Guest Post: The Microeconomics Of Inflation (Or How We Know This Ends In Tears)

Tyler Durden's picture

Submitted by Martin Sibileau of A View From The Trenches blog,

A week later and everyone is a bit more nervous, with the speculation that US sovereign debt purchases by the Federal Reserve will wind down and with the Bank of Japan completely cornered.

In anticipation to the debate on the Fed’s bond purchase tapering, on April 28th (see here) I wrote why the Federal Reserve cannot exit Quantitative Easing: Any tightening must be preceded by a change in policy that addresses fiscal deficits. It has absolutely nothing to do with unemployment or activity levels. Furthermore, it will require international coordination. This is also not possible. The Bank of Japan is helplessly facing the collapse of the country’s sovereign debt, the European Monetary Union is anything but what its name indicates, with one of its members under capital controls, and China is improvising as its credit bubble bursts.

In light of this, we are now beginning to see research that incorporates the problem of future higher inflation to the valuation of different asset classes. One example of this, in the corporate credit space was Morgan Stanley’s “Credit Continuum: Debt Cost and the Real Deal” published on May 17th, 2013. Upon reading it, I was uncomfortable with the notion that inflation is the simple reflection of the change in a price index, which implies the thesis of the neutrality of money. For instance, the said research note discusses how standard financial metrics compare vis-à-vis a rate of inflation.

Why is this relevant? The gap between current valuations in the capital markets (both debt and credit) and the weak activity data releases could mistakenly be interpreted as a reflection of the collective expectation of an imminent recovery. The question therefore is: Can inflation bring a recovery? Can inflation positively affect valuations?

I am not going to comment on others’ views or recommendations, but on the underlying method. A price index is a mental tool that has no relation to reality. In the real world, we trade driven by relative prices. To infer economic behaviour off changes in a price index is a mistake. The impact of inflation is more complex. For this reason and in anticipation of future debates on this topic, I offer you today a microeconomic analysis of such impact, on value.


I suggest that a good way (but certainly not the only one) to assess the impact of inflation on the valuation of a firm is to think of the same within the typical free-cash flow approach. After all, what matters is not how inflation can affect a certain component of its capital structure, but how the entire value of a firm is impacted, before the same can be shared among the different contributors to the said capital structure (i.e. equity, debt holders, etc.)

Simplifying, as far as I can recall from the times when I worked in the area of Private Equity,  the way to calculate the free cash flow of a firm for a determined period is to obtain its operating margin, add to it depreciation & amortization costs and subtract capital expenditures, changes in net working capital and taxes. I show the formula below:


– Operating Costs

Operating margin


+ Depreciation & Amortization

- Capital Expenditures

- Change in net working capital

- Operating tax

Free Cash flow



What follows is a discussion on the impact of inflation on each of the components of the valuation formula above:

Revenues (= unit price x volume sold)

Under inflation, only those firms that have pricing power can defend the value of their production. At the same time and because inflation brings unemployment and the destruction of purchasing power, in general (not for all firms, of course), sales volume drops too. This backdrop encourages consolidation, where big players get bigger and small ones disappear. With it, the bigger firms obtain oligopolistic to monopolistic pricing power which assures two things: The currency zone where this development takes place loses in innovation and prices become less flexible. This inflexibility, when fully unfolded, directly leads to indexation, which is the stepping stone for any hyperinflationary process. If the consolidating firms are public, it is likely that during the consolidation process they become private via leveraged deals, as long as credit is still available.

Operating costs (=unit cost x volume bought + factors)

With regards to direct inputs, the same pricing problem described above arises. There are those firms that have leverage with their suppliers and can force these to delay price increases (i.e. margin contraction) and those that can’t. Consolidation therefore pays off on this front too, carrying the same consequences mentioned above. From an accounting perspective, when inflation is high, firms can’t even measure the cost of their inputs and are forced to take a Schrodinger approach, with either Last in-First Out (LIFO) or First in – First Out (FIFO) accounting.

With regards to indirect inputs, these can be segmented into labour and capital. Labour intensive firms will struggle with a unionizing work force and inflation always nourishes the growth of unions, to renegotiate labour contracts. All things equal, this context simultaneously encourages higher unemployment and illegal immigration, because while credit is available at negative real rates (i.e. the nominal interest rate is lower than the inflation rate), firms will find more convenient to replace labour with capital. This takes place during the lower stages of an inflationary process. In later stages, credit disappears and the higher interest rates make refinancing debts unfeasible, bankrupting those firms that dared to invest in capital expenditures.

