Innovation Versus Inflation

Throughout human history, innovation has been a constant. Two of the most transformative innovations — money and inflation — date back thousands of years. For long stretches, gold served as the foundation of the monetary system. It was nearly impossible to counterfeit or destroy and had limited practical uses outside of finance and jewelry. Economists often praise gold-backed currency eras for their long periods of stable prices.

But there’s a catch: gold mining. Historical estimates suggest gold supply increased by about 2% annually. If money supply grows by 2%, logic suggests there should be 2% annual inflation. So why didn’t prices rise accordingly?

The answer, we believe, lies in innovation. Innovation consistently reduces costs and prices, which can counterbalance mild inflation caused by expanding money supply. If innovation drives a 2% deflation rate, it neutralizes the 2% inflation from gold supply growth — resulting in price stability.

And the pace of innovation appears to be accelerating. Contributing factors include larger global populations, better access to capital, rising educational levels, and increased international exchange of products, services, and ideas. Lower tax rates also play a role.

This wave of innovation accelerated around 1978, when a Democratic Congress passed a capital gains tax cut — despite President Carter having requested an increase. When Republicans gained control in 1980, further tax reductions followed.

The past dozen years, particularly following the Great Recession, have baffled many economists and policymakers. Inflation and interest rates remained unusually low. Our explanation: accelerating innovation. Yet innovation is notoriously hard to measure. In the past, we could track innovation by counting the number of cars, radios, or computers. Today, many innovations—like emails, text messages, or Google searches — are essentially free.

So what do we expect going forward?

• We’re not overly concerned about the large spending bills proposed in Congress. These programs are spread over several years, allowing for course corrections.
• Passing such legislation is proving difficult in a divided political environment.
• We continue to believe innovation will play a key role in offsetting inflation.
• We’ve added several inflation-protected income positions to client portfolios to support diversification, income stability, and flexibility for future opportunities.

Consider this: in the 20th century, stock markets in Germany and Japan underperformed the U.S. by just 1% — despite both nations having their industries decimated during World War II. That’s a strong case for staying invested. A well-constructed stock portfolio still appears to be one of the best places to be.

Katz Family Financial