How does inflation destroy stock market values?
There are grounds for believing that initially stock prices rise in line with inflation. But as the inflation gets out of hand and turns into hyperinflation, it destroys price relativities and hence price signals. This eventually collapses the economy and destroys the ability of companies to make money. This in turns results in the stock market collapsing in real terms.
Distorted corporate behaviour
Comments about the South American experience suggest companies have to have multiple books to survive. They sometimes have management accounts in a foreign currency. They need to know the different inflation rates for their inputs and their outputs, which can differ considerably. Companies that are not on top of this do not survive. Also many companies make more from their speculation than actual productive enterprise.
Indeed part of the harm of hyperinflation is probably the extent to which people devote their energy to speculation. A society can not thrive on people flipping cans of sardines to each other any more than they can survive on flipping houses. Even if for some time it appears to be a profitable activity for participants with benefits to society as a whole. Speculation has a role in a capitalist economy, but except under exceptional circumstances, will be detrimental if it becomes the primary focus of most people and corporations.
The market ticker has introduced an alternative mechanism for the movement in stock prices as inflation takes off. His model is based on collapsing margins. Basically as inflation takes off the foreign exchange rate collapses. This makes imports more expensive. In the case of the USA commodity prices rise. Rising prices for oil, agricultural and mineral commodity prices feed through to the cost of production. Companies then have to decide how much of this increase in costs they pass on to the customer.
Generally companies can be expected to wear part of the increase in production costs by reducing their margin or profits on their products. The proportion varies depending on factors specific to the firm, industry and market. There is a considerable body of literature on where the burden of a tax will fall. Exactly the same analysis holds for other increases in the cost of production. The burden will often fall in part on the company.
Decreasing margins are normally not associated with rising share prices. Indeed, share the share price is meant to reflect the stream of profits the firm is expected to produce. If margins are being squeezed then the stream of future profits are also likely to be squeezed. Eventually this should impact on the stock market. Exactly when reality impacts on share prices is indeterminable at the best of times. When prices are being manipulated in the manner they appear to be in the USA, then it is probably even harder for outsiders to predict. Insiders may be able to predict it much of the time, but not when it eventually collapses, unless it is when they initiate it. Some of those manipulating the prices will be able to predict movements.
Reduced discretionary consumption
Of course the rising prices of necessities in the USA will also affect company profitability. Money flowing overseas to pay for higher oil and other commodities is money that will not be saved, invested or spent domestically. Suggesting firms heavily reliant on domestic demand will be adversely affected on the demand as well as the cost of production side. This will make it even harder for those firms to pass all of the effects of rising input prices.
Too many problems
It does seem that the end game for the USA is not going to be pleasant. For what it is worth much of Europe and Japan are also up the creek without a paddle. It is almost inconceivable that one of the grey swans (known unknowns) will not initiate another other round of the GFC. Then there are the Black Swans (unknown unknowns).
The developed world is in the early stages of a depression. How deep and how long it lasts can be influenced by our politicians. But not the fact that there has been a credit induced boom that has distorted prices and production. Squandering money is not sensible at a time like this. Resources will be needed to feed the people and provide them with power.
The UK had difficulty feeding itself during the war. It has since increased its population and paved over much of its agricultural land. Agricultural productivity has increased, but will it be enough to enable them to maintain their current rates of obesity? When Margaret Thatcher had her millions of unemployed she had increasing North Sea oil revenue and relatively low levels of debt. These advantages are gone. It will be a bumpy ride.
Countries producing things for Westerners will also have to restructure their economies to produce things for other people. Capital will have to be written off, even if new production facilities are created. During the last depression the US fared particularly badly. It was the workshop of the world. It also implemented the most Herculean efforts to stave off deflation and maintain employment. There are grounds for believing it was these very efforts that helped make the depression as long and bad as it was.
Obama, Bernanke and their ideological kin around the world are making similar mistakes to Hoover and Roosevelt. They could be making the Greatest Depression.
- Fergusson A (1975) When Money Dies – The Nightmare of the Weimer Collapse – large file, links to book
- Parsson JO (1974) Dying of Money – Lessons of the Great German and American Inflations – large file, links to book
- Peter Bernholz (2006) Monetary Regimes and Inflation: History, Economic and Political Relationships
- Kindleberger CP, Aliber R (2005) Manias, Panics, and Crashes: A History of Financial Crises
- Reinhart C, Rogoff K (2009) This Time Is Different: Eight Centuries of Financial Folly
- Yves Smith (2010) ECONned: How Unenlightened Self Interest Undermined Democracy and Corrupted Capitalism
- Mark Spiegel Don’t Bother with Comparisons to the 1970s… They’re Useless
- Reinhart C, Rogoff K (2008) The Aftermath of Financial Crises
- Reinhart C, Rogoff K (2008) Banking Crises: An Equal Opportunity Menace
This article focuses on inflation. Reinhart and Rogoff present a very good case for expecting declining prices as the credit expansion goes into reverse. The argument against them is that we have never been in a world of fiat (un-backed paper) money before.
Personally I think the paper money printing component will be dwarfed by the reduction in credit. The circulation of money will slow. Inflation will only come in later when money printing on the part of the authorities finally results in people getting rid of their currency as fast as they can. But this can take years. People have been conditioned to value their paper money. The psychological change will not come quickly. As Adam Smith said, there is a lot of ruin in a nation. But when things reach a tipping point, they will move with bewildering rapidity.
Of course, the politicians could prevent the worst of the inflation. But they would have to be willing to let the economy right itself. This I do not believe they will do, at least not until much damage has been done. There is no real evidence for my views. No one does or can know. Although some will be proved right.