Which stocks win and lose under higher inflation?

Overview

Over the past several years, Leithner & Company have been assessing the likelihood that consumer price inflation will remain above its historical average (see Why inflation is and will remain high, 15 August 2022 and The Risk of Higher Rates the RBA’s Overlooking, 20 March 2023). We’ve incorporated this risk, which ever more people now agree is growing, into our plans and actions.

We’ve also recognised two things which have escaped everybody else’s attention: firstly, over the past century the mainstream’s conception of inflation has changed drastically; secondly and accordingly, central banks and governments have underestimated inflation’s magnitude.

For decades, it hasn’t been defined according to what economists once identified as its sole cause: instead, it’s been redefined and measured exclusively in terms of what they previously regarded as merely one of its several possible consequences.

The implications are momentous: today’s mainstream can’t coherently describe – and therefore central banks and governments can’t effectively combat – inflation. How can you fight something whose cause your definition excludes?

On the basis of this deficient understanding, governments have injected into the economy ever-heavier doses of fiscal poison. This debased conception has also encouraged – and governments have pressured – central banks to buy vast quantities of debt; accordingly, supposedly “independent” central banks have submissively underwritten governments’ escalating profligacy (see in particular Tight(er) financial conditions will end the bull market, 24 March 2025 and Central banks don’t dispense “Stimulus” – they peddle poison, 21 September 2020).

Central banks and governments have thereby painted themselves into a corner.

Governments’ reckless spending boosts consumer prices; yet central banks’ responses – higher policy rates of interest – risk tipping feeble economies into recession. Neither governments nor central banks show any sign that they’ll change their ways: governments will remain spendthrift and central banks will remain their lapdogs. Accordingly, risks of above-average inflation and below-average growth (or recession) are likely to remain elevated (see also The consensus is wrong: America’s economy is chronically ill, 13 January 2025; How we prepare for – and profit from – recessions, 18 August 2023; How we’ve prepared for the next bust, 28 November 2022 and Recessions usually crush shares – but investors can always reduce their ravages, 31 October 2022).

In High valuations – not rising bond yields – threaten American stocks (29 June), I demonstrated that yields per se are usually unimportant. In sharp contrast, valuations are always crucial – and Australian and value stocks abate this major risk. In his article, I demonstrate that inflation is also important; among other things, it affects stocks’ returns. I also outline the implications if economies such as Australia’s have entered a new era of consumer price inflation.

My argument proceeds in five stages. I

1. summarise the crucial change to inflation’s definition – and its consequences;
2. examine the grounds for my belief that the risk of higher inflation is greater than the mainstream recognises;
3. review past assessments of inflation’s impact upon equities’ returns;
4. consider orthodox grounds for and against a new era of inflation, and conclude that those in favour outweigh those against.

Lastly, I conduct analyses which answer two key questions: under various rates of consumer price inflation since the Second World War, (a) how have stocks as a whole (measured by the Standard & Poor’s 500 Index) performed? (b) Which types (i.e., value versus “growth”) and which sectors (energy, technology, etc.) have generated the best and worst returns?

My analyses uncover two sets of results. Firstly, as a measure of inflation the Consumer Price Index (CPI) has always been inadequate; even as a measure of consumer price inflation, it’s become corrupted. Specifically, it now systematically – a cynic realist would say deliberately – underestimates most Australians’ costs of living.

Invalid measurement thereby enables central banks falsely to claim credit for their intermittent, feeble and failed attempts to “fight” inflation – and distracts attention from their constant, energetic and successful efforts to manufacture it.

Secondly, during periods of median and above-median consumer price inflation – that is, more than half of the time – value and energy stocks outperform “growth” and other sectors (particularly technology). From these results follow two key implications: 

1. Like the Internet during the Dot Com bubble, etc., it’s unlikely that AI will permanently boost productivity above its long-term mean; I thus doubt that it’ll significantly tamp inflation.
2. If CPI’s rate of increase remains above-average, and you buy and hold value stocks and major producers of energy, you’ll fare relatively well (see also Why Santos and Woodside are among our biggest holdings, 18 May). If, however, you’re a “growth” and “tech” speculator, you incur a significant risk of underperformance (see also Why we’ve never held tech – and have long owned energy, 2 March).

Inflation: A Brief History of Two Conceptions

What is inflation: an increase of consumer prices (the crux of the contemporary mainstream, i.e., Keynesian conception), or overproduction of money or credit (crudely, the gist of classical, monetarist and Austrian School approaches)? The history of its definition is revealing (see in particular Justin Lahart, “Using a Dictionary to Define Inflation Can Spell Trouble,” The Wall Street Journal, 14 May 2011).

From the 19^th century until the publication of its Eleventh New Collegiate Dictionary (2003), Merriam-Webster defined inflation largely in classical terms. The second edition of its New International Dictionary (1934), for example, defined it as a “disproportionate and relatively sharp and sudden increase in the quantity of money or credit, or both …”

Such an increase, it elaborated, “may come as a result of unexpected additions to the supply of precious metals …; or it may come in times of business activity by expansion of credit through the banks; or it may come in times of financial difficulty by governmental issues of paper money without adequate metallic reserve and without provisions for conversion into standard metallic money on demand.” It concluded: “in accordance with the law of the quantity theory of money, inflation always produces a rise in the price level.”

Note that by this definition rising consumer prices aren’t inflation: instead, they’re one of its possible consequences (others include rising prices of assets such as real estate and stocks).

Leading economists of the late-18^th and early-19^th centuries, such as David Ricardo and Adam Smith, didn’t use the term “inflation.” They did, however, observe that an increase of the supply of paper currency relative to its metallic backing debases the currency and thus boosts prices. John Locke (1691) and David Hume (1752) originated the core concepts of what became the Quantity Theory of Money: as its supply rises, its purchasing power falls; indeed, changes of money’s supply cause commensurate changes of overall prices. Ricardo identified the Bank of England’s issue of excess (because they were inconvertible into gold) paper notes as the cause of rapidly escalating prices in Britain during the Napoleonic wars.

In the simplest terms, cause (increase of the supply of money and credit) eventually begets one or more consequences (such as rising consumer prices).

In 2003, reflecting the usage that had prevailed for decades among economists, governments, investors and journalists, Merriam-Webster amended its definition of inflation to “a continuing rise in the general price level usually attributed to an increase in the volume of money and credit relative to available goods and services.”

Since then, central banks have completely “demonetised” their definition: as far as they’re concerned, inflation apparently has nothing to do with the supply of money and credit.

The U.S. Federal Reserve, for example, now defines it as “the increase in the prices of goods and services over time.” According to the RBA (“Inflation and Its Measurement,” undated), it “is an increase in the level of prices of the goods and services that households buy. It is measured as the rate of change of those prices. Typically, prices rise over time, but prices can also fall (a situation called deflation).”

In the RBA’s view, “supply disruptions” – but not increases of the supply of money and credit – can cause inflation. According to it, the Fed and other central banks, prices rise as a consequence of factors such as “excess demand” (also known as “demand-pull inflation”) and increasing costs of production (“cost-push inflation”). Yet they seldom ask: “why does demand become ‘excessive’? Why do costs increase?” If they did, loose monetary policy and lax fiscal policy (which slack monetary policy accommodates and thus encourages) would rank high on their list of answers.

Since the GFC, central banks have tacitly but firmly concluded that money and credit don’t matter; accordingly, they believe, they and commercial banks can expand the supply of money and credit without impacting the prices of consumer goods and financial assets.

