Is innovation deflationary? What about A(G)I?
Innovation is great but it doesn't always make prices or interest rates decline
I’ve noticed a lot of venture capitalists and entrepreneurs say something along the lines of “innovation is deflationary.” By this they generally mean one of two things (or both): innovation causes prices or interest rates to decline. While that is sometimes true, it is not always true. The world is complex.
I get the sense that a lot of venture capitalits and entrepreneurs look at graphs like this, and note that interest rates have fallen as innovation has thrived over the past forty years:
Looking at that graph, it’s tempting to conclude that all of the innovation we have seen in technology over the past few decades caused that decline. But interest rates are set by the Federal Reserve and the financial markets, not innovation.
But that’s interest rates. What about prices? Surely innovation has reduced prices! Not really:
If we really believed that innovation affected prices, we could just as easily make the claim that innovation is inflationary! Something else is going on here with innovation, inflation, and prices and interest rates. Let’s prompt ChatGPT: Analyze the claim “innovation drives deflation”. How might this claim be valid? How might it be invalid? What simplifying assumptions does it make and what complexities does it elide?
ChatGPT’s response appears between the section breaks.
The claim “innovation drives deflation” is rooted in the observation that technological advancements often lead to lower production costs and increased efficiency, which can in turn lower prices for consumers. However, the relationship between innovation and deflation is multifaceted and depends on various economic and contextual factors. Below is an analysis of the claim from several angles:
Validity of the Claim:
Cost Reduction:
Innovation often leads to cost reductions through improved efficiencies, automation, and the optimization of supply chains. These cost savings can then be passed on to consumers in the form of lower prices.
Increased Productivity:
Innovations can boost productivity, meaning more goods and services are produced with the same or fewer resources. This increased supply could outpace demand, leading to lower prices.
Disruptive Technologies:
Disruptive innovations can replace expensive products or services with cheaper alternatives, driving down prices across entire industries.
Competitive Pressures:
Innovation can foster intense competition as companies strive to outdo each other, often leading to price wars which can result in deflationary pressures.
Invalidity of the Claim:
Demand-Pull Inflation:
Innovations can create new markets or increase demand for existing products, potentially leading to higher prices if supply can’t keep up with demand.
Cost-Push Inflation:
Some innovations might require significant investments or have high maintenance costs which could push production costs up, potentially leading to higher prices.
Wage Inflation:
Innovations can sometimes lead to higher wages, espeically if specialized skills are required to develop or manage new technologies. This could result in cost-push inflation.
Monopolistic Pricing:
Innovation can sometimes lead to monopolies or reduced competition if a single entity controls a groundbreaking technology, which could allow for higher pricing.
Simplifying Assumptions and Overlooked Complexities
Static Demand:
The claim may assume that demand remains static, overlooking how innovation can shift demand curves.
Uniform Adoption and Impact:
It assumes a uniform rate of adoption and impact across different sectors and regions, eliding the varied effects of innovation in different contexts.
Market Dynamics:
The claim oversimplifies market dynamics, including competition, consumer behavior, and regulatory responses which can significantly mediate the relationship between innovation and price levels.
Externalities:
It may overlook externalities and broader economic or societal impacts that could influence the deflationary or inflationary effects of innovation.
Long-term vs Short-Term Effects:
The claim may not differentiate between the short-term and long-term effect of innovation on prices.
Global Economic Interactions:
It might elide the complexities of global economic interactions, including trade, international competition, and cross-border innovation.
Policy and Regulatory Responses:
The claim might not account for how policy and regulatory responses to innovation could affect price levels.
The claim “innovation drives deflation” offers a simplified lens through which to view the complex interplay between innovation, economic dynamics, and price levels. While there’s merit to the claim in certain contexts, the multifaceted nature of economic systems and the diverse impacts of innovation necessitate a more nuanced analysis to fully understand the relationship between innovation and deflation.
Human, here.
“Innovation is deflationary” is as pithy as it is appealing. Unfortunately it doesn’t really give us an accurate picture of innovation’s effects on either price or interest rates.
