from a different angle—cost control. Prices rise in part because a segment of the health care market is incentivized to charge for unnecessary procedures, in part because of inefficiencies, like bad data sharing. There are now entrepreneurs (like Garner health) and many others getting funding using big data to make medicine more efficient. According to Deloitte, venture health care funding doubled in 2020 vs 2019 and the easy capital raising environment is bolstering new company creation. As they do, it’s conceivable that medical inflation slows even as new expensive procedures come on line that improve health but charge a premium to do so.
Given this, I am on the look out for assets that not only help me in a higher inflation environment, but also in a lower one as well. Government bonds are great for this (if you are confused about what a bond is write me and I’ll explain). While I own foreign bonds, last year I bought protection against higher US interest rates. So far, this protection has been a bad bet. If we get more inflation and US interest rates rise, I plan on buying US government bonds as protection against low inflation. The deflationary locusts are out there, I just don’t know how effective they will be when they pick their next target. That’s why investing is tricky.
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