Why Companies Should Prepare for Inflation

Why Companies Should Prepare for Inflation

          
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Why Companies Should Prepare for Inflation

Management in a Two-Speed Economy, Corporate Development & Finance
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    The strategy implications of inflation are these: True profit margins will be squeezed in spite of higher reported profits. Cash requirements will be increased and so will the cost of money. These forces, of course, also lead to a concentration of industry…

    Bruce D. Henderson,
    “Inflation and Competition,”
    BCG Perspectives, 1969

    For a time, it seemed that the worst was behind us. In the first quarter of 2010, economic indicators were sending encouraging signals that the crisis was over. Many observers asserted that if the momentum could be maintained a little longer, it would become self-reinforcing. But by early summer, a number of economic indicators in the United States had turned south again. The U.S. economy slowed, and there was rising fear of a double-dip recession that could drag down many other developed economies.

    These developments have led to growing fears of deflation. To be sure, some observers have been highlighting the risk of a long-term, Japanese-style deflation for some time—most prominently Nobel laureate economist Paul Krugman. Krugman’s concerns have been echoed more recently by other economists as well, such as Harvard’s Kenneth Rogoff, and even by some central bankers, such as James Bullard, head of the Federal Reserve Bank of St. Louis.

    And yet, while mainstream economic opinion was focusing on the threat of deflation, an out-of-print book published in 1974 on the mechanics of the German hyperinflation of the 1920s was becoming favorite summer reading among London investment bankers. The title? Dying of Money: Lessons of the Great German and American Inflations. (See “The Dynamics of Inflation: Jens O. Parsson and Dying of Money,” below.) Did the bankers know something that the economists were missing?

    The Dynamics of Inflation

    Jens O. Parsson and Dying of Money

    There is a surprising paucity of modern literature on inflation economics and its impact on business. Most academic studies of inflationary periods in developed economies focus on the macroeconomic conditions and policy mistakes that led to inflation. Those few that deal with the impact of inflation on business mostly address questions of inflation accounting, valuation, and corporate finance.

    Dying of Money: Lessons of the Great German and American Inflations, written by Jens O. Parsson and published in 1974, is a notable exception. In fact, when it became the favorite summer reading among London bankers in 2010, it created its own inflationary pressures, with hard-to-find used copies trading on eBay for as much as $699. When Parsson wrote his book, the U.S. economy was on the brink of superinflation. Interest rates were at new highs. Wage and price controls had been imposed by the Nixon administration, although the resulting shortages and market distortions made them politically untenable, and prices were once again set free to rise. And in response to the 1973 Yom Kippur War, Arab oil producers began to shut off the supply of oil, driving up the price.

    Parsson describes the mechanics that can lead to rapid inflation and eventually to uncontrolled hyperinflation. Drawing from the German experience during the Weimar inflation of 1920 to 1923, his book illustrates how an initial increase in the money supply fosters prosperity without immediately leading to significant price increases; how ever-higher rates of money inflation are required to maintain the beneficial stimulus; and, finally, how latent inflationary pressure becomes embedded in the economic system.

    Parsson’s book goes on to describe how this entire system seems under control as long as trust in the fundamental value of the currency is preserved—but it starts to break down when the population loses confidence. “The economics of disaster commence,” he writes, “when the holders of money wealth revolt.” This revolt is expressed by the simple act of getting rid of money and money wealth as quickly as possible—out of fear that the longer it is held, the less value it will have.

    Is the Weimar experience likely to be repeated in major developed economies such as the United States today? We don’t think so. And yet the recent interest in Parsson’s book among bankers and other financial experts indicates that inflationary scenarios are back on the agenda of many practitioners.

    Examples include Hawkins, “Inflation Accounting and Analysis” (cited elsewhere); Mathews, “Inflation and Company Finance” (cited elsewhere); and Alfred Rappaport and Robert A. Taggart, Jr., “Evaluation of Capital Expenditure Proposals Under Inflation,” Financial Management, Vol. 11, No. 1 (Spring 1982), pp. 5–13.

    We believe that the investment bankers may be on to something. Despite near-term deflationary pressures in at least some developed economies, especially those that are carrying high levels of debt, we think that what today’s business leaders should really be worrying about is the threat of inflation.

    Why? Even if the deflation scenario comes to pass, the probability that it will be severe is low. Most likely, deflation will be in the neighborhood of 1 to 2 percent per year, as has been the case in Japan in the aftermath of its Lost Decade of the 1990s. What’s more, many companies—both in Japan and in sectors of the economy that have a recent history of price declines, such as telecommunications or information technology—have already had to cope with deflation, so the techniques for doing so are relatively well known, making it easier for businesses to adapt. (See the Appendix, “Coping With Deflation: Lessons from Japan.”)

    By contrast, should the inflation scenario come to pass, the probability that it could be severe is much higher. The threat may be less immediate than the risk of deflation, but it is likely to have a more profound impact on business competition over the long term. And the vast majority of companies are unprepared—for the simple reason that few executives in leadership positions today have ever had the experience of managing in a period of high inflation.

    In many respects, the current economic environment is a perfect breeding ground for inflation. The loose monetary policy of many central banks, with extremely low interest rates and unprecedented quantitative easing schemes, has strongly inflated the monetary base and central banks’ balance sheets. At the same time, ongoing fiscal-stimulus packages have left many governments with huge debt levels that they may be tempted to inflate away. Ultimately, inflation may be the price we pay for the successful prevention of another Great Depression. (William White, chair of the OECD's Economic and Development Review Committee, discusses alternative options for reducing the current unsustainable debt overhang; see also Collateral Damage: In the Eye of the Storm; Ignore Short-Term Indicators, Focus on the Long Haul, a BCG White Paper.)

    Higher inflation rates can appear to be beneficial at first because they not only reduce the real burden of servicing debt but also, to the degree that price increases lead to rising wages, increase disposable income. But continued inflation destabilizes the economy, discourages productivity growth, leads to inefficient capital allocation, depresses company valuations, and carries the seeds of future recessions. That’s why senior executives need to start now to think through the consequences of inflation on their business, understand their company’s exposure, and prepare for an inflationary scenario that may materialize sooner than many expect.

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