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NYU FINC-UB 0042 - Flations: Inflation and Deflation

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Flations: Inflation and DeflationC15.0042Lesson 9Edward M. KerschnerE. KerschnerWholesale prices in the U.S. - 1750-2000Rolling 10 year Inflation Rate -10%-5%0%5%10%1750 1775 1800 1825 1850 1875 1900 1925 1950 1975 2000InflationPrice Level102040701202001750 1775 1800 1825 1850 1875 1900 1925 1950 1975 200043211234561.6 % average4.4 % averageE. KerschnerWholesale prices in the U.S. - 1750-2000Rolling 10 year Inflation Rate -10%-5%0%5%10%1750 1775 1800 1825 1850 1875 1900 1925 1950 1975 2000InflationPrice Level102040701202001750 1775 1800 1825 1850 1875 1900 1925 1950 1975 2000World War IICivil WarWar of 1812Revolutionary WarWorld War I“GreatSociety” E. KerschnerInflation Inflation is not a “natural disaster” that strikes economies randomly, like a drought or a tornado. Inflation is an aberration that occurs when the government pursues a systematic policy in favor of rising prices.E. KerschnerInflation and Deflationary Policies+ Inflation has been used as a primary method of financing wars. Prior to the mid-twentieth century nearly every bout of severe inflation in the U.S. was associated with, and caused by, a war. During the Revolutionary War the Continental dollar lost 99% of its value. The Civil War period did not experience the hyperinflation of the Revolution, but still experienced an annual inflation rate of 20%. - The government pursued deflationary policies after the Civil War, shrinking the money supply by using the Federal budget surplus to buy in greenbacks. By 1879, prices had returned to pre-Civil War levels.- Whereas the deflation of the late 19th century was either good or bad, depending upon where you were situated in the U.S. economy, the deflation of the 1930s was a catastrophe for everybody. Americans took away from the trauma of the 1930s a single, overriding lesson: Deflation = Disaster.E. Kerschner+ After World War II, the U.S., haunted by the Great Depression, systematically pursued inflationary policies. The inflationary bias in the economy of the 1950s did not immediately lead to high inflation because President Eisenhower, who had witnessed hyperinflation in Europe in the late 1940s, was a vigilant inflation fighter.+ Kennedy brought to Washington neo-Keynesian economists who planned to use deficit spending and accommodative monetary policy to expand GNP 4.5% annually without increasing the rate of inflation.+ Guns, Butter and Inflation: 1965-70. President Johnson decided in the mid-1960s to fight both the War on Poverty and the rapidly escalating War in Vietnam without raising taxes.Inflation and Deflationary PoliciesE. Kerschner+ The U.S. did not take the threat of inflation seriously in the early 1970s. In the late 1970s the overwhelming bulk of leading economists argued that we should learn to live with high inflation, indexing more contracts and government programs, and attempt to stabilize the inflation rate at around 10 percent. The thinking at the time was that the substantial cost of disinflation was unbearable.- By 1979/80 two newcomers to Washington’s corridors of power, Paul Volcker and Ronald Reagan, pursued an anti-inflation mandate. By the turn of the 21stcentury inflation was nill; fears of deflation arose.+ Aggressive monetary (near zero Fed rates “longer and lower” than “normal”) and fiscal (President Bush’s tax cuts produced record deficits) seemed to remove the deflationary risk.+ Is reinflation now inevitable?Inflation and Deflationary PoliciesE. KerschnerBenign Deflation Although moderate deflation may seem abnormal and therefore dangerous to investors accustomed to secular inflation since World War II, short periods of deflation have been common in American history. Therefore, prices have been relatively stable over the long term; they were actually no higher in 1940 than in 1795. It is the secular inflation of the 50 years after WWII that is an aberration. Long term (since 1750), average annual inflation rate is around 1½%. Benign deflation is distinct from debt deflation, when prices plunge because debtors are unable to pay their debts, the financial system is damaged, and economic activity declines. By preventing companies from boosting earnings through price increases, benign deflation encourages cost-cutting via innovation. This occurred in the late nineteenth century.E. KerschnerBenign Deflation Even though the price level was declining, the decades after the Civil War were a period of explosive economic growth and creativity. Completion of a continental railroad network, and the concomitant telegraph system, created a national market that encouraged a spate of technological innovations. The number of patents issued doubled between the 1860s and 1880s. Among the specific innovations: • use of electricity in factories; • the electric streetcar; • refrigerated cars for meat-packing; • the telephone; • the typewriter; • the roller mill to process oatmeal and flour; • major advances in making steel, which replaced iron for many uses.E. KerschnerBenign Deflation In the last four decades of the 19th century, value added by U.S. manufacturers grew at a pace of 5-7% annually. From the 1870s to the 1890s—a period of rapid population growth driven by heavy immigration from Europe—national income per capita expanded by a remarkable 88%. It is quite possible that the deflation of the late 19th century to some degree caused this spate of technological innovations. Unable to raise prices in order to boost profits, businesses had no choice but to cut costs via innovation—whether that involved using electricity in a factory, replacing clerks’ pens with typewriters, installing labor-saving manufacturing equipment, or using railroads to distribute products more efficiently.  Was the late 1990s a period again of “benign deflation” caused by the technological innovations of the “information age?”E. Kerschner Investing in a deflationary environment. Companies with one or more of the following characteristics benefited in late 1990s:• Strong brands that reduce vulnerability to price competition. Almost by definition, the companies with the strongest brands also have the largest market share, giving them a competitive advantage via economies of scale.•Rapid unit growth that is sustainable because the company has a large market share and is gaining market share, which enhances competitiveness by providing economies of scale.• Sells proprietary products


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