The financial markets have displayed some volatility of late. The latest excuse was the on-shoring of the second case of China’s coronavirus in the U.S. And, no wonder, on a valuation basis, equities are at or near the highs of the dot-com era and similar to October 2018. Remember what happened next?
As I’ve written before, equity prices are fueled by excess money creation. That is now well recognized by market commentators, but, we are told not to worry because we see such monetary largesse from every major central bank in the world, and our Fed has demonstrated time and again that they will not tolerate too steep of a stock market “correction.” The excuse for the use of Quantitative Easing (QE) by all of the central banks is that there are looking to dig their economies out of deflation or disinflation and want to spark some semblance of inflation (where demand is just slightly higher than supply so that there is a strong employment market and wages are rising).
The problem is, as explained below, that such policies can’t generate that kind of inflation. Instead, we get asset inflation (financial assets and real estate), a type of inflation that isn’t officially recognized, and about which no one will complain. There are negative economic consequences of such inflation which are recognized, but the blame for those negative impacts is wrongly placed (also explained below).
Where Inflation Originates
Way back in the 1960s, the famous economist Milton Friedman wrote that “inflation is always and everywhere a monetary phenomenon,” meaning money printing causes it. Today, competing with Friedman’s pronouncement is a new theory, called Modern Monetary Theory (sometimes abbreviated as “MMT”). Likely we will be hearing a lot about this new theory in the upcoming election cycle. Its basic tenet is that governments can print as much money as they want to, and, as long as it doesn’t cause inflation, it’s okay. (So, trillion-dollar deficits at a time of full employment are okay if there isn’t any inflation!)
The problem really is one of definition. Today’s definition of “inflation” is simply too narrow. When the CPI (Consumer Price Index) and PPI (Producer Price Index) are flat or even down, the automatic conclusion drawn is “there is no inflation.”
What’s “Normal”
We live in an economic world where what is considered “normal” in today’s economy is what occurred in the post-WWII era, from about 1955 to 2008. When he first took the chairmanship of the Fed, Jerome Powell said he wanted to “normalize” interest rates. That was code for raising rates to levels that persisted in that post-WWII period. As you know, the equity markets threw a big fit, and the Fed has become a money printing machine ever since (with equity prices on a real tear).
That post-WWII era was characterized by a period of high levels of economic growth caused mainly by growing populations (baby-boomers) and aided by technology (first computers, then PCs, finally the internet). But, in today’s developed world, population growth is almost flat, and, in a few years, it will be negative (like it has been in Japan since 1990).
China’s One-Child Policy
As an interesting aside, China, for the past 30 years has been the world’s growth leader. But now, due to the short-sighted “one-child” policy, is now experiencing population stagnation and over the next couple of decades, will actually see negative population growth. In China, the retirement “system” is that the oldest male child (and his wife) take care of that male’s parents in their old age. During China’s “one-child” era (1980-2015; today it’s a “two-child” limit), most girl babies were aborted. Today’s working age population, up to 40 years of age, is becoming inadequate to sustain aggregate GDP growth. In addition, there aren’t enough women to marry!
Living With the Wrong Economic Model
In the post-WWII era, the worldwide model of economic health was the growth of aggregate GDP. And that model is alive today and adopted by almost all economists. But, as populations stagnate, and then decline, aggregate GDP becomes anemic (like Japan’s since 1990). The political, and much of the economic world (including markets) panic when aggregate GDP doesn’t grow (called “recession”) and policy makers today do the things they did in the post-WWII era, such as deficit spend and print money with the ultimate objective of making aggregate GDP grow.
The simple fact is that today’s economic world isn’t a continuation of post-WWII trends. It isn’t a hard concept to grasp that if GDP declines, but the population is declining at a faster rate, then while it is technically a “recession” in post-WWII lingo, GDP, per capita, is actually growing, and the ensuing policy panic is ill placed.
In the Letter to the Editor Section of the January 22, Wall Street Journal, Professor Kenneth Button of George Mason University commented that, while “GDP may have grown at a ‘blistering rate’ in the 1950s and 1960s, and much less in the first two decades of the 2000s,” if you look at GDP growth “in per capita terms to allow for population changes, the average annual rise in GDP per person was $505.1 in the first 20-year period and $626.5 in the second.” The policy panic that aggregate GDP growth is too slow is, simply stated, not only ill begotten, but actually makes the “wealth inequality” gap worse (see below).
The “No Inflation” Syndrome
The reason that we don’t see “inflation” is because we are in a new, slow, low or no growth era due to population stagnation. The result is overcapacity in most industries. This, along with technology and changing attitudes (the “Amazon Effect”) has caused traditional major retailers to close stores, and the malls and strip malls to have 10%+ vacancy rates. These are classic signs of overcapacity. Because of this, the world’s CPIs and PPIs are flat, and, due to a narrow definition, the overwhelming conclusion is that there is no “inflation.”
But wait! What about all that money that’s being printed. MMT thinks it’s okay. But Friedman would argue that it is pumping up the prices of something.
The Wealth Gap Widens
You hear the politicians complain about the fact that the gap between the rich and poor is widening. There is a measure of this called the “Gini Coefficient.” And, indeed, it indicates that wealth inequality is worsening with more and more assets concentrated into fewer and fewer hands. Some politicians will place the blame for this on the shoulders of those nasty large corporations which only care about profit. But, there is much more to this story.
Inflation Is Too Narrowly Defined
Friedman’s pronouncement that inflation is caused by excessive money printing is still true. The problem in today’s economics profession is that “inflation” is too narrowly defined; limited to the prices of goods and services, while asset price inflation is excluded. If inflation is defined to include asset prices, then it would be well recognized that, today, we have plenty of it. The money today that has been, and continues to be, created tries to accomplish the impossible (i.e., to raise the prices of goods where supply overwhelms demand). That money, instead, find its way into the financial economy. And here, who is going to complain about the inflation of rising equity prices?
There Are Negative Impacts
Since the Financial Crisis, there has been a huge growth in government and corporate debt (deficit spending and corporate stock buybacks), record high PE ratios in the equity markets, miniscule interest rates for savers, and unaffordable housing prices for a significant sector of the working population.
Another aside: Working families are all but priced out of the single-family market in many major metropolitan areas, and there is now a boom in the construction of multi-family units, because that is what is affordable. In addition, we see significant speculative investment in the single-family space for the purpose of renting them out.
Conclusions
Today’s asset inflation and widening income inequality gap are caused by excessive government budget deficits (monetized by the Fed), and by the harebrained idea that money printing via QE and protecting equity prices would somehow “trickle down.”
Robert Barone, Ph.D. is a Georgetown educated economist. He is a financial advisor at Four Star Wealth Advisors. www.fourstarwealth.com. He is nationally known for his writings and Robert’s storied career includes his having served as a Professor of Finance, a community bank CEO, and a Director and Chairman of the Federal Home Loan Bank of San Francisco. Robert is currently a Director of CSAA Insurance Company (the AAA brand) where he chairs the Finance and Investment Committee. Robert is the co-portfolio manager of the UVA Unconstrained Medium-Term Fixed Income ETF (FFIU).