What about artificial intelligence? A lot of people expect that the advent of artificial general intelligence, which would be one of the most profound innovations to have occurred in the history of humanity, will be deflationary. The idea is something like this: when AGI arrives, most or all human labor will cease and production costs of almost everything will decline towards zero, which must be deflationary.
While this model has some kind of intuitive appeal, it’s not clear that it’s correct. Let’s again prompt ChatGPT: Assume that artificial general intelligence arrives some time within the next five years1. What would you expect to happen to interest rates?
Its response follows in the next section break.
The arrival of Artificial General Intelligence (AGI) within the next five years could potentially have a profound impact on interest rates. Here are some considerations regarding how AGI could affect interest rates, along with some speculative scenarios:
Economic Growth:
AGI could drive substantial economic growth by automating many jobs, optimizing processes, and creating new industries. This growth might increase demand for capital, which could drive interest rates up.
Conversely, if AGI leads to deflation (e.g., by significantly reducing production costs), it could lead central banks to lower interest rates to stimulate spending.
Monetary Policy:
Central banks might find it challenging to set appropriate interest rates in the face of economic disruptions caused by AGI. There could be a scenario where central banks might keep interest rates low to support employment and manage economic transitions.
Inflation:
If AGI results in significant productivity improvements, it could lead to deflationary pressures, which might lead central banks to adjust interest rates downward.
Conversely, if AGI leads to wage inflation (e.g., by creating labor shortages in certain areas), this could prompt central banks to raise interest rates to control inflation.
Investment:
The potential for significant returns on investmetns in AGI-related industries could attract a lot of capital, possibly driving up interest rates.
Income Distribution:
If AGI exacerbates income inequality, there might be less consumer spending, which could lead to lower interest rates to stimulate demand.
Global Economic Dynamics:
The impact of AGI on interest rates could also be influenced by how quickly different countries adopt AGI and how global economic dynamics shift as a result.
Market Predictability:
AGI could potentially improve market predictability and risk assessment, which might influence interest rates. Better predictions and risk assessments could lead to more optimized interest rate levels.
Regulatory Response:
The regulatory environment post-AGI could significantly affect interest rates. Governments might impose new regulations on AGI, which could have ripple effects on the economy and, by extension, on interest rates.
Public Perception and Behavior:
Public percention of AGI and its impact on job security and economic stability could influence consumer and investor confidence, which in turn could affect interest rates.
Technological Unemployment:
Significant job displacement could lead to economic instability, possibly prompting central banks to adjust interest rates to manage economic conditions.
These scenarios involve a high level of speculation and the actual impact of AGI on interest rates would depend on a multitdue of factors including how quickly AGI is adopted, how it is regulated, and how individuals and institutions react to it. The complexity and potential rapidity of these changes might challenge conventional economic models and monetary policy tools.
Human, here.
Interest rates and prices and the influence of innovations, including AGI, on them are, in short, complicated. Indeed even sophisticated investors have a history of having made disastrous bets on interest rate movements:
Long-Term Capital Management faced a cataclysmic collapse in 1998. Their strategies, heavily reliant on interest rate arbitrage, imploded amidst unexpected interest rate movements following the Russian financial crisis.
JP Morgan’s “London Whale” Incident: In 2012, JP Morgan Chase incurred losses of over $6 billion due to outsized positions taken by its trader, Bruno Iksil, known as the “London Whale.” The debacle was partially attributed to misjudged bets on the interest rate environment.
Bill Gross at Janus Henderson: Bill Gross, once hailed as the “Bond King,” made several missteps in predicting interest rate movements during his tenure at Janus Henderson, which contributed to underwhelming performance and ultimately led to his retirement in 2019.
The bottom line is the economy is complicated. One can look at, say, SpaceX, and reasonably say “SpaceX’s innovations caused the price per kilogram of material lifted to space to decline.” It doesn’t follow from this that innovation causes all prices to decline. Some innovations cause some prices to decline, but the general trend of prices over time has been to increase.
While it is in theory possible that we’ll see a widespread collapse in both prices and interest rates once AGI arrives, that is by no means a forgone conclusion.
Note that five years is an arbitrary choice here. It could be 10 years, 20 years, etc.