Quality vs. Inflation and the Deficit

Inflation has skyrocketed during the first half of 2022, which also saw a sharp downturn in the stock market in response to the Federal Reserve’s increase in interest rates to reduce demand. This resulted in a bear stock market and raised the prospect of an economic recession. The nonpartisan Government Accountability Office (GAO) has meanwhile projected a national debt “death spiral” in which interest on the growing Federal debt will overwhelm our ability to pay.¹

Henry Ford wrote in 1930, “Substituting the engineer for the politician is a very natural step forward. The engineer can do that which the politician can never do under any circumstances. The engineer creates and harmonizes while the politician can at best only rearrange what he has in hand.”² While the Federal Reserve is nonpartisan rather than political, there are nonetheless practical limits on its ability to manage inflation. The Fed cannot fix broken supply chains that result in shortages and inflationary high prices, nor can it create skilled workers to fill vital jobs. If a shortage of semiconductor devices results in a shortage of automobiles, then higher interest rates on auto loans will do little to reduce prices. They may convince people to defer new car purchases, but otherwise will not have the desired effect.

Quality and manufacturing professionals can, on the other hand, defeat inflation and grow the economy and associated taxable activity to generate a surplus with which to pay down rather than increase national debt. This is because waste (muda) is inflationary, and its removal enables simultaneous low prices, high wages, and high profits. High wages and profits are taxable economic activity. This is easy to understand with some very simple economic principles.

Money supply, velocity, and economic activity

The Federal Reserve’s countermeasures against inflation consist of (1) its ability to regulate the money supply by buying or selling debt,³ and (2) its authority to set the discount rate that banks pay when they borrow money from the Federal Reserve. Higher interest rates increase the cost of borrowing and reduce the velocity of money, or the number of times each dollar changes hands in a particular year. Fisher⁴ defined the equation of exchange, or Fisher equation, which relates the supply and velocity of money to economic activity. This is simply MV = PQ, where:

• M is the money supply.
• V is the velocity of money, or the number of times each dollar changes hands in a given year.
• P is the vector (in the context of matrix algebra) of prices for goods, services including wages, capital costs, and also waste; that last part will be extremely important.
• Q is the vector of the associated quantities.

Another way to state this is, where p_i is the price of the ith item and q_i is its quantity,

Fisher explains in more detail:

“Let us begin with the money side. If the number of dollars in a country is 5,000,000, and their velocity of circulation is twenty times per year, then the total amount of money changing hands (for goods) per year is 5,000,000 times twenty, or $100,000,000. This is the money side of the equation of exchange.

Since the money side of the equation is $100,000,000, the goods side must be the same. For if $100,000,000 has been spent for goods in the course of the year, then $100,000,000 worth of goods must have been sold in that year.”

Fisher used a simple example in which the only goods are bread, coal, and cloth, to illustrate this as a balance in which each quantity is a weight on a scale, and the price is its position on a scale, as shown in Figure 1. The money supply M is the purse on the left side of the balance, and velocity V is its position. The loaf of bread, bucket of coal, and roll of cloth on the right side represent the quantities, and their positions are their prices.

Figure 1: MV must balance PQ.

If MV increases and quantities do not, prices will increase and inflation will occur. Spectacular examples include the debasement of money by Imperial Rome, Weimar Germany, and Zimbabwe. Even in the absence of debasement, a huge influx of gold and silver from the New World ruined the economies of Spain and Portugal during the 16th century. Gold and silver now have industrial uses, but their value several hundred years ago was due primarily to their scarcity rather than what one could actually do with them. The same lesson could carry over to cryptocurrency which, like the infamous tulip bulbs of 17th-century tulip mania in Holland, is valuable only because people believe it is valuable. Only goods and services have real value. If the Federal Reserve reduces MV to compel a reduction in prices, then a reduction of quantities produced also might take place—which is how we get economic recessions.

Revenues must balance expenditures

It is useful in the context of manufacturing and service industries to add another equation to Fisher’s equation of exchange; revenues (R) must, in the absence of accumulated debt or earnings, balance expenditures (E). We could even include accumulated earnings among the expenditures, which are in this case on investments, because accounting debits must always equal credits. The same goes for accumulation of debt. But we will assume steady-state conditions to keep the discussion simple. Revenues therefore come from the sale of goods and services, and expenditures cover everything that goes into realization of the product or service. These include wages, materials, energy, cost of capital, profits and, very significantly, all forms of waste.

We can illustrate this with a simple example. Suppose that a society’s only industry is laying bricks, and value consists of completed walls. This is, for simplicity, a closed system in which the workers own the business, so they earn profits as well as wages and also buy all the output from themselves. Each worker can lay 125 bricks per hour, which was the actual figure cited by Frank Gilbreth prior to the introduction of his non-stooping scaffold. Also assume the following expenditures and revenue:

• Brick and mortar @ 5 cents
• Labor per brick @ 10 cents
• Profit per brick @ 10 cents
• Revenue per brick must therefore be 25 cents to balance the expenditures, at least in a steady-state situation in which neither debt nor earnings accumulate.