Yet it’s easy to show that money and credit DO matter. Although it’s unreliable as a short-term operational tool, over the long term the Quantity Theory of Money remains valid. To see why, let’s first define some key terms. Firstly, “broad money” is the RBA’s most encompassing measure of money. It’s overly simple, but for our purposes it suffices: it comprises all highly-liquid financial instruments (such as currency, balances of cheque and savings accounts, and term deposits) and non-bank borrowings (including funds held in cash management trusts and short-term debt securities issued by financial intermediaries) held by private sector entities.

Secondly, the RBA defines business credit as funds borrowed by Australian private and public business enterprises from domestic banks and other financial intermediaries. It comprises lending to domestic corporations and unincorporated businesses to finance activities such as cash flow and inventory management, the purchase of capital assets and investments in commercial projects.

Business credit includes intermediated financing like bank overdrafts, commercial loans, revolving lines of credit and asset-backed or equipment financing, but excludes non-intermediated debt (such as corporate bonds or promissory notes issued directly through capital markets) and equity funding.

The RBA defines housing credit as funds borrowed for owner-occupied and “investor” real estate. It includes both loans held directly on the balance sheets of financial institutions and those which have been “securitised” (packaged into mortgage-backed securities). Finally, personal credit comprises all lending to households that’s unrelated to residential real estate or the financing of unincorporated businesses.

Using data compiled by the RBA, Figure 1 plots long-term measures (expressed as compound annual growth rates (CAGRs)) of the two conceptions of inflation. Four results are noteworthy. Firstly, in 1986 the heterodox measures – namely the long-term growth of the supply of broad money and of the three categories of credit, which averaged 16.2% per year – greatly exceeded the orthodox measure (CPI, whose growth averaged 8.8% per year).

Figure 1: Broad Money, CPI and Three Categories of Credit, Ten-Year CAGRs, Australia, October 1986-July 2026

Secondly, since 1986 the heterodox measures have as a group decelerated much more rapidly than CPI: in July 2026, their ten-year CAGRs averaged 4.2% per year versus CPI’s 3.1%. Broad money has slowed least (most recently, to a ten-year CAGR of 6.5% per year in July 2026), housing credit a bit more (5.5%) and personal credit most (-1.5%). Business credit, whose rate of growth collapsed as low as 1.9% per year in late-2018, has accelerated to 6.1%.

Thirdly, although for our purposes it’s not essential it’s still worth mentioning: since the early 1990s the rate of growth of housing credit has continuously exceeded – and usually greatly exceeded – the rate of growth of business credit. To some extent, and likely to a significant extent, this development reflects Australian corporations’ lessening reliance upon banks and their growing use of capital markets to finance borrowing.

Finally, albeit less markedly than previously, the heterodox measures continue to exceed CPI. In Australia over the past 40 years, monetary inflation has always exceeded consumer price inflation. Is that because inflation’s orthodox definition excludes any mention of money and credit?

In The Wall Street Journal on 3 September, Murray Sabrin, Ph.D., in effect proposed a return to the classical definition of inflation. He wrote: “the Fed should stop trying to micromanage the price of money by targeting interest rates. Instead, it should stop expanding the money supply and allow short-term interest rates to reflect supply and demand in money markets, just as long-term interest rates are determined by market participants. Ending monetary manipulation would go a long way toward slaying the inflation dragon.”

It’s vital to appreciate: under any circumstances that’s MUCH easier said than done – and under today’s it’s almost impossible to imagine.

Most notably, from the mid-1970s until the mid-1980s, Australia, Switzerland and all “G7” nations (Canada, Britain, France, Germany, Italy, Japan and the U.S.) targeted the supply of money. In particular, the Thatcher government in Britain strove mightily to hit its target; ultimately, only Germany and Switzerland clearly succeeded.

By the early-1990s, these countries abandoned their money supply targets in favour of CPI targeting or interest rate manipulation. Various financial innovations made it difficult to define what counted as money – and thus to measure its quantity. More importantly, money supply targets presuppose what today’s zeitgeist utterly lacks: long-term discipline. Hence under current conditions no government or central bank would even consider them, never mind reintroduce them.

Table 1 encapsulates the monetary distemper of our times. The contemporary definition of inflation excludes what was once regarded as its cause; on this basis, central banks haven’t, can’t and thus won’t combat it. Quite the contrary: whether deliberately or unwittingly, they’ll manufacture it.

Table 1: Inflation – A Summary of Two Irreconcilable Conceptions

Consumer Price Inflation and the S&P 500’s Total “Real” Returns

Because they’re longest, I’ll analyse American series of CPI and stock return data. Since January 1872, the S&P 500 Index’s “real” (CPI-adjusted), total (including dividends) and short-term (12-month) return has averaged 8.8%. Its corresponding medium-term (five-year) and long-term (ten-year) returns, expressed as CAGRs, have averaged 7.2% per year and 7.0% per year respectively (Figure 2).

Figure 2: CPI-Adjusted Total Returns (CAGRs), S&P 500 Index, Short, Medium and Long Terms, January 1871-July 2026

For two reasons, my analyses will exclude data from 1871 to 1944. Firstly, entirely different monetary arrangements prevailed during that era – namely a classical gold standard without a central bank (Congress passed the Federal Reserve Act in 1913, and it commenced operations in 1914). As a result, a gentle and salutary deflation characterised much of the final quarter of the 19^th century.

Secondly, and in sharp contrast, monetary instability characterised the period from 1914 to 1945: it comprised very high rates of inflation (by both classical and contemporary conceptions) during and immediately after the two world wars, sharp deflation during the early-1920s and early-1930s, and the corruption of the classical gold standard into a “gold-exchange standard.”

The combination of slowly-expanding money supply (ca. 2% per year), rapid advances of technology and strong economic growth underpinned the extended “good deflation” – and the currency’s sharply rising purchasing power – from the 1870s to the mid-1890s. (From the late-1890s to 1914, as a result of new technologies and major discoveries in Canada and South Africa, the supply of gold and thus of money accelerated.) In diametric contrast, “bad deflation” during the early-1920s and early-1930s resulted from sharp contractions of the money supply.

Fed Chairman Alan Greenspan, in his address to the Economics Club of New York on 19 December 2002, identified consequences of gold’s demonetisation: “although the gold standard could hardly be portrayed as having produced a period of (year-to-year) price tranquillity, … the price level in 1929 was not much different, on net, from what it had been in 1800. But, in the two decades following the abandonment of the gold standard in 1933, the Consumer Price Index in the United States nearly doubled. And, in the four decades after that, prices quintupled.”

Specifically, the dollar’s purchasing power plunged from $1.00 in January 1934 to $0.037 in July 2026. That’s a CAGR of -3.5% per year and a near-total collapse of ($0.037 - $1.00) ÷ $1.00 = 96.3% (Figure 3).

Figure 3: Purchasing Power, $US (January 1871=$1), January 1871-July 2026

Greenspan’s comments were ironic: he acquired the nickname “Easy Al” as a result of his willingness and even eagerness, at practically any sign of trouble, to slash the federal funds rate (which banks charge one other for overnight loans) and the discount rate (which the Fed charges banks for direct emergency loans) and thereby flood the economy with artificially cheap credit.

His nickname referred to his “easy money” policies – above all the “Greenspan Put.” Whenever Wall Street experienced a major downturn, he injected torrents of “liquidity” into the financial system. His actions resembled a put option, i.e., an “insurance policy” which limits losses if assets’ prices drop. On this basis, Greenspan repeatedly encouraged speculators to intensify their high-risk behaviour.