Where the required labour is low skilled but expensive due to social security legislation, firms will also replace it with illegal immigration, whenever possible.


The impact of inflation on operating margins (i.e. revenues – operating costs) is to drive consolidation, the replacement of labour by capital, indexation, price rigidity and the loss of competitiveness. The loss of competitiveness is the natural result of an environment that favours oligopolistic/monopolistic structures and short-term investment opportunities. It is very common to blame entrepreneurs or management for this outcome. However, the conditions that drive firms to adopt these survival strategies are the exclusive responsibility of politicians.

Depreciation & Amortization

“…Both depreciation and amortization (as well as depletion) are methods used to prorate the cost of a specific type of asset to the asset’s life…these methods are calculated by subtracting the asset’s salvage value from its original cost…” (Investopedia)

It is clear that any attempt to accurately portray the value and life cycle of fixed or intangible assets under inflation becomes irrelevant. What if due to high inflation the salvage value of an asset is higher than its original cost?

Under inflation there is uncertainty on the true cost of maintaining the fixed resources involved in the operation of a business. This uncertainty forces firms to cut back on capital expenditures. Investment demand and economic growth therefore collapse

Capital expenditures

Because nothing can be reasonably forecasted under inflation and growth and efficiencies are better served via consolidation and without innovation, capital expenditures can only be of a very short nature, if any.

Change in net working capital

This item is perhaps the most neglected and yet, most relevant, in my view. For valuation purposes, an increase in net working capital means that a higher amount of capital is tied to the operations of a firm. Therefore, a lower amount of cash is available to the contributors of capital to the firm (i.e. debt and equity holders). For this reason, the change in net working capital is subtracted in the valuation formula above.

What is net working capital? In simple terms:

Accounts receivable

+ Inventory

-  Accounts payable

Net working capital

If from one period to another the time necessary to collect on accounts receivable increase and/or the inventory turnover necessary to run an operation decreases, the value of the firm falls, as less cash is available to the contributors of capital. Alternatively, if the firm manages to increase the time necessary to honor accounts payable –all things equal- more cash is available.

What is the impact of inflation on net working capital? Complete! Under inflation, firms seek to delay any cash outflow. The higher their accounts payable, the more debt they dilute. At the same time, bank lending quickly shrinks. At high inflation levels, even working capital lending disappears. At this stage, vendor financing is key and only those companies that demonstrate a steady commitment to their suppliers can obtain credit from them. Suppliers, on the other side, often go bankrupt precisely because they cannot collect on their receivables. One of the painful ironies of inflation is that under it, liquidity evaporates!

With regards to inventory, this is counter intuitive, but firms will try to maximize its amount, as long as they can get vendor financing. The accumulation of inventory allows firms to lock in a cost of production that would otherwise be uncertain. This is very inefficient. Just-in-time production models become totally unfeasible. The accumulation of 

inventory is more understandable when one realizes that inflation is the destruction of the medium of indirect exchange, which forces us to barter. Under barter, inventory is not a burden.

Just as much as firms seek to delay cash outflows, they will want to collect as quickly as possible. Those firms that operate at the end of the distribution chain and can sell to a granular, cash-paying public will be at an advantage over those that operate at earlier links of the chain (and have a concentrated customer base which demands vendor financing). Inflation therefore leads to consolidation on this basis too, towards the end of a distribution chain.

An example of a firm that would fit this profile, benefitting from an inflationary context would be Costco Wholesale Corp. (and no, this is not an investment recommendation, but a hypothetical example). As Costco sells in bulk, its customer base would grow, since the public that seeks to escape from a devaluing currency and lock the price of necessary staples would see an advantage in purchasing the same in quantities, at a discount. Simultaneously, the company would be in a privileged position to exert pricing power over its suppliers and grow via acquisitions. As an extreme (but illustrative) example, I recall that during the ‘80s in Argentina, when employees were paid their salaries, many took the day off (and parents left their kids with nannies) to go shopping. They were simply ensuring that not one day would pass with them holding depreciating currency, which had to be exchanged as fast as possible for all the goods that were going to be consumed until the next wage payment. They set off in a hurry and bought, when possible, in bulk!


