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How Our Techno-Economic Revolution Prevents Inflation
Technology Briefing |
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TranscriptDespite an accommodative Federal Reserve and historic levels of fiscal stimulus, don’t expect to see disruptive consumer price inflation reminiscent of the 1970s. Why? Because technology is inherently deflationary. And we’re in the midst of the most aggressive surge in the deployment of technological innovation that has occurred in at least seventy years. In fact, to see a period when technological change impacted the economy to the extent we’ll see from 2021 through 2030, we have to look back roughly 120 years to the third techno-economic revolution when the telephone, electricity, and the automobile were all simultaneously surging toward mass adoption. This begs the question, “Why is technology the antidote to inflation?” The answer: Because technology allows the production of goods and services to scale efficiently. If the production of goods can scale efficiently enough to satisfy the market's present and future demand for goods, the price of those goods does not increase even though demand skyrockets. And, as technology improves, this scaling reaches a tipping point in more and more industries, so inflation pressure gets weaker and weaker. Today, as explained in trend #1, we have more revolutionary technologies in the pipeline than ever before, and the pace of technological innovation is still accelerating. Therefore, deflation is more likely than inflation across almost every sector. Obviously, certain industries will be more susceptible to short-term supply shocks and temporary inflation spikes. But long-term inflation across the general economy, like we saw in the 70s, is not something we need to worry about even in the face of prolonged and substantial fiscal stimulus. Consider the facts. First, automation-driven increases in productivity will prevent the kind of prolonged labor-cost surge we saw in the 70s. Wage growth is only inflationary when wages grow more rapidly than productivity. In the next five years, robots will replace more humans in factories, Amazon's AWS service will reduce the need for companies to hire data center engineers and self-service checkout lanes will reduce the need to hire additional personnel at retailers. Over the past 25 years, for every percentage point drop in labor’s share of industrial and agricultural revenues, operating margins increased by 30 basis points in manufacturing and 280 basis points in agriculture; today, it’s estimated that across the remainder of the U.S. economy, labor’s share of revenue could fall 15% due to automation and that could more than double average operating margins to more than 20%. In our Golden Age boom enabled by the ongoing technological revolution and complemented by low-interest rates and high liquidity, displaced workers and the chronically unemployed will both find jobs. Yet, because of a low “labor force participation rate” coupled with higher productivity, wage inflation will remain muted, rising at a rate slower than increasing productivity. As a result, automation will clearly have a favorable impact on the demand-side of the inflation equation. Coincidently, Korn Ferry's 2021 salary survey indicates that "more businesses are planning no raises for all employees." The survey notes that Covid-19 is the primary driver of this in the short term, but technological improvements will also put downward pressure on wages in the long term as well. Second, the supply-side deflationary impact of technological innovation on goods and services will be even more significant than its demand-side impact. Technology is allowing more businesses and industries to pass an important inflection point at which the production of goods and services can scale faster than consumer demand for them. As technological improvements lower production costs and increase the speed at which goods and services can be produced, it becomes easier to satisfy the market's demand for particular goods. Beyond automation, which lets products be produced with less labor, technological innovation permits the rise of “new entrants” and “substitutes” with new supply chains and business models. There is no better example of this than the business ecosystem enabled by today’s smartphone. If the supply of goods to meet existing or new needs always meets demand, then there is no room for price increases! Said another way, innovation means there is more 'slack' in the production of goods and services than there appears to be on the surface. During the current Golden Age and beyond, innovation will enable the economy to create a nearly infinite supply of goods and services, for the first time in history. And, info-tech, biotech, and nanotech are simultaneously converging to make this happen across the entirety of the economy. Consider a few real-world examples. Let’s start with, Software-as-a-Service (or SaaS). Already, the market has correctly awarded SaaS companies high sales and earnings multiples in part because they can scale so efficiently and can essentially add new customers for free. For example, if 100,000 new people join Facebook tomorrow, Facebook's costs are going to be virtually unchanged. At the start of the pandemic, Zoom became the perfect example of this phenomenon. Thousands of companies around the world all moved to remote work in less than a month and, after ironing out some small glitches and capacity issues, Zoom was able to handle the increased demand for its product without needing to double or triple the price of the service. This is a great business model for Zoom and other teleconferencing companies, but it is also highly deflationary because the entirety of the market's sudden demand for remote conferencing tools was met nearly overnight without the need for price increases. Such technology-driven effects have already been extended to several commodity industries. Commodity industries are well known for boom-and-bust cycles when the market swings from oversupply of a resource to undersupply. In times of undersupply, there are sharp price spikes, followed by price collapses as the “supply imbalance” is corrected. For example, if oil prices get high enough, producers using fracking technology can ramp up production to meet the demand by quickly completing “partially finished wells” and soon prices come down. That wasn’t an option even a decade ago. Similarly, if a drought in the American Midwest lowers corn production causing short-term corn prices to soar, you can bet that next year farmers will bring idle corn production capacity online to take advantage of higher prices. And these aren’t isolated examples. Technological innovations in agriculture, mining, and other parts of the commodity space are making it easier for producers to quickly and efficiently close supply gaps, returning prices to pre-shock levels. This means that technology is reducing the inflationary impact of natural disasters and geopolitical shocks. In the case of energy, fracking technology, more sophisticated methods of detecting new fossil fuel reserves, and improvements in wind and solar technology are all combining to stabilize the overall price of energy within a range that maximizes global economic growth. The same is true for farming. Farmers are achieving record yields in crops like corn and dairy farmers are building robotic milking parlors that reduce costs by milking dozens of cows simultaneously. Because of inherent constraints on biological processes in