Notice the two actions: first (in the early-1930s and early-1970s) the U.S. Government demonetised the currency; subsequently, the Fed demonetised the definition of inflation. These actions removed most shackles from central banks and governments.

Greenspan’s suppression of rates – which presupposed gold’s partial (domestic) demonetisation in 1933 and total (international) demonetisation in 1971 – ultimately fuelled not merely monetary and thus consumer price inflation, but also inflated the Dot Com bubble of the late-1990s and the housing market bubble of the early-2000s. Those bubbles, in turn, led directly to the GFC – which, conveniently for him, erupted after he left office.

Have the massive inflation and suppression of rates during and after the COVID-19 pandemic fuelled AI and stock market bubbles today?

Easy Al’s monetary policy, in his own words on 19 December 2002, “unleashed from the constraint of domestic (and foreign) gold convertibility, … allowed a persistent over-issuance of money. As recently as a decade ago, central bankers, having witnessed more than a half-century of chronic inflation, appeared to confirm that a fiat currency was inherently subject to excess.” From 1945 until his appointment in 1987, inflation primarily affected consumer prices; since his tenure, it’s primarily influenced asset prices – particularly publicly-listed stocks – and today it afflicts both.

I just love Greenspan’s use of the word “witnessed” in the previous paragraph – as if central bankers have been passive bystanders rather than active manufacturers (along with commercial banks) of the virtually continuous and cumulatively massive inflation since the Second World War!

A month before Greenspan’s speech, Ben Bernanke (who in February 2006 succeeded Greenspan) addressed the National Economics Club in Washington (see “Deflation: Making Sure ‘It’ Doesn’t Happen Here”). In a startling passage that earned him the nickname “Helicopter Ben,” he said: “like gold, U.S. dollars have value only to the extent that they are strictly limited in supply. But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost.”

“By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so,” Bernanke continued, “the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services.”

“We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation.”

Figure 4: CAGRs, U.S. Consumer Price Index, January 1871-July 2026

From January 1871 until the Second World War, monetary deflation was regular and often extended; indeed, before the turn of the century it was the norm. In contrast, consumer price inflation was highly erratic but relatively low (Figure 4). Whether expressed as a 12-month percentage change or as five-year and ten-year CAGRs, it averaged 0.5%-0.7% per year.

In sharp contrast, since January 1945 deflation has been rare and brief; in contrast, consumer price inflation has been virtually constant. Whether expressed as a 12-month percentage change or as five-year and ten-year CAGRs, it’s averaged 3.7% per year. The most recent (to July) figures, respectively, are 4.2%, 4.3% and 3.4% per year.

Numerous studies have examined inflation impact upon stocks’ returns. They typically uncover two key results. Firstly, since 1945 stocks’ “real” total returns have usually outpaced inflation. Over short, medium and long terms their CPI-adjusted returns including dividends, in other words, have on average been positive.

“In contrast to the return on fixed-income assets over long periods of time,” concluded Jeremy Siegel (Stocks for the Long Run: The Definitive Guide to Financial Market Returns & Long-Term Investment Strategies, 4^th ed., McGraw-Hill, 2008), “the historical evidence is convincing that returns on stocks over the same time periods have kept pace with inflation.”

Secondly, returns have varied according to the (conventionally-defined) rate of inflation. “Short-term real returns,” says Siegel, “are highest when inflation rates are low, and their returns fall as inflation increases.” When consumer price inflation’s rate of increase is low to moderate (no more than, say, 3% per year), stocks typically generate above-average returns – that is, double-digit – returns. When inflation rises above 5%, however, stocks’ returns sag to low single-digits.

Moreover, real returns often become negative when high inflation prompts central banks aggressively to lift their policy rates of interest; these actions, like the Fed’s in the late-1970s and late-1980s, can (and during those intervals did) trigger recessions.

For each month since January 1945, I calculated the CPI’s 12-month percentage change and the S&P 500’s 12-month CPI-adjusted total return. I then ranked these data according to CPI, divided them into quintiles (five groups with equal numbers of observations) and computed the Index’s mean return for each quintile. I then repeated this exercise for medium-term and long-term intervals (expressing the CPI’s rate of change and the Index’s CPI-adjusted total return as CAGRs). Figure 5 plots the results.

Figure 5: CPI-Adjusted Total Returns, S&P 500 Index, by Quintile of CPI, CAGRs, January 1945-July 2026

They confirm that stocks’ real total returns typically (80% of the time over 12-month periods, and effectively 100% of the time over five- and ten-year intervals) exceed the rate of consumer price inflation. Over short, medium and long terms, and regardless of inflation’s rate, “real” returns are usually positive. Equally, returns depend upon the rate of inflation: in the short term, medium term and long term, they’re highest when inflation is lowest (Quintile #1), and abate as it accelerates.

Indeed, during the 20% of intervals when it rises most rapidly, short-term returns plunge to an average of -3.5%, and medium- and long-term returns to 1.5%-2.5% per year.

Conventional Reasons to Expect Higher Consumer Price Inflation

From a heterodox point of view, my results thus far imply higher rates of consumer price inflation – and lower returns from stocks – in the years to come. Earlier this year, CPI’s five-year CAGR in the U.S. rose as high as 4.6%, the highest since 1985; and the current ten-year CAGR, 3.4%, is the highest since 1998 (recall Figure 4).

These high rates, central banks confidently stated several years ago, were merely the “transitory” effects of the spurt of high inflation triggered by governments’ responses (in the form of a tsunami of debt-financed spending) to the COVID-19 pandemic. They were clearly wrong, and today it’s hardly just me: prominent mainstream figures also highlight the risk that inflation will henceforth “stick” at relatively high levels. Three major reasons underlie the orthodox concerns. I’ve summarised them in no particular order of importance:

Reason #1: “Deglobalisation” and “Onshoring”

Triggered by geopolitical tensions, pandemic-era disruptions and rising trade barriers (not just those which Donald Trump has threatened or erected), since the GFC and at a quickening pace, companies (particularly American ones) have been transferring manufacturing, R&D, etc., from overseas – particularly China, whose low costs of production had lured Western companies since the 1990s. They’ve returned these operations to the U.S., neighbouring friendly or nearby allied countries.

The globalisation and “offshoring” of the 1980s-2000s boosted productivity and lowered production costs; it thereby placed downward pressure upon consumer price inflation. “Deglobalisation” and “onshoring” since the 2010s, in contrast, have reduced efficiency, raised costs and tamped productivity; they’ve thereby boosted consumer price inflation.

Why has this been happening? “Just in time” global manufacturing, which commenced in the 1960s, accelerated in the 1970s-1990s and peaked in the 2010s, prioritised the lowest possible costs of production. Today, companies value the resilience of supply chains, as well as their security and proximity to consumers, more highly than the cheapest inputs. Five major factors – summarised below in no particular order – have propelled this shift; rising Sino-American economic and military tensions underlie them:

Mounting Trade Barriers: tariffs and non-tariff barriers, as well as expanding trade sanctions (particularly U.S.-China trade frictions), discourage and penalise economic reliance on potential rivals and adversaries. Shifting production home, or to nearby friendly or neutral ground, hedges against trade restrictions and seizures of assets.

