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Dr. Toiletpaper (or how I learned to love inflation)

Updated: Mar 25

The current supply shortage of toilet paper, hand sanitizer, and select grocery items is analogous to a bank run, or a liquidity crisis, in technical terms. The fundamental element of this is that the demand for the item is driven by the expectations. Under normal circumstances, the current supply would be sufficient to meet demand at the current market price. However, fear that the product might not be available makes it rational for a consumer to buy those products when she wouldn’t otherwise buy it. And that increase in demand might be enough to cause others to rationally fear the same thing. After all, no one wants to be stuck without toilet paper. The interesting thing about this from an economic perspective is the existence of two equilibria… there is an equilibrium in which everyone only buys what they currently need, leaving plenty of stock on the shelves, and there is an equilibrium in which everyone rationally panics based on the expected behavior of others. The panic is rational because they can accurately anticipate that others will buy more in this scenario based on everyone’s incentives. Paul Krugman has a classic example of this type of analysis with babysitting here.


The classic solution to a bank run is deposit insurance, where the government uses its vast resources to guarantee the availability of liquidity in the markets. I am surprised we haven’t had more reassurances from public officials of the sufficient inventory or production capacity of the currently scarce products. Instead, we hear appeals to moderation: "You don't have to buy so much. Take it easy. Just relax… Can you buy a little bit less, please?”[1] Does this imply that there is indeed a limited supply if we need to ask people to buy less?


Such a run is an example of a market failure: not everyone who wants a product at the current price can buy one. One necessary ingredient leading to this situation is a breakdown of the market price. Normally, when demand exceeds supply, then the price should increase, leading some people not to want the product anymore. If you turn enough people off buying toilet paper in the beginning of a run, then you’ll still have some on the shelves, and the panic will subside. After a day or two, the price can go back to normal. A 10% increase might have been enough to keep toilet paper on the shelf, as a rational person could expect it to decrease back to normal in a week when she actually needs it. There is a reason that Costco has received so much attention for toilet paper shortage in the past few weeks… it is known to have low prices.


This shortage of toilet paper and other items is partially due to retailers’ reluctance to raise their prices in response to increased demand. This is symptomatic of a larger issue that has been troubling economists for over a decade now… low inflation. At a time when interest rates have been close to zero for record periods of time, we have struggled to get even a target 2%. Economists have posed many explanations of this effect, from a global savings glut to strongly anchored expectations to high levels of market concentration (monopoly and oligopoly). If one were really to expect inflation levels to be higher at the end of this crisis, we would expect to see commodities such as gold increase during the outbreak, but the reverse has happened.[2]


So what? Maybe prices will respond to a negative supply shock—this might be good, as it allows producers of those goods to expand production in response to market forces. This is, after all, the point of a market system. A bit of inflation might actually be very useful for policy-makers, alleviating wealth inequality by depreciating money-based assets, lowering the real value of debt burdens, and allowing overvalued assets to decline in real terms without having to face a nominal decline. Furthermore, it could allow the central bank to have a real interest rate well below zero while keeping the nominal rate above or at zero. However, inflation also has well-known downsides, primarily for wage earners, retired people, and in export markets. In addition, there is evidence that high inflation is more volatile, making pricing risk more of a burden on businesses. Furthermore, once inflation takes off, it can be hard to bring back into control, as expectations are a significant part of inflation levels, and current monetary policy theory indicates that the way to decrease inflation is to increase central bank interest rate levels, further choking-off investment.


The bigger issue is what happens if we have a negative supply shock with no inflation. Imagine you are a toilet paper supplier to a large national retail chain, and your largest customer is faced with the current toilet paper shortage. Imagine also that this customer has a contract that locks prices you can charge them for the next year. Do you pay your employees overtime to increase production? Would you pay a premium for extra raw materials on short notice? Even if you saw this crisis coming a month ahead of time, would you make big investments in new machinery, knowing that the demand is likely to fall just as quickly as it increased? After all, people’s overall need for toilet paper hasn’t increased. Without the benefits of price adjustments, the answers to these questions are probably no. The key insight here is that inflation is a market force pushing speculators to increase investment in a particular area. And investment is a crucial mechanism for business cycles.


It is quite common in such scenarios for people to buy much more of such a sparse commodity than they would otherwise consume, with the intention of reselling the item at a profit once the run has taken hold. These people are often (and in many cases correctly) denounced as profiteers and can be arrested in some localities. In essence, they have identified a commodity that is increasing in value at a faster rate than the interest rate and intend to make a profit exclusively through the increase in price. If others do the same, then the ready supply of that item can reduce faster, causing the price to increase faster, and we have a rational bubble (a situation in which commodity prices increase dramatically above their intrinsic value due to price speculation). This is another instance in which two equilibria exist: one in which the market operates normally, and another in which expectations lead to skyrocketing commodity prices.


As objectionable as one might find such miscreants, I would rather have the option to buy TP at $5 a roll when I need it then not have any available at all. They serve a purpose… providing supply when the market has failed. The proper punishment for them isn’t jail, but restocking our shelves with a small 2% price hike and leaving them with a Ford F-450 full of toilet paper.


[1]Remarks by Donald Trump at a White House press conference on 15 April 2020. [2] Though admittedly there are other possible explanations for this effect.

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