Every quarter received for placement of a brick is paid out for materials, labor, and profit (dividends or reinvested retained earnings), so it changes hands twice. Placement of each brick in a wall therefore generates fifty cents of economic activity. If each worker lays 125 bricks per hour, or 1,000 in an eight-hour day, he or she generates $500 in total economic activity. If we assume the same tax rate for labor and employers, $50 (the profit) is taxable because the workers’ taxable wages are deductible by the employer, which results in a wash.

Removal of waste increases wages, profits, and taxable economic activity

Everything the employer spends to create the product adds to the price and therefore the revenues, but is deductible by the employer. Only the difference between the revenues and expenditures constitutes taxable profit, and expenditures include waste. Waste therefore not only fuels inflation, it reduces profits and therefore tax revenues.

The original bricklaying job design required the workers to bend over to pick up each brick from the ground, so they could lay only 125 per hour. Now suppose Gilbreth’s non-stooping scaffold delivers the bricks at waist level to allow each worker to lay 350 per hour, or 2,800 per shift. Change the expenditures and revenue to reflect the improved productivity:

• Brick and mortar @ 5 cents (unchanged by labor efficiency)
• Labor per brick @ 5 cents
• Profit per brick @ 5 cents
• Revenue per brick must therefore be 15 cents to balance the expenditures

Placement of each brick now generates only 30 cents of economic activity, but each worker now lays 2,800 rather than 1,000 per day for a total of $840 rather than $500 per day. This is a 68 percent increase in MV, but it is far from inflationary because the total price per brick laid is 15 rather than 25 cents. In addition, if we assume again that wages are a wash, because they are taxable to the worker but deductible for the employer, then we have $140 rather than $50 of taxable profit per worker per day. This is exactly how higher productivity, in this case through removal of waste motion, counteracts inflation, increases wages and profits, and pays down the national debt.

Waste is inflationary

It is also noteworthy that the price of each brick laid was higher than it needed to be due to wasted motion, namely the need for the worker to bend over to pick up each brick from the ground, that was built into the job. If we recall that R = PQ, where P is the vector of prices and Q the vector of quantities produced, and R = E, where expenditures include the cost of waste, then the presence of waste will by necessity result in higher prices. If we have to pay people to bend over to pick up bricks, then the cost of this waste will appear in construction prices.

Meanwhile, there is a story to the effect—which is confirmed by my own recent experiences—that manufacturers in the People’s Republic of China (PRC) knowingly sell poor quality products and deal with complaints by refunding the purchaser’s money. I bought a PRC-made light-emitting dog collar for my black Labrador Retriever, who is otherwise almost invisible at night. It stopped working in roughly two weeks. The seller refunded my money and told me I did not even have to return it. I bought another collar from a different manufacturer, and the switch broke within two or three weeks. They refunded my money and told me I didn’t have to return it, so there is ostensibly no harm and no foul. Suppose, however, that half of the collars sold are of equally poor quality. If they have to sell two to keep the revenue from one, then the collars will be twice as expensive as they ought to be.

Poor quality is, however, only one of the Toyota production system’s Seven Wastes, and it is often not even the most costly. Gilbreth’s bricklaying example proved that roughly 64 percent of the workers’ labor was wasted by bending over to pick up each brick. Manual harvesting of crops such as strawberries is equally wasteful or even worse, as is immediately obvious from videos and even still photos of farm workers bending over and walking.⁵ The fact that the workers “were bent at an almost 90-degree angle, using two hands to pack strawberries into plastic containers that they pushed along on ungainly one-wheeled carts” along with the photo in the article, tells us instantly why strawberries are expensive (inflation again) while the workers’ wages and farmer’s profits are far lower than they should be. If the farmers cannot sell the berries because they are overpriced, they will have to lay off the poorly paid workers and possibly go out of business themselves—which is how we get economic recessions.

Failure to adopt better methods and better technology also is a form of waste, and its cost can be astronomical. Ford wrote: “If a device would save in time just 10 percent, or increase results 10 percent, then its absence is always a 10 percent tax.”⁶ Relatively inexpensive carts that can be pulled by tractors or powered by solar energy allow strawberry pickers to lie on them facedown to work while their relative motion to the plants beneath them is similar to that in a moving assembly line.⁷ The workers need only reach down to get the berries, and do not need to either walk or bend over.

The key principle is to always assume that a job is not being done as well as it could be done, and the inefficiencies involved may amount to a hundredfold or even a thousandfold rather than 10 percent.

Waste causes stagflation and unemployment

If we recognize that expenditures include money spent on wasted labor, cycle time, material, and energy, along with poor quality, then revenues must be higher to cover the expenditures. If the quantity of goods and services is constant, then prices must increase to cover the waste, and higher prices are inflationary. Stagflation, or economic contraction as a result of inflation, results when higher prices reduce sales but the sellers cannot reduce prices to increase the quantity demanded.

That is, when the Federal Reserve reduces the money supply and/or the velocity of money, it hopes that MV = PQ will reduce the vector of prices rather than the vector of quantities. However, if the prices are high to cover the sellers’ actual expenditures, including expenditures on waste, the sellers cannot reduce their prices without incurring actual losses. The vector of quantities demanded (Q) will fall instead, which will reduce economic activity.