Growing Subsidies and Incentives: in response to aggressive Chinese industry policy, which for decades has lured industries, over the past few years Western governments have begun to revive industrial policies to repatriate strategically-vital industries. In the U.S., legislation such as the CHIPS Act and the Inflation Reduction Act (yes, the latter’s name is deeply misleading!) offer hundreds of billions of dollars of tax concessions and cheap finance to encourage companies to build factories, etc., domestically or within friendly nations.

Narrowing Wage Gaps and Advancing Automation: the incentive to outsource has abated. Wages in Asian manufacturing hubs, particularly China, have over the last decade climbed significantly; as a result, they’re no longer dramatically lower than in Western nations. Concurrently, massive strides of robotics and AI mean that factories require fewer workers, and thus reduce or even eliminate the advantage of low-cost foreign workforces.

Increasingly Vulnerable Logistics: the COVID-19 pandemic exposed the weaknesses of long supply lines, and this year’s conflict with Iran has shown that crucial shipping routes are highly vulnerable to disruptions and volatile shipping costs. Manufacturing closer to target markets can trim transit times from several weeks to a few days.

Heightened Protection of Intellectual Property: operating within traditional offshoring nations – namely China – frequently exposes multinational corporations to systemic theft of intellectual property and forced transfers of technology. Reshoring or moving to close allies gives businesses stronger regulatory protection and legal recourse to safeguard proprietary technologies.

Reason #2: Ageing Demographics

The world’s population is aging rapidly. According to data compiled by the United Nations, the global median age has risen from 26.5 years in 2000 to 33.6 in 2024 – and it expects that this trend will continue indefinitely. According to the U.S. Census Bureau (An Aging World: 2025), the percentage of people aged 65 and above will double to nearly one fifth of the world’s population by 2060. 

As their populations age, and unless augmented by immigration, the workforces of most nations – not just wealthy ones – shrink. China provides a striking example: the World Bank classifies it as an upper-middle-income nation, and it ranks ca. 66^th in the world for nominal GNI per capita among sovereign states (Australia ranks 12^th). It also faces a demographic crisis: its population is ageing faster than almost any other country’s, and over the next decades its workforce will decrease dramatically.

As an aside and as a result, China as a whole will get old rather than rich. Its population comprises a very small number of super-rich individuals and a massive number with low or modest incomes. As recently as 2020, approximately 600 million of its people – more than 40% of the total – earned just ca. $US140 per month. China’s wealth divide is much sharper than Australia’s and almost as great as America’s.

If it ever could, it can no longer afford to “play the long game.” Perhaps that’s why its invasion of Taiwan, if it occurs, must happen sooner rather than later.

As Australia’s and the world’s population ages, several accompanying economic shifts will place upward pressure upon consumer prices:

Shrinking Workforces Boost Wages: as a population ages, birth rates drop, rates of retirement rise and proportionately fewer people work. Unless AI or something else slashes the demand for employees, a smaller workforce means tighter labour markets; lower rates of unemployment, in turn, encourage workers to seek higher wages – and pressure businesses to grant them. Companies can either absorb these rising costs via thinner profit margins or attempt to pass them to consumers via higher prices.

Slower/Stagnant Productivity Growth: older people require disproportionate amounts of healthcare and elder care. These services are harder than others (such as customer support, data entry and basic content writing) and manufacturing to automate or replace with AI. The result, unless offset by factors other than AI, is downward pressure upon productivity (the value of the output which a worker produces over a given interval of time). When productivity stagnates, the cost of producing goods and services rises.

Rising Debt-Financed Government Spending: as populations age, governments must devote ever more expenditure to pensions, medical care and other support for the elderly. Yet there are proportionately fewer younger people – that is, taxpayers – to finance these expenditures. If governments print money in order to finance this increased spending (rather than reduce outlays in other areas or raise taxes), they’ll fuel inflation.

Reason #3: Growing Geopolitical Instability

For several of the reasons already mentioned, chronic geopolitical conflicts and tensions can create structurally higher consumer price inflation. For reasons related to defence and security (“energy security is national security”), ever more companies are (re)patriating production facilities from lowest-cost nations to home countries or allied nations (“friend-shoring”). This shift replaces cheaper labour and materials and efficient logistics with dearer local wages, higher prices of materials and the rapidly-rising cost of new infrastructure. These higher costs, unless offset elsewhere, beget higher consumer prices.

Events since February of this year have reconfirmed that cold, warm and hot wars in critical regions disrupt the steady flow of agricultural fertiliser, energy and other vital goods. Conflicts in key producing regions render shipping costs vulnerable to sudden and recurring price spikes.

Shortages of basic goods and services raise the production cost of virtually every other good and service. Finally, rising global tensions force governments to devote considerable additional resources to the armed forces, border and national security. Today, this spending is to a considerable extent debt-financed; as such, it pumps extra money into the economy, which lifts the overall level of consumer prices.

Charles Goodhart and the Corruption of CPI

Charles Goodhart is a British economist. After completing an undergraduate degree at Cambridge and a Ph.D. at Harvard, he spent most of his career at the Bank of England and the London School of Economics. In 1975, in the footnote of a paper he delivered at a conference convened by the RBA, he formulated what’s become known as “Goodhart’s Law.” It’s commonly expressed as: “when a measure becomes a target, it ceases to be a good measure.”

He’s laconically reflected: “it does feel slightly odd to have one’s public reputation largely based on a minor footnote.”

Goodhart’s Law and Australia’s CPI

These days, the central banks of most Western nations target the rate of growth of consumer price inflation; hence Goodhart’s Law applies (see Per Bylund, “CPI Meets Goodhart’s Law: Can Economic Metrics Become Fallacies?” The Daily Economy, 18 May). Specifically, when restraining CPI’s annual rate of increase becomes an overriding goal of monetary policy (such as the RBA’s target rate of 2-3% per year, which since the December quarter of 2021 it’s failed to achieve), we can expect that governments will amend – critics would say “game” – it in order to improve the odds that they hit the target.

We’ve already seen that the mainstream’s measure of inflation, which CPI encapsulates, understates inflation according to the previous (and now heterodox) definition. I’m now saying that the Australian Bureau of Statistics (which defines and compiles data for this country’s CPI) has over the years amended it so that it further understates the actual rate of inflation.

For example, it’s revised the method by which it quantifies changes of a good’s or service’s quality; as a result, “headline” inflation falls without any improvement of consumers’ purchasing power or decrease of their cost of living. For example, if a mobile phone plan or electronic device provides significantly more features or data for the same price, the ABS records a reduction of price.

This policy suppresses the rising prices of technology-related expenditures. Even if you’re paying more dollars to buy (say) a new laptop, smartphone, etc., ABS records a decrease of their prices.

Much more importantly, before September 1998 Australia’s CPI included the cost of mortgage interest payments. However, in that month the ABS changed to an approach which focusses solely upon the cost of buying a new dwelling (excluding the land which it occupies) rather than the ongoing cost of financing it. Since then, property prices and mortgage rates have zoomed; consequently, the removal of interest payments has significantly decreased the CPI. When the RBA raises its Overnight Cash Rate, homeowners’ costs of living clearly rise – but CPI no longer reflects it.

More generally, it’s been no accident: over the years, the ABS’s alterations of Australia’s CPI have almost invariably reduced its estimate of consumer price inflation. As a result, and as Goodhart foresaw, CPI no longer measures – arguably, it no longer intends to measure – the average household’s cost of living: it’s merely a statistical index which helps the RBA set its policy rate.

