The inflationary blind spot

Every time #inflation rears its ugly head, the fight central banks fight is different – as an economist by training, I therefore don't envy decision-makers at the Fed and ECB the least in their current attempt to fight inflation. At the same time, as a psychologist and risk manager, I pay particular attention to cognitive biases that can impede such fights – such as the stability bias if linear mental models cause decision-makers to miss important structural shifts. A very concrete concern is that the pandemic might have masked the onset of an entirely independent structural shift affecting the economy and hence inflation.

And when I scan what central bankers, academics and journalists say and write about inflation, two issues are eerily absent. You could characterize one as "hardware" and the other as "software."

First, there is a basic hardware issue: In many economies – advanced ones such as Western Europe but also emerging ones such as China – the working population is shrinking. The problem of the shrinking base of the population pyramid has been known for years, even decades, but I haven't seen our central banks articulate a clear position on what this will mean for the relationship between inflation and wage increases.

The traditional paradigm is that for equilibrium, wages should grow at the same 2% rate as general inflation. However, if one core production input is structurally shrinking, it must become more expensive relative to other production inputs (e.g., machines) in order to incentivize and enable substitution. Any first year economist should be able to explain why wages must rise by more than 2% each year if every year, say, more truck drivers retire than new ones enter the job market. (In Germany, some sources put the replacement ratio at as little as 50%.)

The problem is that if wage increases above 2% continue to be seen as an "issue" and cause of core inflation, central banks might embark on a battle to fight shrinking populations with sky-high interest rates which obviously won't work – and, in fact, will undermine the natural countermeasure, namely the investments into machines such as self-driving vehicles to substitute disappearing human workers.

The "software" issue is falling productivity of the remaining workers. The way soft things go, this one is a lot more fuzzy and multi-facetted, but let's try to tease a few – more precisely, four – distinct trends apart: There is an attitudinal shift in the millennial generation, an age effect for older workers, the impact of modern technologies, and societal and regulatory goals competing with economic efficiency. Quite some baggage!

Young workers have different priorities in life

Managers consistently report that they experience many young workers as less resilient (e.g., more likely to call in sick for minor ailments) and harder to motivate to do unpleasant work and overtime. Taken at face value, this trend has two implications: Output per contracted FTE drops if there is more off time (e.g., sick leave and time arguing with one's supervisor) and the quality of the work falls (e.g., disinterested workers making more mistakes because they pay less attention). And the cost of workers for unpleasant jobs rises significantly if there is little supply. For some jobs, it is already virtually impossible to find workers – e.g., in Germany more and more supermarkets close down their meat counters for lack of staff (Germany of course requires a licensed "Fleischfachverk?ufer*in" to sell steaks, and nobody is taking up an apprenticeship for this any more); my Mom's favorite butcher has reduced opening hours to 3-6pm.

And importantly, while the upbringing of today's children is likely to play a role (think helicopter parents), millennials also have a point and simply might be rational. To illustrate, it may make sense to quickly detour to Korean culture which for the Western world is something of a mirror of the past.

I've been told that Korean parents teach their children how to give them backrubs even before they can speak. It exemplifies a core tenet of this highly hierarchical society: Historically, as a young person, you were supposed to have few rights and privileges but many duties vis-à-vis your elders and society at large – be it the paramount duty to make your parents proud, the punishing military service, or a brutal work ethic. Rewards were promised mostly as you became older: As a boss, you got to use your underlings as a mixture of a butler and a slave, and as a grandparent, you got to play with little toddlers for your diversion.

South Korea obviously is changing and becoming more Western – however, this exaggerated portray of Korean culture is surprisingly similar to how my grandparents described their upbringing in Germany and how elder Americans described their own conservative upbringing. It therefore helps recognizing that also in Western culture, we still have fragments of the expectation that young people should make sacrifices for the elder. This notion became tangible when I went through a difficult period early in my own career and my father kept telling me that "the years of being an apprentice are different from the years when you are the master."

Millennials might simply have woken up to the fact that life has a somewhat lousy track record of holding up the far-away end of the bargain – e.g., if house prices grow faster than the income of a young person, it will dawn upon him or her that the dream of an own house may never materialize and they may be better of enjoying life now than saving up for a distant dream. By the way, a similar effect might be at work when societies don't produce enough offspring: As Daniel Gilbert observed in his book "Stumbling on Happiness", in average, married couples become increasingly unhappy once they have children, reaching the nadir when the kids reach puberty, and finally recovering their pre-children level of happiness once the kids are out of the house. It is hence entirely rational not to have children except that societies who do not succeed in convincing their young of the opposite for obvious reasons are bound to die out…

In other words: A hedonistic lifestyle might be beneficial for millennials at society's and therefore ultimately their own peril, not least in the form of inflation.

An aging workforce takes it toll on productivity, too

While millennials might call in sick more often due to a malaise called hangover or work-aversion, older workers will have more genuine reasons to call in sick as their bodies age, and wide-spread obesity and other consequences of an unhealthy lifestyle don't help with the physical performance of older workers. Older people also often find it harder to adopt to new technologies (e.g., operating electronic work tools), and there is even a hormonal shift in males that may make them less zealous and fervent workers in their last 10-15 years in the workforce.