Operating tax

Tax payments are simply one more cash outflow. Even without inflation, one tries to minimize and delay this outflow. Under high inflation, delaying its payment is a matter of survival and represents and additional source of financing. Because all hyperinflations took place before the internet era, we don’t know how easy it will be to delay tax payments when the next hyperinflation arrives. I imagine it will be much harder in the digital era.


The inflationary policies carried out globally today, if successful will have a considerably negative impact on economic growth. The microeconomic impact described above brings the following unintended and unnecessary macroeconomic consequences:

-Oligopolistic/ Monopolistic structures

-Loss of innovation, competitiveness

-Indexation, price rigidities

-Unionization of labour force and higher unemployment

-Illegal migratory flows

-Destruction of public capital markets

-Higher fiscal deficits

If this analysis is correct, the record asset values we see today cannot be interpreted as the omen of an imminent recovery. I am not saying that these nominal values are not justified. What I am saying is that they should not be interpreted as an indication that economic growth is on the way

Comment viewing options

Select your preferred way to display the comments and click "Save settings" to activate your changes.
Tinky's picture

Boo! Wet blanket.

SafelyGraze's picture

OT: I discovered that rhizomes have taken over the lawn

was just sitting on the ground. idly pulled a weed.

guess what.

it went everywhere.

pulled most of it out.

which only exposed more rhizomes.

they are difficult to extract from the ground.

pulled and pulled.

all day.

turns out that most of the lawn isn't grass at all.

just greenery from rhizomes.

hands are blistered and lacerated.

rhizomes are still everywhere.

lots of bare soil. looks ugly as hell.

the neighbors are complaining.

I which I had never started.

rhizomes everywhere.

just leave them alone.

it's better not to know.

just pretend that the greenery is actually grass.

lovely, lush, soft, beautiful grass.


swmnguy's picture

I'm suspicious that your post wasn't OT at all.  And that maybe you're some kind of poet.

freewolf7's picture

Those damn rabbit holes.
Only the brave

Colonel Klink's picture

Seems hard to remove all the rhizome monied families from the garden of civilization.

Silveramada's picture

Japan, 10yrs bonds, the petro$ exit, euro zone collapse...we need a game changer before the PM's tsunami wave will crash this phony financial nonsense, any of them-and more-are good candidates, just a matter of time,

economics9698's picture

The game changer is a break up of the USA into smaller countries.

espirit's picture

Ahh, the global game of pass the hot potato (debt) has fewer players, and nobody is going to want to be the final bagholder.

What's in your wallet?

ouchtouch's picture

This is why we can't have nice things!

Seer's picture

You saying that cake isn't nice?

suicidalpsychologist's picture

No, this cant be possible!  hahahaha.

Petrus Romanus's picture

Well, in the physical world what goes up must come down. Just as what inflates will eventually burst. There is no fix left except war, and that is not a fix but a distraction. We must be getting close to the end game by now, especially when we start seeing the "terrorism" ramp up. Couple this with the facade of representative government, impartial / equal protection, and adherence to the constitution crumbling rapidly and you may be able to see into the true abyss!

Caviar Emptor's picture

But it's not inflation in the classic sense: it is not "demand-pull". It's liquidity-driven ("cost-push"), and therefore has more pernicious, unpredictable effects: not all cost will spiral, wages will stagnate and decrease sharply in real terms. So we'll be stuck in Biflationary hell: while cost of necessities will spiral, the ability to afford said costs will spiral down. Demand destruction will continue apace. Capital will concentrate into fewer hands. Hoarding will slow the velocity of money. The real economy will continue to contract while the paper economy bloats

Seer's picture

Yeah, the slowdown of money velocity.  Money velocity is, when one gets down to it, nothing more than a growth speculator.  Organic growth is dead; and, I'm not even thinking that there's any paper-tricks left to hide this fact.