Many Australians reckon – rightly – that their actual cost of living is rising much faster than CPI. To quantify this gap, the ABS also produces Living Cost Indexes (LCIs). Among other things, they include mortgage costs; for this and other reasons, they often show higher rates of consumer price inflation for some households than others – and recently some households have endured a much higher rate of inflation than the CPI indicates.

I’ve taken four of the ABS’s LCIs – those for households headed by (a) aged pensioners, (b) employees, (c) recipients of other government transfers and (d) self-funded retirees – and expressed them as five-year CAGRs. The LCI for households headed by aged pensioners, for example, increased from 45.43 in June 1998 to 51.79 in June 2003; that’s a CAGR of 2.7% per year, and so on for all other groups and intervals to June 2026. I then did the same for the CPI; Figure 6 plots the results.

Figure 6: Living Cost Indexes, Four Groups versus CPI, Five-Year CAGRs, June 1998-June 2026

It confirms that in several respects many Australians are correct and Jim Chalmers, among others, is dead wrong (or wilfully blind).

In 2002, the five series largely coincided. Post-GFC, however, they began to disperse. In particular, from 2008 to 2020, as mortgage rates plunged, employees’ LCI decelerated more than others’. As everybody knows, the past 5-6 years have been very different: everybody’s cost of living has risen dramatically.

Not everyone, however, knows – or, at least, some refuse to acknowledge – that it’s increased more for some than others. It’s climbed most steeply for employees: in the five years to June 2020, their CAGR was 0.6% per year; during the five years to June 2024, it zoomed almost 8-fold to 4.7% per year. During that latter interval, the corresponding CAGRs were 4.0% (recipients of other government transfers), 3.9% (CPI), 3.6% (aged pensioners) and 3.5% (self-funded retirees).

In this crucial sense, today’s picture remains largely unchanged. In the five years to June 2026, the CAGRs are 4.4% (employees), 3.9% (recipients of other government transfers) 3.5% (aged pensioners), 3.2% (CPI) and 3.1% (self-funded retirees). CPI’s medium-term CAGR has receded from 3.9% per year to 3.2%. It reflects self-funded retirees’ rising cost of living – but falls short of employees’, whose very high rate has hardly budged.

Among other reasons, employees are most likely to hold mortgages or to rent, and self-funded retirees and aged pensioners are most likely to own their homes without a mortgage; over the past few years, rents and the costs of a mortgage (including interest) have escalated rapidly; as a result, the cost of living for employees has risen most and for self-funded retirees least.

For employees, and to lesser extents aged pensioners and other recipients of government transfers, over the past few years LCI has hardly fallen; moreover, it’s significantly exceeded CPI. Adding insult to injury, the government, RBA and media ignore LCI and obsess about CPI.

Goodhart’s Prognosis

As detailed in The Great Demographic Reversal: Ageing Societies, Waning Inequality, and an Inflation Revival (co-authored with Manoj Pradhan, Palgrave Macmillan, 2020), Charles Goodhart is a leading proponent of the proposition that economies have entered an era of structurally higher consumer price inflation and rates of interest (see also Raghuram Rajan, “Bracing for a More Inflationary World,” Project Syndicate, 11 July 2024).

This new era has terminated the long period of falling and eventually very low consumer price inflation and rates of interest which had prevailed roughly since 1990.

Goodhart regards the 30 or so years before the COVID-19 pandemic as an anomaly driven by unique global tailwinds – in particular China’s entry into the global economy. What’s more, these favourable conditions have now vanished. He reckons that the annual rate of growth of consumer price inflation in major economies will settle at ca. 3-4% or more, and remain at this elevated level for decades to come. On that basis, unless their income rises more quickly than inflation, most households can expect cost of living pressures to persist – or even intensify – rather than abate.

The implications are crucial. Central banks will be unable to return the inflation “genie” to its 2-3% CPI “bottle” – and the harder they try the greater becomes the risk that they’ll trigger recessions.

Insatiable government spending, and consequent high and rapidly-rising government debt, will defeat monetary policy’s alleged objective of “price stability” (central banks’ unstated but actual objective, however, namely the monetisation of their masters’ debt, will largely succeed).

The Wall Street Journal (“Will Inflation Stay High for Decades? One Influential Economist Says Yes,” 9 March 2022) summarised Goodhart’s thesis: “the low inflation since the 1990s wasn’t so much the result of astute central bank policies, but rather the addition of hundreds of millions of inexpensive Chinese and Eastern European workers to the globalized economy, a demographic dividend that pushed down wages and the prices of products they exported to rich countries. Together with new female workers and the large baby-boomer generation, the labour force supplying advanced economies more than doubled between 1991 and 2018.”

This demographic “sweet spot,” reckons Goodhart, has now disappeared.

WSJ continued: “as labour becomes scarcer, workers will push for higher wages, in turn driving up prices. At the same time, businesses will manufacture and invest more locally to help offset both labour shortages and the nationalist and geopolitical pressures curbing globalized supply chains. That will increase production costs and local workers’ bargaining power. Global savings will fall as older people consume more than they produce, spending particularly on healthcare.”

Over the next several decades Goodhart therefore foresees:

1. Higher Structural Inflation: shrinking workforces and retreating globalisation will boost consumer price inflation to ca. 3%-4% per year.
2. Higher Interest Rates: as societies age, people save and invest less and consume accumulated wealth; in order to induce investment, rates must rise.

The Key Objection to Goodhart’s Claim

Goodhart’s contentions hardly lack critics, and they point overwhelmingly to technology. In particular, they claim that rapid advances of artificial intelligence, automation and the like will boost productivity. Significantly higher efficiency, in turn, will enable businesses to produce more goods and services without raising prices. 

AI’s proponents argue not just that it’ll prevent an acceleration of consumer price inflation. Indeed, by dramatically lowering the cost of producing goods and services, it’ll be powerful deflationary force.

Today’s tech bulls aren’t just adamant; they’re messianic: AI is transformative. Over the past couple of years, the phrase “fourth industrial revolution” has been used to summarise its impact. The first three revolutions occurred over extended intervals when disruptive technologies were introduced and increasingly swiftly adopted. The first was the mechanisation of industry and agriculture in the 18^th and 19^th centuries respectively; electrification during the late-19^th and early-20^th centuries triggered the second, and digitisation since late-20^th century has unleashed the third.

According to Forbes (“AI: Overhyped Fantasy or Truly the Next Industrial Revolution?” 15 August 2024), “the advent of AI … has kickstarted the next industrial revolution. It promises the most dramatic changes yet as electronic brains ... supercharge our productivity, creativity and capability across every field of human endeavour.”

Ed Yardeni, President of Yardeni Research, Inc., told Fox Business on 3 January 2025: “the Roaring 2020s scenario predicts scalable Artificial Intelligence and chronic labour shortages … In this scenario, productivity growth continues to improve …” The Wall Street Journal (“The U.S. Needs a Productivity Miracle. It Might Just Get One,” 26 December 2024) added: “the U.S. could be on the cusp of a productivity boom similar to the one triggered by internet technology in the 1990s.”

Marc Andreessen, co-founder and general partner of the Silicon Valley venture capital firm Andreessen Horowitz, is among the most vocal advocates of AI-driven “hyper-deflation.” He contends that a massive surge in AI productivity will cause a collapse of businesses’ pricing power (see, for example, “Billionaire Marc Andreessen Says AI Will Be So Powerful ‘Everything That Costs $100 Will Sell for a Penny’ in a Hyper-Deflation Era,” Yahoo Finance, 26 October 2025).