In many cases, the strengths of older people such as experience and thus superior judgment will more than compensate for these impediments, but in some situations they may not – and even less if, say, digitalization makes processes more rigid and thus prevents older workers from bringing to bear their superior judgment. And this is not the only downside of digitalization.

Digitalization and a workforce of digital natives may be a double-edged sword

There is no doubt that digitalization can dramatically increase productivity – you read here on LinkedIn and elsewhere about this all the time. What is less talked about is that it also can have the opposite effect – yet empirically I increasingly believe that quite often digitalization shoots itself in the foot!

Long after the introduction of scanners for supermarket cashiers, the famous German discount chain Aldi continued to have cashiers type up prices – their well-paid staff not only was much faster than scanners (to the dismay of shoppers trying to frantically stuff their purchases into a shopping bag as they came flying along) but even capable of knowing the prices of all 2,000 or so products by heart. In the meanwhile even Aldi has switched to scanners because benefits such as better inventory management and the ability to sell a plethora of weekly changing non-food specials outweigh the loss of speed – but this anecdote still illustrates that digitalizing a process does not necessarily make it any faster.

And when you observe the mindbogglingly confusing, complicated and inconvenient way how many workers need to interact with systems (be it a cashier system requiring identical items to be scanned individually or a buggy software constantly malfunctioning when recording overtime or a system excessively demanding authorization by an overextended supervisor), you realize that it's not only the Aldi cashier who became less efficient thanks to digitalization.

And what does this mean for inflation if now more and more businesses digitalize, if there is a huge shortage of UX designers and experts bridging practical business experience and technological skills to ensure that new digital workflows are efficient also in quirky and wondrous real life (as opposed to the realm of zoom-cast PowerPoint presentations), and if new technology is still often more imposed on than co-developed with front-line users?

Besides, I see our digital native millennials drown in an ocean of messaging tools – "did you see my message with the new specs? No? Oh, hold a sec, I am not sure if I sent it on Teams Chat, Slack, WhatsApp, Telegram, or email, or maybe I simply uploaded it in one of our 47,000 shared folders in the cloud…"

I have not found a single person who believes that in aggregate, this fragmentation of messaging channels is increasing productivity and efficiency – yet I also don't see any definite answer to what the efficient optimum communication strategy would be, and an active effort of any company to, uh, slack the slack in Slack.

Finally, in tallying the cost associated with digitalization, we should not forget the skyrocketing cost of cybercrime – both the infrequent yet catastrophic damages from individual incidents as well as the mounting cost of the defenses. For this reason, I am extremely reluctant to buy, say, an IoT-enabled fridge requiring me to negotiate with a hacker the release of my food on a Sunday night – yet when I look at the latest offerings on the CES fair in Las Vegas, it seems that few people share my concerns.

In short, while digitalization is genuinely promising a lot of upside, we need to consider total cost of ownership – and there is scarily scant effort by anyone to truly minimize any of the cost items in the equation through better design, and no real optimization in the decision where and how to deploy digitalization in light of the total cost of its ownership. The result: Lots of unintended indirect cost increases through digitalization.

The cost of ESG

There is no doubt that we need to invest to counter global warming – both to address rootcauses to limit further warming and to address consequences (i.e., mitigation) as we missed the boat for completely undoing global warming at least for the next few decades. Society also has every right to decide to give non-economic priorities such as gender equality and inclusion of minorities more weight and hence to not blindly optimize everything for economic performance. However, there equally should be no doubt that new rules and regulations – explicitly enacted by parliaments and governments or, not always of the same democratic caliber, informally enforced by vocal activists – will increase cost.

I had covered this topic already in a post last June – arguing that such a regulatory burden not only adds direct cost but also indirectly increases prices by causing underinvestment. And almost every day there are new examples in the news drawing attention to this precise effect – e.g., when increasing biofuel requirements not only increase fuel cost but also cause smaller refineries to go out of business, creating a shortage in refinery capacity.

And this is not just about environmental protection. There is a general issue that compliance with well-intended regulations easily becomes a purpose of its own, with workers spending more time on documentation than the actual work, be it caregivers in a home for the elderly, brokers advising clients on investments, or mechanics repairing a minor defect of a plane waiting to depart with 300 passengers impatiently jostling in their seats (who has not heard the captain explaining a 30 minute delay in take-off by "just some paperwork" required after a repair?).

Consumer protection is another mammoth inflation inflator that even can be at odds with the goal of environmental protection. For example, when the European Union decreed that consumers can return any online order within two weeks for a full refund, they burdened not only online sellers with huge cost from a flood of returns but also mother earth with a gigantic pile of trash as much of the returned merchandise is not suitable for selling any more or restoring it to a sellable state is more expensive than destroying it.

Summary

Taking all of this together, we are in a midst of two major trends inflating prices for the long run. One is the effect of shrinking populations that is a demographic fact that must be embedded in the "new normal" to which central banks steer when reading the economic stars and setting monetary policy. The other is a set of self-indulgent choices we as a society have made around how we work and consume where we seem to be racking up a bill like a toddler who has figured out how to buy things on Alexa without having quite understood that mommy ultimately will have to pay for it. And like any driver knows, if you aren't aware of fast-moving objects in your blind spot, a fatal crash may occur.

How do you see these trends play out in the cost structure of your industry? How do you think we – as a society but also as leaders – can cope and contain the cost implications of these trends and thus tame inflation?