The tipping point comes sooner as economies-of-scale-in-reverse really starts kicking in.

disabledvet's picture

there is a history here...especially here in the USA but in Britain which obviously had nothing but wars for 800 years straight...and that history is one of DEFLATION. not saying what the Fed is doing is the "right policy" (i prefer gold money myself) just saying "normally these massive asset price collapses are followed by a secondary." this one has not. "eliminate all the possible reasons...whatever's left...however the reason." in short: QE. this is a very good look at how businesses run at the micro level...but cash flow accounting is true in ANY investment environment...and while, an inflation there are issues vis a vis credit...getting "bang for your buck" is not one of them. in a DEFLATION however "nobody can spare a dime." finding any customers is really hard...we work for nothing...have even less to show for it. up until World War II the USA never had a Government to basically "provide" for this condition. that ended with the German and Japanese surrenders. "and that included a draft." it's almost impossible to create an inflation in the USA...though the post 9/11 one was pretty impressive. this one is pretty extraordinary as well. can it be sustained though? what's sustained this "ugly underbelly."

Seer's picture

"up until World War II the USA never had a Government to basically "provide" for this condition. that ended with the German and Japanese surrenders. "and that included a draft.""


World War I Selective Service System Draft Registration Cards, M1509

On May 18, 1917, the Selective Service Act was passed authorizing the President to increase temporarily the military establishment of the United States. The Selective Service System, under the office of the Provost Marshal General, was responsible for the process of selecting men for induction into the military service, from the initial registration to the actual delivery of men to military training camps.

Britain was at war for many years because it's an island nation that basically exhausted its own resources.  As is the case of all wars, the battle has always been about resources.  Yes, Britain engaged in plenty of defensive wars, but that's just how it goes: and, though no expert, were some of these defensive postures the result of past offensive wars?

"May we look upon our treasures, and the furniture of our houses, and the garments in which we array ourselves, and try whether the seeds of war have nourishment in these our possessions, or not."
~ John Woolman, 1720-1772

Petrus Romanus's picture

"Yes, Britain engaged in plenty of defensive wars, but that's just how it goes: and, though no expert, were some of these defensive postures the result of past offensive wars?"

Yes! Just as most wars of antiquity. But after this long we are left with the hereditary aftermath of a dying system. The offspring of these bloodlines, that have managed to maintain the false system of divine right to rule, are desperate to retain their position and wealth. The problem for these people is that they did not create this system, but instead were born into it, and have no clue how to manage it. Longevity and future generations were never in their minds. These people have matured in an era where they have been so insulated from reality that they are actually of the mind that they are not human. They actually believe that they are divine and that their wealth is their birthright rather than a complete and utter fraud.

Seer's picture

"The inflationary policies carried out globally today, if successful will have a considerably negative impact on economic growth."

"Policies" and whatnot are meaningless in the face of insufficient NATURAL CAPITAL.

Sure, we could remove ALL "regulations" and let it all fly, allow there to be "economic growth," but that would only itself be another HUGE bubble, which would ultimately end in widespread ruin.

If it's not sustainable then it IS a Ponzi!

People ought to start DEMANDING that any time someone blathers the words "economic growth" that said blatherers must provide their views on how MUCH (percentage) and for how LONG "economic growth" should be.

People clamoring for such are either:

1) Ignorant (don't understand simple math- exponential functions); or,

2) Are just looking to steer a Ponzi/bubble their way.

Fucking pikers (again)...

OneTinSoldier66's picture

Yes. Whenever I hear/see "economic growth", I think "economic model", which just means central planning of some sort or another.

Seer's picture

You nailed it!

If one looks at all the growth shit it's ALWAYS about projections, and "projections" ARE based on a plan.

I see most, however, thinking that tossing out central planning would magically resolve the issues of growth (when most don't understand that nature doesn't allow itself to be exponentially exploited, indefinitely).

Caviar Emptor's picture

The only reason they want to create inflation: so the debt serfs can't default en masse.

Seer's picture

I think that it might also have a firm toehold in severing foreign debt.

noless's picture


18 year old held without bail for song lyrics posted to Facebook containing reference to Boston bombing.



Convicted violent offenders no longer eligible for food stamps, what's that thing people here keep saying about no riots until?..

Rimon's picture

The main issue with these kinds of arguments and conclusions is the fact that developed wold has been running de facto inflation targeting regimes for decades - yet growth has been just fine

orez65's picture

"... yet growth has been just fine"

No, it's an economic illusion.

That "growth" has happened on the back of DEBT.