Sam Altman, CEO of OpenAI, has repeatedly asserted that AI will “bend the inflation curve” toward “massive economic abundance.” Two historic variables restricting human progress, he says, are the cost of energy and intelligence. AI aims to slash the marginal cost of intelligence to near-zero, and will act as a “structural deflationary anchor” across the global economy (see “Sam Altman Says AI Will Cause Massive Deflation, Making Money Worth Vastly More,” Futurism, 29 January).

Elon Musk, CEO of Tesla and xAI, prophesies an “age of radical abundance” where poverty is “eliminated.” He believes that pairing advanced AI with humanoid robotics will remove human labour constraints from manufacturing, logistics and services. Labour costs will “evaporate,” he has claimed, and the cost of producing everything from groceries to healthcare will collapse to “near-zero” (see “Elon Musk says only AI and robotics can solve the ‘insanely high’ $38 trillion national debt crisis – but it would cause ‘significant deflation,’” Fortune, 1 December 2025).

It’s not just mega-tech moguls: Kevin Warsh, the Fed’s chair since May, has contended that AI is a “meaningful long-run disinflationary force.” Its widespread adoption will significantly boost productivity and thereby reduce the cost of producing goods and services. He expects that this “good disinflation” will give the Fed “headroom” to maintain “lower baseline interest rates over the long term.”

During an interview with CNBC in July 2025, Warsh stated: “AI is going to make everything cost less, and the U.S. could be the big winner.” In an op-ed article in The Wall Street Journal (“The Federal Reserve’s Broken Leadership,” 16 November 2025) he added: “AI will be a significant disinflationary force, increasing productivity and bolstering American competitiveness.”

Finally, Jim Chalmers has joined the bandwagon. According to The Australian Financial Review (“AI the ‘biggest economic transformation in our lifetime’: Chalmers,” 1 September), the Treasurer “says artificial intelligence will transform the Australian economy, boosting productivity and creating higher living standards, but Treasury has warned businesses and governments must match the swift AI adoption of the United States to reap the benefits.”

On the other hand, The Australian (“Jim faces productivity test as AI boost stalls,” 1 September) reported: “Jim Chalmers has been handed Treasury advice dampening expectations that AI will significantly transform Australia’s productivity slump, with a risk the technology fails to budge a key economic indicator that has sunk to 60-year lows.”

Why I Believe Goodhart and Doubt AI Enthusiasts

“America appears to be in the midst of a productivity boom the likes of which hasn’t been seen in years,” Axios reported on 1 February 2024. “But (Fed Chairman Jerome) Powell appears sceptical that those productivity gains will be sustained ...” At a press conference on 31 January 2024, Powell “guessed” that productivity’s rate of growth during recent quarters would subsequently recede towards its long-term average. He also declined to regard AI as a panacea: it may lift productivity’s rate of growth, “but probably not in the short run. Probably, maybe in the longer run.”

Lisa Cook, a member of the Fed’s Board of Governors, observed that AI “has yet to show signs of lifting productivity.” On 30 September 2024, she told reporters: “although I share the view that AI could lift productivity out of this period of low growth, it bears emphasis that recent productivity gains have been modest despite rather impressive changes in information technology.”

She concluded: “the modest productivity growth seen of late already incorporates gains from some types of AI. Whether generative AI delivers a similar, incremental contribution to productivity growth or something larger remains to be seen.”

Using data compiled by the Federal Reserve Bank of St Louis, Figure 7 plots the most valid and reliable measure of productivity: output per hour worked. It plots this measure as a short-term (12-month) percentage change, a medium-term (five-year) CAGR and as a long-term (10-year) CAGR. Since 1948, each of these measures have risen at an average rate of ca. 2.1% per year.

Figure 7: Growth of Productivity (Output per Hour Worked), CAGRs, U.S. Non-Farm Workers, Quarterly, January 1948-April 2026

The short-term measure has fluctuated greatly (standard deviation of 1.8%) and without trend. The medium- and long-term measures, in contrast, have varied much less (standard deviation of 0.8% and 0.6% respectively) and have fluctuated cyclically: sometimes they accelerate above the mean, and at other times they decelerate below it. This meandering clearly disconfirms the conventional wisdom:

• From 1978 to 1999 – that is, the era when the personal computer and Internet were developed and rose to ubiquity – productivity’s long-term rate of growth slowed below its long-term average;
• These CAGRs lifted above the long-term average in 2002-2011 – to rates that were no higher than those that prevailed in the 1960s and 1970s;
• Since 2012, AI has risen to prominence and tech stocks’ returns have zoomed – yet productivity’s ten-year CAGR has sunk below its average since 1948.

“Due to the volatility of productivity data,” reported WSJ on 26 December 2025, Yardeni “prefers to look at a rolling five-year average of productivity growth (that’s an arithmetic mean, not the ten-year geometric mean plotted in Figure 2), which hit an annualised pace of 1.9% in the third quarter of 2024, from a low of just 0.6% in the fourth quarter of 2015. Yardeni believes this could reach 3.5% in the second half of this decade.” 

As Figure 7 makes plain, he’s super-bullish: bearing in mind that arithmetic means always exceed their geometric counterparts (see How you – and managed funds – overstate your returns, 17 October 2024), he’s predicting an acceleration of productivity’s that’s rarely ever been observed. For that very reason, I doubt it.

Consumer Price Inflation, “Growth” and Value Stocks’ Returns

As I’ve previously demonstrated, value stocks – those which sell at low multiples of price to book value, price to earnings, etc. – generally outperform so-called “growth” stocks (which sell at high multiples of price to book value and price to earnings; see in general Why value investing usually outperforms, 29 April). That’s partly because value outperforms growth when the overall market slides (see in particular Which stocks best navigate economic and political risks? 10 August).

It’s also reasonable to expect that value will increasingly outperform “growth” as the rate of consumer price inflation rises.

Why? Firstly, value companies typically generate cash flows and earnings today. “Growth” companies, in contrast, generate relatively little cash; they’re priced at high current multiples on the expectation that they’ll generate much higher earnings and cashflows over the next 5-10 years and beyond. During inflationary periods, which depress the purchasing power of earnings, investors increasingly favour actual current earnings over prospective future earnings.

Secondly, when the rate of inflation accelerates central banks often raise their policy rates of interest. Higher rates increase the discount used to value future cash flows, reducing growth stocks’ present values.

Figure 8a: CPI-Adjusted Total Returns, “Growth” and Value Stocks, by Rate of Inflation (Five-Year CAGR), January 1945-July 2026

Figure 8a and Figure 8b, which plot data compiled by Kenneth French, confirm these expectations. As rates of inflation rise, the medium-term (Figure 8a) and long-term (Figure 8b) CAGRs of value stocks don’t decrease meaningfully and seldom become negative. Conversely, “growth” stocks’ returns don’t just decrease: over a wide range of consumer price inflation, especially at high rates, they become negative.

Figure 8b: CPI-Adjusted Total Returns, “Growth” and Value Stocks, by Rate of Inflation (Ten-Year CAGR), January 1945-July 2026

I sorted the medium-term returns in Figure 8a by rate of inflation, created quintiles of returns and then computed the average return within each quintile; I then repeated the exercise with the long-term returns and rates of inflation in Figure 8b. Figure 9 summarises the results.

