Forget Inflation, Stagflation may be the Threat

Blain’s Morning Porridge 10 June 2021 – Forget Inflation, Stagflation may be the Threat

“Slow growth and inflation is the worst of all worlds…”

This morning: Money supply economists argue inflation is nailed on, even if Central Banks and Governments taper QE and hold back further fiscal spending binges. But the consequences of the last 12 years of monetary experimentation, the massive inflation in financial asset prices, the changed investment environment, and rising inequality mean the coming crisis really will be different this time. Maybe it’s not inflation we should fear, but its much more evil and thuggish sibling – Stagflation.

After my comments on inflation or deflation in yesterday’s Morning Porridge, I got my head bitten off by a proper economist for understanding nothing about Economics or Inflation. Channeling his inner Milton Friedman vibe; “inflation is always and everywhere a monetary phenomenon”, the economist explained my idiocy in detail in relation to the inevitable surge of inflation that is nailed on to occur shortly.

Being told off by an economist is a bit like being mugged by a lame sheep wielding a cotton wool bat.

Despite holding a degree in the “dismal science”, I am oft unconvinced by the competing views of what Monetarists, Austrians, the Kilmarnock School, Neo-Keynesians or NMT supporters determine the data is telling them. The multiplicity of views highlights economics is about assumptions and opinions rather than rules.

To digress: A mathematician, physicist and economist are washed up on the proverbial desert island. After a month they are starving when a tin of beans washes up. The physicist suggests: “if we light a bonfire beneath it, the tin will expand and explode.” The mathematician adds: “and I can calculate the trajectory of each bean so we can collect them..”. They both turn to the economist who thinks and then contributes to the debate: “Assume we had a tin-opener..”

I consider economics to be “headology”: The study of what people believe to be real, understanding the psychology of crowd behaviour – which more often than not results in what they actually need, rather than what they think they want. It’s a voting process. (I nicked the idea from Terry Prachett’s Discworld Novels, but it works as well as any other economic tract…)

Going back to this morning’s story…

Understanding economics is useful, but if you want to know what markets are going to do, or how they will react – headology and the psychology of crowds are better. Learn to balance economic orthodoxy versus irrational markets. At the moment, it’s pretty clear the jury is out on inflation as the US 10-year bond yield has fallen from 1.70% to 1.49% in just a few weeks. We will know more from today’s US inflation data.

The bank economist ticking me off cited a recent Centre for the Study of Financial Innovation “is inflation really dead” You-Tube debate staring Tim Congdon and others on inflation as his base. (To be fair – the marvellous Bronwyn Curtis came over best – but I would say that, having known her for years!)

Congdon is the ayatollah of money supply purists – his Talibanesque approach to the veracity of historical data “conclusively demonstrates the phenomenal increase in broad money we’ve seen over the past 18 months to combat the pandemic can only result in much higher inflation”, or words to that effect. You can’t argue with him – no, seriously, you can’t… More to the point, Congdon expects the current inflationary spike that’s already nailed on will likely remain a medium-term shock for 2-3 years with 5-10% inflation, whatever the underlying state of the global economy in terms of scaling back spending, tapering, supply shocks, trade tensions, politics and changing economies.

Except… this time – the world is different. It’s all about consequences and how these effect the long-term. Consequences….

The economic consequences of the Great Financial Crisis of 2008 are legion. There are so many triggers: the regulatory kickback to ensure it never happened again, the monetary policy experimentation that followed the immediate crisis, QE, distorted artificially low interest rates, and now the swing towards fiscal policy solutions including furloughs and financial carpet bombing corporates with money. Each of these triggers a whole wave of primary, secondary and tertiary conseqences. It has created a financial ecosystem like we’ve never seen or had to understand before.

After 2008 central bank balance sheets ballooned as a result of QE and interest rate control – but we saw zero inflation in the real economy. All the inflation has been confined to financial assets – bonds, stocks and shares, which as we are all aware have seen spectacular rallies over the last 10 years despite the dismal shape of the global economy. These gains have been entirely fuelled by QE and ultralow accommodative rate policy.