Every man, woman and child in the United States owes the Federal Government $1 Million.

Plus whatever debt the states, county and local officials have.

Rimon's picture

If an illusion lasts for decades then it's more real than "reality"

Seer's picture

I think that nature is the final arbitrator on this.

proLiberty's picture

There are all manner of unintended and unknowable consequences when nominal wealth measured in ever-depreciating currency units is increasingly disconnected from real wealth.

Public officials make distortion of the value of the currency part of official policy solely based on how it benefits government and its cronies. This is theft by embezzlement just as surely as when TGI Friday waters down the liquor.

Seer's picture

"Public officials make distortion of the value of the currency part of official policy solely based on how it benefits government and its cronies."

Revolving door.

The cronies use govt to set policies beneficial to them.

It's the System.  And we programmed the System a LONG time ago to lie to us: we can't have perpetual economic growth on a finite planet.  We pay the liars handsomely so that we don't have to face reality... but, reality cannot be hid from forever.

Snoopy the Economist's picture

I read an article on seeking alpha which of course did not address the real issues and most of the commenters were praising the banana-ben for his QE prowess. This made me sick so I left a comment which was cut in half since they likely believed I was being 'unprofessional' to the banana lover - all I did was point out facts and they cut my comments.

I appreciate ZH where there are far less idiot banana lovers and my comments are uncut.

ableman28's picture

Good analysis.  What the Fed says it is doing, stimulating the economy until unemployment goes down is just the usual lies and attempt to make the average person think that the people who control the economy have their interests at heart and are trying to help.

The absolute reality is that the Fed can't climb down from the level of Treasury and other paper until the roll over financing needs of the government begin to decline...which means reducing deficit spending.  In nearly every western country the central banks are buying their own governments paper in order to suppress borrowing rates by governments awash in deficit spending.  If free markets these liars profess to believe in were allowed to operate US 30 year would be approaching 7% plus.  And that kind of interest rate on current and mounting roll over debt requiremnts would cause an astronomical increase in total cash required to service government debt.

Since central banks and national governments are siamese twins......both survive or neither does and each exists to serve the interests of the other.........regardless of what central banks want they are forced to do what they are doing.

The only simple way out at the moment is for the Treas to bring its roll over financing needs short.....all less than 5 year paper.  The Fed could buy heavy at that end and abandon the long end.  The government would have suppressed interest rates, the public would have a very steep yield curve, and eventually if the government gets it financial house in order the Fed can let more and more of the paper they hold mature, receive the principal and put those monies back where they came from........out of thin air and electrons.  That would kill the inflationary impetus a bit from the huge increase in the Feds balance sheet.

But the reality is that the government will never, ever, ever get its financial house in order.  Forget poor and minorities nearly the entire economy is dependent on government spending.  Any kind of sizable decline and the fat lady sings.

Bam_Man's picture

Absolutely correct in your final pragraph.

They now refer to a 0.5% reduction in the Federal Budget - which still is almost $1 trillion in deficit - as "austerity".

The Fed and the FedGov are both "all-in" now. There is no turning back.

mickeyman's picture

-Oligopolistic/ Monopolistic structures

-Loss of innovation, competitiveness

-Indexation, price rigidities

-Unionization of labour force and higher unemployment

-Illegal migratory flows

-Destruction of public capital markets

-Higher fiscal deficits

Those aren't bugs. Those are features.

robnume's picture


cnmcdee's picture

John F Kennedy issued an executive order to have money created without interest, directly created by the Treasury thus there are red seal, and green seal notes from that era.. Magically 6 months later he was shot to pieces with the eventual death bed confessions the CIA did the deed.

lanchende's picture

yea, like 50 of 'em

cornflakesdisease's picture

Here's the deal.

The boys have been working for more then 100 years to get their dollar king / one world government thing set up.

The dollar isn't going away, nor is the euro, they have fought too hard to get it and will not let any of it collapse.

Adjust your perimeters around that fact.  It's all about a one world government.

Just waiting for peace and security and it will all come crumbling down.  Western Religion will be the first thing to go.