Figure 9: CPI-Adjusted Total Returns (CAGRs), “Growth” and Value Stocks, by Quintile of Inflation, January 1945-July 2026

In the 20% of observations when medium- and long-term inflation is lowest (Quintile #1), growth and value stocks’ medium- and long-term returns differ little. In the median quintile, however (#3), value modestly outperforms growth; and in the 20% of observations when medium- and long-term inflation is highest (Quintile #5), value crushes growth.

Consumer Price Inflation and Stocks’ Returns by Sector

Which sectors of the market perform best in the face of accelerating consumer price inflation? Firstly, we can expect that producers of energy (oil, gas and coal) often will thrive because their revenues track rising commodity prices (for details, see Why Santos and Woodside are among our biggest holdings, 18 May and Forget next year’s commodity prices: focus on 2075’s, 1 September 2025). Secondly, to the extent that they can raise rents to match the rising inflation, so too will companies such as Real Estate Investment Trusts (REITs) which own commercial real estate.

Finally, “defensive” sectors such as energy utilities and retailers of consumer staples such as supermarkets, sell goods and services which people can’t easily forego. Even if consumer prices rise rapidly, consumers must still buy groceries and heat and cool their homes.

Banks and other financial institutions like insurance companies occupy a middle and more complex position. On the one hand, they benefit from the higher rates of interest rates which typically accompany accelerating inflation. In particular, when the rate of inflation rises from a low to a moderate level, banks’ net interest margin (NIM, the difference between what banks earn from borrowers’ loans and what they pay to depositors and lenders) rises. When rates of interest increase, banks typically lift their loan rates faster than their savings and deposit rates, and thereby (unless they seek to lift market share) increase their NIMs. Higher rates of interest also mean that households and businesses pay more interest on mortgages, credit cards and business loans.

High rates of inflation, however, hurt banks’ profits by increasing and loan defaults. When consumer prices rise fast, household income often fails to keep pace; as a result, people often have less money to pay their debts. The quality of loans thus decreases; hence banks set aside more money to cover impaired and defaulted loans, which reduces their profit. The high borrowing costs which typically accompany high rates of inflation also make people and businesses less likely to borrow; as a result, the growth of banks’ balance sheets slows or even becomes negative.

Finally, when consumer price inflation rises the valuations of banks’ fixed-rate loans and mortgages generally decrease in real terms. That’s because the higher is the rate of inflation the greater is the loss purchasing power over time of fixed payments. Banks feed these non-cash losses through their profit & loss statements.

Which sectors perform worst when consumer price inflation accelerates most?

Because it’s a cluster of quintessential “growth” stocks, the tech sector heads the list: high-growth companies rely on future earnings whose present value falls when inflation and discount rates rise. Non-discretionary retail stocks also rank high among the losers: sellers of non-essential goods struggle because inflation shrinks the purchasing power of consumers’ disposable income; moreover, these companies often can’t pass rising wholesale costs directly to shoppers without losing sales.

Figure 10: CPI-Adjusted Total Long-Term Returns (CAGRs), Five Sectors by Quintile of Inflation, January 1945-July 2026

Data compiled by Kenneth French (for details, see Want to shrink your returns? Buy “growth” stocks! 23 March) broadly confirm these expectations. I sorted the CPI-adjusted long-term total returns of stocks in the energy, banking and financial, health, retail and technology sectors by the long-term rate of inflation, created quintiles of sectoral returns and then computed the average return within each quintile; Figure 10 summarises the results. In the 20% of observations when long-term inflation is lowest (Quintile #1), energy underperforms the other sectors (whose CAGRs average 12.8% per year).

In the median quintile, however (#3), energy modestly outperforms the other sectors (whose CAGRs average 9.5%); and in the 20% of observations when long-term inflation is highest (Quintile #5), energy (6.6% per year) crushes the other sectors (which average 1.8% per year).

Investors Beware: We’ve Heard the “Transformative Tech” Tech Story Before

Today’s acolytes of AI and their sermons about technology’s ability to boost the economy’s overall productivity – and thereby to allow central banks to adopt looser monetary policies and lower rates of interest without fuelling an acceleration of consumer price inflation – are nothing new. In August 1995, at the meeting of the Federal Reserve’s Open Market Committee, its Chairman, Alan Greenspan, invoked Goodhart’s Law. He declared: “there is a major statistical problem.”

In his view, accepted measurements of productivity such as output per hour worked simply didn’t reflect the strong acceleration of productivity that was obviously occurring. Why did he believe that productivity was quickening? Why did he think this was self-evident?

Greenspan’s remarks in this and other FOMC meetings during the next several years contained three unspoken but nonetheless clear premises. Firstly, technological revolutions always beget rapid, economy-wide advances of productivity; secondly, the Internet was expanding rapidly; thirdly, it constituted a “once-in-a-century” leap of technology.

What subsequently became known as “hedonic adjustments,” which in Greenspan’s view equity markets were correctly taking into consideration, allegedly demonstrated that “there has indeed been an acceleration of productivity if one properly incorporates (as) output that which the (stock) market values as output ...”

In 1995, in short, Greenspan experienced an epiphany: the stock market was rising – and would continue to climb – because productivity was accelerating. Data couldn’t detect it, but he convinced himself that his superior insight, plus some statistical sleight of hand, could!

Furthermore, given this alleged boost to productivity, profits were supposedly much higher (i.e., companies were expensing what they should have been capitalising) – and thus stocks were actually much cheaper – than was generally recognised.

Greenspan became one of the Dot Com boom’s most ardent apostles, and he used his public addresses as sermons to spread its gospel.

Most notably, on 13 January 2000 he delivered a speech entitled “Technology and the Economy,” and over the next three years delivered variants of this address. “When we look back at the 1990s from the perspective of 2010,” he reckoned in its first version, “the nature of the forces currently in train will have presumably become clearer. We may conceivably conclude from that vantage point that, at the turn of the millennium, the American economy was experiencing a once-in-a-century acceleration of (technological) innovation, which propelled forward productivity, output, corporate profits and stock prices at a pace not seen in generations, if ever.”

“Alternatively,” he acknowledged, “that 2010 retrospective might well conclude that a good deal of what we are currently experiencing was just one of the many euphoric speculative bubbles that have dotted human history. And, of course, we cannot rule out that we may look back and conclude that elements from both these scenarios have been in play in recent years.”

In this and later speeches, Greenspan championed the first possibility: “... it is information technology that defines (the 1990s). The reason is that (IT) lies at the root of (this period’s) productivity and economic growth.”

Having allegedly clarified the present, in an address entitled “The Revolution in Information Technology” which he delivered at a “New Economy” conference on 6 March 2000, he also purportedly divined the future: “businesses continue to find a wide array of potential high-rate-of-return, productivity-enhancing investments. And I see nothing to suggest that these opportunities will peter out any time soon.”

“Indeed,” Greenspan said, “many argue that the pace of innovation will continue to quicken in the next few years, as companies exploit the largely untapped potential for e-commerce ...” On that basis, “so far as I can judge ..., it is not evident that we are seeing, as yet, a cresting in the growth of productivity.”

Four days later, on 10 March 2000, NASDAQ peaked at 5,048 – and during the next 30 months crashed almost 85%. As its collapse quickened, in a speech entitled “Business Data Analysis” delivered on 13 June 2000, he subtly retreated: “that there has been some improvement in the growth of aggregate productivity is now generally conceded by all but the most sceptical.”

Was he serious? Was he not aware that a couple of years previously the Congressional Budget Office had commissioned an economist, Robert Gordon, to investigate this crucial issue? In “Has the ‘New Economy’ Rendered the Productivity Slowdown Obsolete?” (NBER revised version, 14 June 1999) Gordon delivered his verdict:

“There has been no productivity growth acceleration in the 99% of the economy located outside the sector which manufactures computer hardware ...”

