What will it be? Inflation. Deflation. Stagflation.
The US bond market is sniffing inflation. Recovering economy. Shiploads of stimulus. Rampant money creation. Surely all these rivers of free-flowing money will float inflation higher?
Larry Summers (Obama’s top economic adviser and one of the architects of the GFC stimulus packages) recently voiced his concerns on Biden’s US$1.9 trillion stimulus package (emphasis added):
‘There is a chance that macroeconomic stimulus on a scale closer to World War II levels will set off inflationary pressures of a kind not seen in a generation. I worry that containing an inflationary outbreak without triggering a recession could be even more difficult now than in the past.’
Bloomberg, 7 February 2021
Creating inflation is not as easy as it was a generation ago in the 1970s.
Lord knows the Bank of Japan has tried. Even the socialists in charge of the ECB have not met with any real success in Europe.
Inflation is a cocktail made of three primary ingredients.
A dash of velocity of money, mixed with a shot of wages growth and a twist of rising commodity prices.
Well, the US Velocity of Money (the rate a dollar moves through the economy) is falling like a stone. It was 2.2 times in 2000. Now it’s 1.1 times and falling. People are holding onto a dollar for longer.
Wages growth? Well that all depends on whether you’re in the ‘haves’ or ‘have nots’…more on that shortly.
The CRB Index (a basket of commodities) has doubled since its lows of April 2020…but it’s still less than half its 2008 peak.
At this stage, the inflationary cocktail is far from lethal.
The 16 March 2021 edition of The Rum Rebellion touched on why there will be NO inflation in Australia:
‘Over the past 18-months, we’ve [Australia] added another $1 trillion ($1,000 billion) to our debt pile…for absolutely NO economic gain.
‘What the media commentators tout as a [economic] “success”, is in reality, a national disgrace…aided and abetted by the RBA’s mindless and reckless interest rate settings.
‘There will be NO inflation in Australia…we simply cannot afford it.
‘A mere 1% rise in interest rates would increase the debt servicing cost on our [$9 trillion] debt pile by $90 billion.
‘Just to pay the additional interest cost would result in 4.5% of GDP being sucked out of the economy.
‘There are no free lunches. We cannot have our economic cake and eat it too.’
The Everest-like debt in the system means even the slightest rise in interest rates results in tax dollars, corporate earnings and household wages being diverted into higher loan repayments and away from productive investment and consumption.
Higher rates also make further debt accumulation a taller order. That’s not good news for an economic growth model wholly and solely dependent upon debt for growth.
The bottom line…interest rates MUST stay low and debt MUST continue to grow (on a ratio of $5 debt to $1 of GDP), otherwise the ‘growth’ engine stalls.
Debt is the great suppressor of inflation…which is why a return to the 1970s is unlikely.
This is an edited extract from a recent issue of The Gowdie Advisory:
‘[The] reason why I struggle with a comparison between now and the late 60s and 70s, is…
‘The mathematics of debt
‘[In late 1974]…total US debt was around US$2.5 trillion…now they spend US$1.9 trillion on a short-term stimulus hit. Crazy world.
‘In 1974, the 10-year US Government Bond rate was 9.5%…it would, due to inflationary pressure, rise to 16% in early 1980s.
Source: Federal Reserve Economic Data
‘For the purpose of this exercise, we’ll do our numbers on 1975 data.
‘Here’s a table comparing 1975 data with current day numbers…and then adjusted for inflation.
‘Irrespective of which measurement we use…debt to GDP basis or per capita basis, it’s blindingly obvious there is way more debt in the US today then there was in 1975.
‘And this debt level is what’s likely to put a governor on the inflation rate.
‘Here’s my back-of-the-envelope reasoning for this.
‘In inflation adjusted terms, per capita debt in 1975 was US$58,000. The inflation-sensitive 10-year bond rate was 9.5%.
‘In simple interest terms, the cost of the debt was…
‘$58,000 x 9.5% = $5,510.
‘The bond rate subsequently rose to 16%…
‘$58,000 x 16% = $9,280.
‘Let’s do the same with today’s numbers.
‘Per capita debt is US$248,000. 10-year bond rate (around) 2.0%.
‘$248,000 x 2.0% = $4,960.
‘On an inflation adjusted basis, the current simple interest cost is slightly less than that of 1975.
‘What would the inflation-sensitive 10-year bond rate need to be, to match the simple interest cost of $9280 (when the 10-year bond rate peaked at 16%)?
‘$248,000 x 3.72% = $9,225.
‘The US 10-year bond rate would only need to rise 1.7% to be the interest cost equivalent of what it was when inflation peaked in the early 1980s.
‘Why can’t it go higher?
‘People can only pay what their incomes afford them to.
‘In real (inflation adjusted) terms, only the top 10% (90th percentile) have had any significant increase in incomes since the late 1970s.
‘The remainder, at best, have had a very modest increase.
Source: Congressional Research Center
‘There is a mathematical limit on how much rates (influenced by inflation) can rise.
‘The more rates go up, the greater the amount of money diverted into loan repayments. Which means there will be less to spend in the economy. Also, the higher rates rise, there’ll be a corresponding increase in loan defaults…especially for zombie companies that don’t earn enough now to cover interest costs.
‘All this results in falling demand…and that takes us back to this scenario…
“In reality, the nation’s most prosperous decade [the 1920’s] had been built on a house of cards. Low wages, high rates of seasonal unemployment, chronic stagnation in the agricultural sector, and a hopelessly unequal distribution of wealth were the darker story that lurked behind 1920s-era prosperity.
“There was a price to pay for so lopsided a concentration of the nation’s riches. Good times relied on good sales, after all. The same farmers and workers who fueled economic growth early in the decade by purchasing shiny new cars and electric washing machines had reached their limit. By the late twenties, when advertisers told them that their cars and washing machines were outdated and needed to be replaced, the working class simply couldn’t afford to buy new ones. Unpurchased consumer items languished on the shelves. Factories cut their production. Workers were laid off by the millions. The good times were over.”
History by Era
‘Personally, I see more of a correlation with the 1920s than I do with the 1960s/70s.
‘Either way, based on history, both roads [deflation or inflation] lead to a substantial fall on the US share market.
‘Because this is THE most overvalued market in US history…’
Source: Hussman Strategic Advisors
Without substantial wage rises — and that’s unlikely if corporates are defaulting and/or increased adoption of lower cost AI solutions — people will not be able to afford the higher debt servicing costs that come from rising inflation.
Throw a market collapse into the mix — the loss of wealth effect — and we have deflation in our future.
Editor, The Rum Rebellion
PS: Vern is also the Editor of The Gowdie Letter and The Gowdie Advisory — investment services designed to help everyday Australians avoid the financial pitfalls of a volatile economy and make informed decisions to grow their wealth for generations to come.