Weisshaupt's picture

Like all thieves and co-conspirators The "boys" don't trust each other.  Someone will get greedy or stupid. They always do. "One World Govt" is the myth they tell each other, but each one thinks they will be the one in charge. Read Dawkins on cheaters,suckers and  grudgers (orsee them as wolves, sheep and sheepdogs if you prefer)   These "boys" are cheaters,  in charge of their herds of suckers:  the sheeple they sold  on the idea of a free lunch and a "co-operative" society.  Cheaters are Sociopaths  devoid of morals or principles have no way of unifying and working together long term.  The more powerful and rich they become, the more likely it is they will become arrogant, convinced of their own superiority, and ready to commit their herd to war and cheat the other cheaters. .  It rids them of the young, rowdy and  unemployed, distracts from the "economic reset" as they issue ration books ( new money)  for the most needed commodities ( Food, fuel,etc)  and everyone is told to be patient because that way they are "helping the war effort" -   Similar economic situations  led to WWI and WWII. Currency War. Trade war. Hot war.   There is no reason to suspect that another world war will not be the outcome here. We are just waiting for Princip.  One or two players will become dominant,  as the United States has been for much of the last 100 years (coincidentally starting in the same general period as  income tax, the Fed and, the 17th amendment), and the UK before that.  After every war, the cheaters find themselves far less powerful, having destroyed most of their sucker herds in their ill-fated bids for total domination,  Obviously the cheaters that avoid the casualties are in the running to become a dominant player.  The big difference this time around is that a world reserve currency is involved, and the current hegemonic structure is due to collapse - and will have global effects as  it does.   As a result, you will most likely have  more players this time round, far more casualties via Bio and Nuke weapons, more destruction, and eventaully balkanization of regions as they move to defend themselves just to survive. A single  new world government is simply unlikely to form due to the nature of the people who are in charge. They aren't Eric Hoffer "True Believers" in the ideology they advocate - they simply see that as a means to an end-  control in their own hands.  When ever  they near having such control, they inevitably stab each other in the back, knowing exactly how they will be treated if they don't hold the reigns of power, because that is exactly how they plan to treat their co-conspirators. The larger the conflict is the better it will be for the grudgers- for if all of the Cheater/Sucker herd participate,  the grudgers will find themselves in charge of the freer, less centralized,  rebuilding period (suckers and cheaters having no gift for it)  until prosperity is restored, and the sucker population grows large enough again to allow the cheaters to again become dominant.  LET. IT. BURN. 

much obliged's picture

"Any tightening must be preceded by a change in policy that addresses fiscal deficits."

So then, government has to stop paying interest on debt. From what I've heard that means that the Treasury issues money and the Federal Reserve is abolished. But the Federal Reserve is owned by share holders of major world banks. An ultimate crony capitalism if the Fed and US government are Siamese twins as purported.

"...inflationary policies carried out globally today, if successful will have a considerably negative impact on economic growth."

"Economic growth" has come to mean acquisitions by larger corporations, done by market deflation, the pending collapse that provides fire sale prices to large cash flush corporations. That in turn leads to layoffs and outsourcing of jobs.

Point is that, have to be careful what you wish for when looking for economic growth. If you hope for "change", you're wishing for a crisis environment in which to force change. Ironically, Federal Reserve's inflationary policy provides impetus for deflationary collapse when the inflationary policy appears to be ending, ushering in the so called economic growth sought by large corporations.

rex-lacrymarum's picture

Or to put it in simpler terms: inflation falsifies economic calculation, something many firms only recognize when it is too late. One of the effects is capital consumption: Machlup once did a study on capital consumption in Austria in the interwar years that to this day stands as a concise, easy to grasp example of the process. In essence, capital consumption results from the fact that in the inflationary environment, a large portion of perceived profits are only illusionary (this by the way is also true of an inflationary environment in which consumer prices are NOT rising strongly; in fact, it may be the more insidious backdrop). In reality, what is perceived as profit is actually a portion of the firm's capital. Sales are compared to input costs that were incurred when money was still worth more; depreciation and write-offs are calculated in money that is worth less than at the time when the items to be depreciated or written off were originally acquired. The phantom surplus that thus appears in the accounts may be used to pay higher wages, higher dividends or directly for consumption purposes by the entrepreneur running the firm. Either way, a portion of the firm's capital will end up consumed. Since this tends to happen over a wide range of industries across the country stricken by the inflationary policy, general impoverishment awaits at the end of the process. It is the surest road to ruin ever devised.