“Indeed,” he continued, “far from exhibiting a productivity acceleration, the productivity slowdown in manufacturing has gotten worse: when computers are stripped out of the durable manufacturing sector, there has been a further productivity slowdown in durable manufacturing in 1995-99 as compared to 1972-95, and no acceleration at all in non-durable manufacturing.”

In short, aided and abetted by Greenspan, in the late-1990s and early-2000s speculators assumed that the “Internet revolution” was boosting productivity’s growth – and that it would thereby support the skyrocketing prices of “tech” shares.

But, as Gordon concluded, productivity wasn’t accelerating. Quite the contrary: it was sagging. When speculators finally came to their senses, “tech” stocks crashed.

What Should – but Doesn’t – Concern Today’s Tech Speculators

“For two years,” emphasised The Wall Street Journal (“The Day DeepSeek Turned Tech and Wall Street Upside Down,” 27 January), “markets’ belief that the rise of artificial intelligence would usher in a new era of productivity growth has fuelled trillions of dollars in stock-market gains.” If this “new era,” like the Dot Com bubble, rests upon false foundations, what’ll happen to these gains?

James Mackintosh (“DeepSeek Undercuts Belief That Chip-Hungry U.S. Players Will Win AI Race,” The Wall Street Journal, 28 January) raised related crucial points: “more AI competition will make it hard for Big Tech to generate the oligopoly-like profit margins that investors hope for. If the companies can’t make fat profits, it will be even harder to justify their high valuations. These valuations, remember, rely on the assumption that AI tools will be both widely used and highly profitable, but even the experts have little explanation of how the business model will work. It will also be harder to explain why they are sinking so much money into AI data centers.”

For more than two centuries, cumulative improvements of technology have propelled countless advances of agriculture’s, mining’s and industry’s (including services’) efficiency – and, therefore, huge increases of living standards. By obsessing about the latest technology, downplaying or ignoring its antecedents and hyping its prospects, today’s AI bulls (and tech bulls generally) are ignoring this reality.

They’re once again parroting the mantra chanted by Alan Greenspan and other “Dot Com” zealots at the turn of the century:

1. “Revolutionary technology” is allegedly generating or shortly will produce an enormous and permanent acceleration of productivity’s rate of increase. In the 1990s, such transformative technology included biotech and genomics, telecoms and above all the Internet and its applications; today, it includes crypto-currencies, EVs, solar and wind power and particularly AI.
2. These large and lasting leaps of productivity, in turn, are supposedly producing or before long will generate the surges of profit which place tech stocks’ recent huge returns – and current valuations – on sound and sustainable bases.

Hard data (Figure 7) debunks these two claims. “Tech revolutions” don’t accelerate the growth of productivity – at least, they never have since the Second World War. Because claim #1 is false, claim #2 can’t be true.

These results should disconcert bullish speculators, but they won’t surprise realistic investors. “You can see the computer age everywhere but in the productivity statistics,” Robert Solow famously quipped in 1987 (the year he won the Bank of Sweden Prize in Economic Sciences in Memory of Alfred Nobel, usually but erroneously called “the Nobel Prize in Economics”).

In the late-1990s and early-2000s, however, Alan Greenspan ignored Solow – and mistakenly inferred from the Internet’s rapid rise that a sharp acceleration of productivity and profits, and a sustainable trajectory of returns, was occurring. Jerome Powell was more sensible, i.e., sceptical about AI’s ability to boost productivity and tamp CPI.

We’ll have to see about Kevin Warsh. As The Wall Street Journal reported (28 August), “it’s clear his views (about AI and productivity are now) more nuanced. AI’s effect on the economy and monetary policy will depend on a wide range of unknowns concerning which sorts of firm prove most profitable, how AI affects employment, and other factors.”

Implications

Whether the Internet during the 1990s-2000s or AI today, “there’s usually a grain of truth that underlies every mania ... It just gets taken too far,” Howard Marks, co-chairman of Oaktree Capital Management, wrote in a note to investors on 2 January 2025. “A lot of what’s been going on,” observed James Mackintosh in The Wall Street Journal, “is similar to when investors discovered the internet. They’ve grasped that AI is A Big Deal, but can’t yet see exactly how or when it will make money.”

“It’s clear,” added Marks, “that the internet absolutely did change the world. In fact, we can’t imagine a world without it. But the vast majority of internet and e-commerce companies that soared in the late ’90s bubble ended up worthless.” Much the same, I suspect, will 25 years hence be true of AI.

The internet, in other words, was a single instance of a long-forgotten pattern to which AI will likely conform. “It has long been the prevalent view,” wrote Benjamin Graham in The Intelligent Investor (1949), that “successful investment lies first in the choice of those industries that are most likely to grow in the future and then in identifying the most promising companies in these industries. For example, smart investors ... would long ago have recognised the great growth possibilities of the computer industry as a whole and of International Business Machines in particular. And similarly for a number of other growth industries and growth companies.”

Today’s advocates of “growth stocks” would heartily agree. They should (re)read Graham: this “prevalent view” is never as easy in prospect “as it always looks in retrospect.” People in general and speculators in particular, in Jason Zweig’s phrase, possess “a remarkable ability to make rear-view mirrors out of rose-coloured glass.”

The problem with “growth” – AI is but the latest example – is that boosters exaggerate its prospects and speculators push the prices of its securities to excessive heights. When realism finally prevails, speculators receive mediocre (if they’re lucky) or disastrous (if they’re not) returns.

Conclusion

Leithner & Company’s assessment of AI is a classic application of principles of value investing. We view it through the lens of economic reality rather than market psychology. It’ll certainly improve – indeed, revolutionise – specific, narrow tasks; equally, we doubt that it’ll greatly or even significantly lift overall productivity.

Our assessment conforms to the historical reality of past tech cycles – which today’s AI boosters ignore or deny. From the contemporary mainstream’s point of view, we’re therefore deeply contrarian.

The mainstream implies that you should ignore today’s risk of higher consumer price inflation. That’s because a revolution is allegedly underway. As Alan Greenspan and others ardently believed a quarter-century ago, today’s AI enthusiasts concur: this revolution will boost productivity’s – and thus tamp CPI’s – rate of growth. They therefore conclude (like Greenspan, they also suppose that more rapid advances of productivity beget higher profits, and that such profits will support high valuations) that AI and tech shares more generally can continue to skyrocket.

Enthusiasts always believe fervently but seldom investigate dispassionately. Why bother when the latest craze is a “sure thing”? In contrast, I’m sceptical precisely because I’ve enquired and analysed.

Tech speculators’ most fundamental beliefs are erroneous: I’ve found no evidence since the Second World War that “tech revolutions” permanently increase productivity’s rate of growth. Nor have I uncovered any grounds to believe that a long-term acceleration of its growth in the U.S. is underway; I therefore doubt that one is imminent.

And if Goodhart is correct and CPI “sticks” at an historically elevated rate, “growth” stocks’ and most sectors’ long-term returns – particularly technology’s – will likely sag and perhaps (given their nosebleed valuations) plummet.

For a quarter-century, Leithner & Company’s general orientation has been strictly towards value; more recently, its specific “tilt” has been towards energy. Persistently higher consumer price inflation will affect them much less adversely – and, as a result, the odds are that they’ll outperform.

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