We’re not sure whether to call it a guest editorial or a soapbox, but in either case we’re handing plugged-in reader Satchel the mike.
Thanks for the questions regarding how I can be predicting deflation when everyone else seems to be saying inflation (and some price measures are pointing that way). It does seem contradictory, but it’s really pretty straightforward when you take it step by step. Apologies to anyone who finds this pedantic or useless. And of course for some of you this will be very obvious. But maybe some of you would find this interesting? As usual, it is long…
First, real wealth is not the same as monetary value (prices). Real wealth (sometimes called real assets) consists of things like real estate, useful goods (like, say, a nice handmade guitar or maybe a store of grain) and control of the factors of production (people typically think equities, but it’s really much broader – intellectual capital, the ability of a mother to teach her young children in their earliest years, small unlisted businesses, etc.). Most real assets are assigned a monetary value or price, especially if they are to be exchanged. This is obvious with real estate or equity prices. But think out of the box. Think about how people sometimes say, “I need to monetize my idea” or “monetize my time”. Wealth is a pretty broad concept.
Real wealth grows slowly, and is correlated with productivity growth, which is a small number, and, although the tech guys will not like to hear this, is actually today lower than pre-WWII. Lots of debate, and no real reason to go into it here, but suffice it to say, we’re talking gains of roughly 1-2% per year per capita. So, real wealth grows slowly, and if too much government gets in the way, it can turn negative (think USSR post- about 1980). (Please guys, don’t tell me about the recent uptrend in trend productivity. I’ve seen the NY Fed data – they’re wrong as far as I can tell, because they’re derived from a deflator that is understated; I guess this is arcane, but for those of you who understand this, you’ll also understand why the government has a systematic bias in favor of understating price inflation measures for obvious reasons.)
In a fiat system, money is debt. Simple as that. Money is literally borrowed into existence. Think about when you buy a house in SF in 1999. Its monetary value then was $1MM. In 2005, say, its monetary value is $2MM. The real value (or wealth) inherent in the house has not increased (technically, there is a slight increase or decrease, but people are already complaining about the bandwith I use, so forgive me if I skip that wrinkle) because it is the SAME house. Same utility. Same wealth. Same real value.
Now, if you borrow $500,000K against it, you get money. Where did that money come from? It was borrowed into existence. That’s how it works. In the old days, before Dr. Greedscam, the amount of borrowing available was limited by reserve requirements, so that the Fed could control the rate of growth, at least somewhat (not that they really did). Following 1991, these limits gradually disappeared, as securitization took hold. In its most extreme and current iteration, one could literally create money out of nothing. All you needed was a willing investor (hello silly Asian savers and Eurosclerotics) in a SIV (or conduit, or ABS tranche, or CDO, or CLO, get the picture?), and you could always find a willing American Debt-Serf. By now the fed had basically relinquished all control over borrowing, especially as it was unwilling to disappoint the masses who were increasingly tricked into thinking debt was wealth (and this confusion was a very happy happenstance for the banks and corporations BTW). Nominal debt (and derivatives) EXPLODED – literally into the hundreds of trillions of dollars, although some of these net against each other. Wall Street siphoned off a little bit every time they created one of these things, then took a little more every time they traded, and for good measure even bought them and traded against the infinitely less sophisticated public officials, pension funds, money market funds and, yes, even homebuyers (through excessive fees siphoned off by brokers, re agents, etc). It was literally a slaughter.
Following the example, after you create the $500K of money, you are no more wealthy. This is important. You have exchanged your future earnings (with interest of course) for the newly-created money. In other words, you have exchanged part of your FUTURE wealth (your earnings power and productive capacity or your ability to consume in the future) for current wealth. (You might sometimes hear people throw around the term “Riccardian equivalence” which is basically this idea.) There is an illusion of increased wealth, because of all the money flying around, but wealth is the same on a net basis (across time), increasing slowly as it does. Actually, you take a hit to your wealth – LOL! That’s why all the hedge fund guys are buying yachts and mansions!! – but you won’t realize that until later, if ever. Where do you think Wall Street got all the hundreds of billions in bonuses in the last 6 years while equity markets returned approximately 0% (excluding the fraudulently small dividends received)? Now that return was for the broad S&P. If you happened to be invested in tech stocks generally…..well, you know it was a(nother) slaughter. Hmmm, BTW, where did all that money go?? I’ll let you figure that out, but I’ll give you a hint – drive around Atherton or, even better, Greenwich, Connecticut for some clues…..
Back to your questions now. I think your confusion about inflation is that you are only thinking about it as prices. Think of it as money (credit) supply. As the credit supply is expanded (through borrowing) it is inflated. As it contracts, it deflates. Inflation/deflation. That’s it.
But think about the effect on monetary values (prices) of things when credit inflates. The extra money created “chases” some asset prices and goods/services up. Generally, these items are what amateur trader/economists call “houses and haircuts” – that is, fixed assets and services that cannot be arbitraged. You can’t get a haircut from China. You can’t get a house from China. And you can’t eat out at a restaurant in China on a Staurday night and still be home for bedtime. So that created money tends to flow here, raising prices for houses, haircuts and restaurant meals. For things that you can get from China, well, you know the story. Price deflation, which is what you would expect because as productivity rises things become cheaper to make (in real terms).
There’s no real reason prices should go up in the aggregate, absent credit creation. In fact, before we had a fiat money system (basically prior to 1913), you might be surprised to learn that a house in 1780 cost basically the same as it did in 1900! Imagine that. Real estate didn’t go up over a 120 year period!! Well, of course that makes sense, because the REAL VALUE doesn’t really change too much. It never does, not even today. (This is of course super oversimplified, but you get the idea.) Incidentally, over this period, living standards and real income increased dramatically, as many prices fell (through increased productivity), freeing people up to enjoy the fruits of their increased productivity.
Sometimes when credit is expanded recklessly, and under apparent mass psychology conditions that no one can really figure out, the public’s attention is turned to a particular asset or asset class. It could be tulips in Holland, could be land in Florida 1925-26, equities in the 1920s, railroad stocks in the 1840s, a crazy company that no one really could figure out what it was supposed to do (except somehow exchange stock for newly created government debt) in the 1720s England, the twin Japanese real estate and stock bubbles of the late 1980s, the NASDAQ in the late 1990s, or, most unfortunately for some of us, what looks to be the biggest bubble of them all, the (almost) global housing bubble. Although no one wants to admit that SF suffers from it, it would be strange for it to sit out the party, don’t you think, since it is usually on the cutting edge and all??
We’re getting to the good part. What happens when there is deflation? That is, when money/credit is destroyed? And what effects will this process likely have on asset prices, and can certain consumer prices (like food or oil, for instance) still rise in an environment like this, or its variant, what is often thought of as stagflation?
I’ll post more tomorrow. If anyone appreciates this at all, or wants me to absolutely stop, either way, put up a comment, and I’ll try to be a “people pleaser” – as I’m sure you can tell, something that does NOT come naturally to me!
Editor’s Note: We’re not all that interested in lowest common denominator thoughts, so please don’t worry about trying to be a “people pleaser” on this post. And as always, thank you for plugging in (and provoking thought).