Some inflation history, and inflation optimism

December 17, 2021

Most people don't know it, but investment returns in the 1970s were worse than the Great Depression's 1930s. Inflation was the culprit, and while the 1970s experienced high inflation, the 1930s actually were deflationary. A dollar was worth more at Christmas 1939 than it was a decade earlier. The real return of the 1970s S&P 500 was -1.4% per year.^{1, 2}

In the last newsletter I mentioned that inflation is the investor's number one enemy. It's been a few weeks, but I haven't changed my mind. It's like running on a treadmill – when there is little inflation you feel good because the angle is low and there is no wind resistance. Once that treadmill starts to have an incline, you have to fight harder just to stay in place. Don't be fooled by the dollar numbers in investment returns - with inflation setting in, you are making less real money than it seems. And cash? Not good.

The former Vice-Chair of the Federal Reserve, Alan Blinder, wrote a good paper on 1970s inflation. If you are interested in the topic, I suggest reading it here. Note the table on the top of the second page: 1970s inflation was 6.85% per year, while 1930s was -1.1%. A few thoughts on this.

1. People perceived 1970s inflation to be higher than 6.85%, partly because 6.85% is a mean number, and the human mind tends to gravitate toward peak numbers and lock them in. At times in the 1970s, annual inflation hit double digits. (Not that 6.85% compounded for 10 years is a small number...)
2. Blinder's thesis is that 1970s inflation was a result of exogenous shocks to the economy. Mapping this forward to the current day, this may be good news. We have no shortage of economic shocks that businesses are trying to absorb. These include supply chain disruption, great resignation, unprecedented government stimulus and competition with the private sector, and Covid.

To make it worse, inflation discriminates against the poor and lower-middle class. There is no buffer in those household budgets. Wage gains get eaten quickly by inflation.

It's not all bad news.

Entrepreneurs like to fight inflation. The 1990s and 2000s saw lower inflation in part because entrepreneurs got better at their jobs. Collectively, as a field, entrepreneurship and businesspeople have learned that more money can be made by lowering prices for customers than by raising them. Low prices open up big markets to many people. It's quite democratic, and it turns out to be deflationary.

Businesses have a hard time doing this when shocks are hitting from all sides, but once things stabilize a bit, lots of them will get back to work competing to take prices down.

As you know, I'm a huge fan of cutting prices for clients at One Day In July. It requires significant back-end operational work to do it well. We've made investments in proprietary, custom software for years to hold costs below competitors even as shocks reach the business.

Another example? Amazon just demonstrated that its automated physical stores reduce per-store operating costs from $4 million dollars a year to $159,000, and they plan to license the software and systems. That is deflation in action. (I'm not weighing in on the social ramifications of this one.)

As businesses get back in the groove, inflation may normalize because these counter-forces will increase.

Dan Cunningham

1. Professor Robert Shiller, Irrational Exuberance.
2. During the Great Depression, the stock market recovered, in real dollars, faster than people believe. It’s commonly stated that it took 25 years to recover from the 1929 high. But the actual number in real dollars, when both dividends and deflation are considered, was only 4.5 years. Source: Mark Hulbert, 4/25/09 NY Times.