farming and infrastructure lead-times in extractive industries, we will still experience short term supply and demand shocks. However, expect these to become rarer, last for shorter periods of time, and be less severe as the decade progresses. As a final example, consider the entertainment industry. Streaming services have dramatically reduced the price of media consumption and allowed new suppliers to scale and compete more efficiently. With a Netflix account, anyone can watch a nearly unlimited number of movies and shows for the price of one ticket to a movie theatre. New music artists can produce studio-quality albums from their basements (via state-of-the-art recording technology) and make their content accessible to millions of potential new fans overnight (via services like YouTube). And by putting the content online, its consumption can scale quickly and efficiently. And these are just a few of many examples of technology helping the supply of goods and services scale more efficiently. And this becomes truly revolutionary when the scaling becomes efficient enough that it can accommodate the entirety of potential consumer demand. Consider cheese as an example. As mentioned earlier, technological improvements in the dairy industry mean that cheese can be produced more cheaply than ever before, and it is relatively quick and easy to add additional capacity. At the same time, there remains a clear upper bound to how much cheese any person can eat in a given day or year. Furthermore, there are still absolute limits to aggregate cheese production. For example, even with robotic milking, we will never be able to produce enough cheese to allow the mean average person to eat a million pounds of cheese a year. But fortunately, the demand for cheese is never going to be that high. So, in the case of cheese, there is clearly a “physical limitation” on supply and a “preference limitation” on-demand limiting the amount of cheese that can be consumed in a given year. The same goes for most Software-as-a-Service and entertainment offerings as well; there are only 24 hours in a day in which we can consume media or participate in Zoom calls so, while production of these goods and services isn't truly infinite, demand cannot be infinite either. And in most cases, the limitations today are far more meaningful on the demand side for most goods and services than on the supply side. Therefore, it is hard to see a way for there to be meaningful inflation in sectors like these because supply will always be able to meet or exceed demand, even if demand spikes due to short-term preference changes or fiscal stimulus. What’s the bottom line? The more efficiently the production of a good or service can scale, the less likely it is to see meaningful price inflation. And the opposite is also true. The recent pandemic provides some examples. Early on in the pandemic, especially as lockdowns were beginning, goods like Clorox wipes, toilet paper, hand sanitizer, and masks quickly became unavailable. For both legal and PR reasons, most retailers chose to remain out-of-stock rather than charge a high enough price to keep the items on the shelves. But this was still clearly an example of an inflationary spike. If you really wanted hand sanitizer you could get it, but you would have to pay 400-to-600% more and purchase it from resellers on Amazon. In practice, inflation for these types of goods spiked because the supply of the goods couldn't scale fast enough to meet the huge demand spike. That being said, less than a year after lockdowns began all of these goods are once again available to consumers at prices comparable to pre-pandemic levels. And consistent with the arguments made earlier, state-of-the-art manufacturing automation enabled companies to ramp up production very quickly. For example, as of this writing, Clorox is on the verge of producing disinfectant wipes at a rate of over 2 million canisters per day. Notably, it would have taken Clorox far longer to do this in the 1970s. So, it’s safe to say that technology is allowing companies to ramp up supply faster and thereby shorten the duration of inflationary spikes in the face of even the most dramatic shocks to either supply or demand. Given this trend, we offer the following forecasts for your consideration. First, throughout the 2020s, technology will prove to be increasingly deflationary. Technology is deflationary primarily because it allows the production of goods and services to scale efficiently. Long-term price inflation of a particular good or service becomes an impossibility when the production of that good or service can scale to meet 100% of current and future demand. Second, as technology enables the OECD countries to cross the dematerialization frontier, their economies will create more GDP, while consuming less matter and energy. In that case, industry-after-industry will become more scalable and the challenge will be to create and protect the intellectual property needed to create and maintain a competitive advantage. Third, there will be a temporary, near-term inflation spike in some industries but then, inflation will quickly moderate because of rapid technology-driven scaling of supply to meet demand. As of early April, the bond market’s expected average inflation rate, (called the Breakeven Inflation Rate), was 2.56% for the next 5 years. As the chart in the printable issue shows, inflation fears have been rapidly rising since last fall, and there has been a fundamental switch in the relationship between the 5-year and 10-year horizons. For the first time since 2008, the 10-year Breakeven Inflation Rate has dropped below the 5-year. That tells us that the market expects a temporary inflation spike in the near term, but then inflation will quickly moderate consistent with our forecast. Fourth, because of inherent constraints on biological processes in farming and infrastructure lead-times in extractive industries, we will experience some short-term supply and demand shocks during the Roaring 2020s. However, expect these to become rarer, last for shorter periods of time, and become less severe as the decade progresses. And, Fifth, in some industries and in some places, inflation will surprise to the upside as they continue to defy free-market realities. While technology will prevent widespread price surges over extended periods, we will continue to see some significant pockets of inflation. For example, housing, education, healthcare, and childcare, have been experiencing high inflation for prolonged periods and this isn’t likely to change until fundamental institutional changes occur. That’s because demand and/or supply is being distorted by nonmarket factors. For example, demand for conventional on-campus college educations is being artificially stimulated by student loan programs that break the connections between value delivered and prices paid. Similarly, regulatory frameworks prevent the widespread adoption of more cost-effective health care business models. Public K-12 education is also stuck with an excessively costly and fundamentally ineffective business model demanded by the teachers’ unions. And in all too many places, restrictions on home construction keep housing costs artificially growing to astronomical levels. Fortunately, even in these “economic backwaters of political dysfunction,” technological innovation and jurisdictional competition will eventually flatten the cost curves and shift resources to more attractive locations, business models, or product substitutes. |
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