Producer price hikes during monetary deflation

Okay, as Jazzbumpa has repeatedly pointed out on his fine blog, as as I've pointed out from time to time here, we're actually in monetary *deflation* right now. That is, the supply of money has shrunk, first because the housing crisis made money go POOF into thin air (i.e., bank reserves suddenly ceased to exist because the assets backing them up ceased to exist), and then because people started stuffing money under mattresses (or, rather, banks started shoveling it into the Fed as reserves), essentially removing it from the economy.

As I've previously pointed out, wages and prices are sticky during deflation. They may decline over time, but they decline much slower than the money supply because a) businesses won't voluntarily sell product for less than it takes to make them, and b) businesses instead voluntarily decrease their volume to match the diminished amount of money available in the economy for buying things, and cut their costs to match their decreased volume by laying off their least productive workers -- making their fewer remaining more-productive workers individually more valuable to the company and thus certainly not getting a pay *cut* because if they leave, they're basically irreplaceable (since every other company only laid off their least productive workers too -- meaning that all you can find on the market is less productive workers than what you have). Thus wage stickiness.

The end result is less economic activity. We can measure this by looking at utilization of manpower. At the peak of the economy, real unemployment was around 8%. Today it is around 18%. What this indicates is that around 10% of the money in the economy has gone poof -- bye-bye, adios, amigos -- and that economic activity as a whole as accordingly declined as output was reduced to match the amount of money that actually exists in the economy.

So we're in monetary deflation -- less money in the economy -- and -- wait. Okay, so we have wage and price *stickiness*, but look, over there, there's actual price *hikes* in some things!

You track the source of these price hikes down, and it is almost entirely producer price hikes being passed along to consumers (because, remember, companies will *not* sell for less than it cost to make the item, and if a producer of a commodity they need to produce the item has increased, they have to pass it along or they become a *former* business). So how does this happen?

Well, we can look at an example. Let's look at the fictitious Anaconda Copper Mine. This mine has about $200 million in debt that was taken on in order to fund its construction. The interest on this debt constitutes the vast majority of its operating costs, because the mine is heavily automated and only 20 or so people are working at the mine at any point in time. These people earn maybe $20K a year because the Anaconda is in a depressed area (as are most mines). So figure $1M in salaries and benefits, and $20M in debt payments, per year.

So anyhow, at full production at current prices, the mine brings in $25M per year. That gives enough money to service the debt plus pay wages plus make a nice little profit. But now the economy has slipped into monetary deflation and the demand for copper has slipped badly that we would only bring in $15M per year.

Well, if we only bring in $15M this year because the demand for copper has fallen by 40% due to the slow economy, we're out of business. So: We cut costs -- we lay off 50% of our workforce -- but that only saves us $500K because we're capital-intensive, not labor-intensive. Out of desperation we raise our prices by 40%, which gets us to $21M per year -- or break-even for our mine.

Now, remember, the cost structure of basically *all* producers in a given industry was pretty much equal to begin with, because of the simple realities of business (if anybody was less leveraged they would have taken on more debt to expand and grab market share from other competitors, and the less efficient producers have already been weeded out via normal economic competition). So individually, *every* producer of copper is arriving at this same decision. And thus, voila, copper rises 40% in price -- despite there being less money in the economy!

In general: During monetary deflation that causes a decline in demand, prices of capital-intensive resources will increase in order to cover the cost of capital. If producers do not cover their cost of capital, they become *former* producers. Rather than have that happen, they raise their prices.

Now, the above is assuming a competitive environment where there is no speculative trading going on. There's a different mechanism going on right now in the oil business that's causing the current spike in oil prices (because world demand for oil has *not* gone down). But I'll talk about that later.

So anyhow: You go into your grocery store and look at the price of food. Has it gone up? Perhaps. If demand for food has gone down (because fewer people can afford to buy it), *farming* is, today, a capital-intensive business. Your average wheat farm employs a half-dozen people max but has millions in capital equipment and land that must be paid for. So expect to pay more for bread, and milk, and anything else that's produced via capital-intensive (vs. labor-intensive) methods. Because, paradoxically, that's the effect of deflation upon capital -- it makes capital more expensive, and, thus, those products which are produced by capital become more expensive too as a factor of leverage.

PS: Yes, I can model producer prices mathematically and show you exactly what, say, a 10% drop in demand would do for the price of bread given a particular leverage factor and labor factor. But it's late, I'm not interested enough right now, and frankly I just wish the folks we're *paying* to be economists would do it rather than continue their incessant nattering about ideological nonsense that has nothing to do with the realities of running a business in a capitalist society.

-- Badtux the Economics Penguin