Money spent on waste cannot be paid in wages or profits, which means it is entirely possible to have low wages and high unemployment simultaneously, as illustrated in the strawberry picking example. The inflated prices that are necessary to cover the waste reduce the quantity demanded and therefore the number of workers necessary to meet the demand. This is the opposite of the Luddite position that a tenfold productivity improvement will make nine out of 10 workers superfluous. Paying 10 people to do one person’s job is far more likely to price the service or product out of the market and result in no employment whatsoever.

Recognize all forms of waste

Remember that any expenditure that does not deliver utility to the customer is waste, and that poor quality is only one of the Toyota production system’s Seven Wastes. Among these are inventory and its carrying costs, and inventory is proportional to cycle time. Waiting is, in fact, almost redundant with inventory because it adds to cycle time. Transportation, e.g. from the PRC to our West Coast, costs money, adds to lead time, and delivers no value or utility to the customer. I for one can identify costs and serious risks, but no utility, associated with importing manufactured goods from the PRC. These have included, as but two of many examples, counterfeit semiconductors⁸ and counterfeit N95 masks.⁹

Location of a business in a high-cost city such as New York, Los Angeles, or San Francisco (where the median home price is $1.3 million, per Realtor.com) also adds cost but no value to whatever product or service is provided. Employers must pay higher wages to attract and retain workers, but the workers do not enjoy a higher standard of living because their pay buys less rather than more. “Pay more, get less” is the very definition of inflation, and the costs are built into the selling price as well. Henry Ford recognized this problem 100 years ago, and it has gotten worse since then.

And finally, the overhead expense of living or doing business in the great cities is becoming unbearable. It places so great a tax upon life that there is no surplus to live on. The politicians have found it easy to borrow money, and they have borrowed to the limit. Within the last decade, the expense of running every city in the country has tremendously increased. A good part of that expense is for interest upon money borrowed; the money has gone either into nonproductive brick, stone, and mortar, or into necessities of city life, such as water supplies and sewage systems, at far above a reasonable cost. The cost of maintaining these works, keeping in order great masses of people and traffic, is greater than the advantages derived from community life. The modern city has been prodigal—it is today bankrupt, and tomorrow it will cease to be.

The same principle carries over into opulent office buildings and corporate headquarters regardless of their location. Ford observed that the existence of such buildings is evidence of organizational failure, rather than success:

"We will not put into our establishment anything that is useless. We will not put up elaborate buildings as monuments to our success. The interest on the investment and the cost of their upkeep only serve to add uselessly to the cost of what is produced—so these monuments of success are apt to end as tombs. A great administration building may be necessary. In me it arouses a suspicion that perhaps there is too much administration. We have never found a need for elaborate administration and would prefer to be advertised by our product than by where we make our product.

“. . . serve to add uselessly to the cost of what is produced” again meets the definition of inflation, and the cost comes out of the pockets of every relevant interested party, including customers, investors, and workers.

In addition, any purchased material or energy that does not become a saleable product is waste. Users of the ISO 14001:2015 standard for environmental management systems should apply it to all material wastes, as opposed to just environmental aspects. Anybody who sees even environmentally harmless materials being sent to landfills should visualize bundles of money on their way to the landfills instead. ISO 50001:2018 is equally useful for addressing energy wastes.

Summary

This article has shown that the quality and manufacturing professions are situated ideally to address inflation, and have ultimately far more power to do so than the Federal Reserve. The latter can address only the supply of money and its velocity, and often with the unintended but easily foreseeable consequences of higher unemployment and lower economic growth. The quality and manufacturing professions can, on the other hand, suppress inflation through the removal of waste from supply chains while increasing employment and economic growth. This, in turn, generates more taxable economic activity with which to pay down, rather than aggravate, the federal debt.

References

1. Government Accountability Office. “Larger Federal Deficits & Higher Interests Rates Point to the Need for Urgent Action.” May 5, 2022.
2. Ford, Henry; Crowther, Samuel.  Moving Forward. Doubleday, Doran, & Company, 1930, p. 249-250.
3. Thornton, Daniel L. “How does the Federal Reserve control the supply of money?” The Regional Economist, Federal Reserve Bank of St. Louis, April 1, 2013.
4. Fisher, Irving. The Purchasing Power of Money. Macmillan, 1912.
5. Becerra, Hector. “A day in the strawberry fields seems like forever.” Los Angeles Times, May 3, 2013.
6. Ford, Henry; Crowther, Samuel. My Life and Work. Doubleday, Page & Company, 1922.
7. Bray, Kari.  “At Biringer, workers harvest strawberries on their bellies.” HeraldNet, June 22, 2017.
8. Computing (UK). “Counterfeit, Substandard Chips are Penetrating the Supply Chain, Industry Insiders Warn.” ACM News, Sept. 20, 2021.
9. U.S. Customs and Border Protection. “CBP Seizes Counterfeit N95 Masks.” April 15, 2021.

About The Author