George Soros has long expounded on the topic of “reflexivity”, a way of looking at financial markets that is both common sense and academic heresy. Reflexivity includes the idea that market prices don’t just reflect economic reality, they actively shape it. Take the petroleum industry for example, where new investment frequently won’t pay dividends for 4+ years. If crude oil prices are stable at $70, oil companies will invest to maintain adequate production levels so we’re likely to have similar oil prices in 5 and 10 years. However, if oil prices plummet below $40, oil companies curtail investment leading to a production shortage in 5 years and potentially $200+ oil.
When there is a consensus on future market prices, it usually ends up being wrong specifically because the consensus exists. In other words, while consensus is self-fulfilling in the short-term as speculators push market prices in the direction of the consensus, it is self-negating in the long-term. If everyone agrees home prices will keep going up, developers build more homes so there’s plenty of supply and prices can’t rise. If everyone agrees natural gas will be plentiful and cheap for many years, investors don’t spend to expand production, causing shortages and higher prices in a few years.
Today we pretty much have a consensus on inflation. There’s a lot of debate over whether the inflation will start in 3 months or 3 years, but just about everyone agrees it’s in our future. Does this mean we’re unlikely to actually get inflation? Inflation is an exception to the “anti-consensus rule” because inflation expectations are themselves inflationary. When we expect prices to rise we buy goods today, demand raises, sell treasuries, and buy houses and commodities. Our expectations are self-fulfilling in an endless loop with no end in sight. While the talk of inflation encourages central bankers to tighten the money supply, they face fiscal and political obstacles that also feed the inflationary loop. As inflation expectations increase and prices start rising, unions push harder for raises and the government struggles to finance its debt at higher interest rates. Without some very tough political decisions, the only end of the inflationary loop is a complete collapse of the currency and the introduction of a new currency regime. Let’s hope we don’t have to break the loop.