Whoopee for markets… but not so good for the real money. (Money supply economists will no doubt argue that central bank balance sheets are not broad money… just like New Monetary Theory supporters suggest money invested by government in the economy can effectively be free and costless.)

Somewhere in the middle is headology – understanding the reality.

In terms of markets – they are now addicted to all that money from QE and now the cash that has flowed into them from pandemic support programmes. The massive and unconstrained inflation in financial assets continues to be where most of new money created by central banks and government fiscal policy has gone!

As I said, there will be consequences.. Consequences include rising financial inequality as the rich rentier classes get richer, and the poor become relatively poorer – consequences beget consequences. We will come back to that particular one of my consequences later…

Monetarists are so sure of the monetary phenomenon of inflation – but do they take account of the complex transmission mechanisms and the behaviours the unique set of circumstances currently in play have created?

For instance, banks created the last crisis, but were reined back from further lending with harsh capital requirements which has converted them from lenders to little more than brokers. Risk now lies in the investment sector – where goals vary according to investor type – some want volatility, some want predictable income flows, some fear inflation, some don’t.

The very clever investment types running these funds – where all that money is now concentrated – aren’t particularly concerned about how the global economy performs. They are invested to generate gains – whether its from growth, from recession, inflation or whatever occurs. Unlike banks, which had a vested interest in their clients remaining solvent, today’s funds are concerned solely with remaining wealthy themselves. They don’t care about economies – whatever guff their PR departments spout about CSR and ESG.

Cheap money has distorted capital markets – anything with a return is now a possible investment. Corporates with fractured balance sheets find it easy to borrow, persuading them to borrow more, which they realise is most effectively employed buying back their own stock… consequences, consequences.

All that money tied up in financial assets – what happens if it was circulating in the economy? The simple equation is that a little inflation is ok. As long as the rate of monetary creation is around the same as the rate of GDP growth – what’s to worry about? But if monetary creation has doubled over 18 months, GDP has stayed flat to negative, but stock markets have doubled – well… think about it… is all that inflation now bounded in these financial assets?

So… what will happen if, as many now expect, central banks decide the time to normalise, to taper excessively low interest rates, has arrived? All that money currently invested in financial assets in search of yield suddenly decides it’s time to go elsewhere? Into alternatives, property, real assets? There is now so much money sluicing around the financial system it’s difficult to see where it can possibly go?

Let’s assume the monetarists are right… that money now does cause an inflation spike.. Will it be corrected by an austere return to balanced budgets and taper? No chance.

This is where it might get really nasty.

As I’ve pointed out, all that corporate money raised from cheap markets was not invested for growth. The dominant spending theme of corporates these last 10-years was not building new factories or creating jobs, but stock buy-backs. These firms are now highly levered and struggling with debt overload.

Nor is the reality of the pandemic yet apparent. The rosy predictions are that vaccination success has created a perfect V-shaped recovery. The reality is very different – firms struggling to survive. This morning it was a fifth of UK hospitality businesses likely to go bust by Christmas. Thousands of small firms are struggling – that is bound to have real multiplier effects.

Putting it all together, the worst-case outcome is not inflation …. ITS STAGFLATION.

It’s going to require an enormous and ongoing government response if economies are going to be held together. If I’m right, then the outlook gets more perilous because of the massive increase in wealth and income inequality. What millennial unable to find a job, buy a house, raise a family is going to vote for the status quo if the future gets bleaker?

I suspect we are only at the start of decades of continuing central bank monetary distortion and government fiscal spending to keep economies on some kind of level keel. Sure, we might see modest taper – but it will be replaced by ongoing fiscal spending, raising all the issues about the sustainability of government debt that gets the financial libertarians so upset.

This is going to get noisy…. and very messy…

Five Things To Read This Morning

FT – Down and Out in Chinese Tech

FT – Bonds rally on both sides ahead of US inflation data

WSJ – China Tempers Climate Change Efforts After Economic Officials Limit Scope

Bberg – JPMorgan Sees Signal of Coming Bear Market in Bitcoin

Bberg – Did Tesla Sell Bitcoin? It’s China Sales are a Clue

No Porridge this Friday or Monday – moving back into our house, so taking a few days off..

Out of time and back to the day job,

Bill Blain

Shard Capital