We May Be At The Starting Point Of An ‘Inflationary Depression’

by Shanmuganathan Nagasundaram - Jun 24, 2021 12:30 PM +05:30 IST
We May Be At The Starting Point Of An ‘Inflationary Depression’US dollar.
  • What lies in the decade ahead for many of the Western economies and indeed most parts of the world is a prolonged period of high inflation combined with an economic depression.

    But the sleight of hand indulged in by central banks allows them to under-report consumer price inflation, allowing them to hide the reality for a few more months.

It is an acknowledged fact within the circle of economists belonging to the Austrian school that central banks have to continuously rely on and actively indulge in ‘voodoo economics’ to hide the extreme imbalances that they have created in the world economy.

What lies in the decade ahead for many of the Western economies and indeed most parts of the world is a prolonged period of high inflation combined with an economic depression. I should add that if one were to account for inflation correctly even today, we are probably in a stagflation (inflation and recession) already in most parts of the world.

But the sleight of hand indulged in by central banks allows them to under-report consumer price inflation (CPI), allowing them to hide the reality for a few more months.

If we draw a comparison between the stagflationary seventies (the 1970s, when gold went from $35 to $850 an ounce, oil from $3 to $40 per barrel etc) and what lies ahead, it’s almost a given at this point that inflation is going to be substantially higher than what we had in the 1970s and the economic recessions much deeper.

Before I proceed further, it would be useful to clarify the term ‘depression’ used above. Most economists confuse depression with deflation. These are two different economic phenomena — the former refers to the condition of gross domestic product (GDP) growth and the latter refers to a monetary phenomenon.

Depression denotes a prolonged period of rapid economic declines and a steep fall in the living standards of most people. It primarily refers to GDP growth that is negative by a substantial degree over a period of at least a few years. Deflation, on the other hand, is a monetary phenomenon that refers to a condition of falling prices of consumer goods.

Depressions can be either deflationary or inflationary — in fact, more often than not, most depressions are inflationary. The Great Depression of the 1930s was deflationary and the one we are living in the early stages of is going to be inflationary.

Does Deflation Lead To Depressions?

Most economists think that the Great Depression of the 1930s was caused by deflation and this is a myth that has entirely been propagated by the US Federal Reserve.

As Murray Rothbard explains in his book America’s Great Depression, deflation (or falling prices) made the depression a lot more tolerable than would otherwise have been the case. The entire century before the formation of the US Fed (from 1815 to 1914), when the US was on the classical gold standard, was deflationary.

This was the period in which the US economy transitioned from a primitive agrarian society to the world’s leading economic powerhouse with an estimated CAGR (compounded annual growth rate) of more than 4 per cent (with real growth being even higher due to falling prices) for a century.

If deflations result in a depression, the US ought to have been a basket case with a century of deflation leading upto 1914.

Ironically, with more than a century of inflation since then, courtesy, the US Fed, the US economy is indeed a basket case today and the unravelling of the currency and the economy when it happens in the years ahead will be swift and decisive.

Now that a very basic but important distinction has been made, we can expand the theme of the inflationary depression ahead.

So How Did We Reach This Precipice?

Well, for the world to have reached such a precarious situation as I have painted above, the problems have to be deep-rooted, fundamental and long standing. That is indeed the case and as Ludwig von Mises said during 1951, the origins can predictably be traced to the central banks.

“There is nowadays a very reprehensible, even dangerous, semantic confusion that makes it extremely difficult for the non-expert to grasp the true state of affairs. Inflation, as this term was always used everywhere and especially in this country (the United States), means increasing the quantity of money and bank notes in circulation and the quantity of bank deposits subject to check.

“But people today use the term ‘inflation’ to refer to the phenomenon that is an inevitable consequence of inflation, that is the tendency of all prices and wage rates to rise. The result of this deplorable confusion is that there is no term left to signify the cause of this rise in prices and wages.

“There is no longer any word available to signify the phenomenon that has been, up to now, called inflation. It follows that nobody cares about inflation in the traditional sense of the term. As you cannot talk about something that has no name, you cannot fight it. Those who pretend to fight inflation are in fact only fighting what is the inevitable consequence of inflation, rising prices. Their ventures are doomed to failure because they do not attack the root of the evil.”

What Mises indeed rued above is what is commonly referred as the phenomenon where “inflation is too much money chasing too few goods”. Or as Milton Friedman said, “Inflation is, and everywhere, a monetary phenomenon”. What

Mises spoke of in 1951, today is ubiquitous. It would be almost impossible to spot a single economic commentator (other than the handful of Austrian economists) who would distinguish the cause from the effects when talking about inflation.

To add insult to injury, most mainstream economic commentators believe that consumer price inflation is caused by growth and that ‘some’ inflation is indeed good, desirable or required for economic progress.

The above US Fed propaganda of that witchcraft called Keynesian economics has indeed been extraordinarily successful — so much so that after a century, even they seem to believe in it themselves. The last US Fed chairman who understood the distinction between propaganda and truth was Alan Greenspan.

His essay, “Gold and Economic Freedom” still remains one of the best expositions written to date on this topic. The subsequent ones have been thoroughbred Keynesians, who pretty much subscribe to the above ridiculous notion as revealed truth.

So, under the garb of promoting economic growth, we have just allowed central banks around the world to print money with impunity. This has long been the case since 1971 when the last linkage between gold and currency was removed.

After Richard Nixon closed the Gold Window ‘temporarily’ in 1971, central banks have had little reason to restrain themselves. But they have indeed gone berserk after 2008 — and even more so in the last year or two. Each transgression makes the erstwhile felony look like a misdemeanour.

We May Be At The Starting Point Of An ‘Inflationary Depression’

But Where Has All The Inflation, Since 2008, Gone?

Going forward we will use the phrase ‘monetary inflation’ to denote the cause and ‘consumer price inflation’ to denote the effects.

During the 1970s, the link between rising monetary inflation and increasing consumer prices was extremely well understood. The money supply growth figures that the US Fed used to publish on a weekly basis was one of the most keenly watched numbers and any abnormal increase in the Fed’s balance-sheet would invite a strong rebuke from ‘bond vigilantes’ who used to send stocks and bonds lower.

It is astonishing to see how basic finance and economics has been reshaped in a diabolical way in just a few decades. Very few commentators and even economists understand the correlation these days.

Even more ironical is the belief that negative GDP growth or unemployment report is good for stocks and bonds as the Fed would then expand its balance sheet via quantitative easing (QE) to suppress yields.

This thinking is almost as perverse as ‘Tulipmania’ and though it has survived longer than the average asset bubble, the days of such ‘voodoo economics’ are numbered and we are now in the early stages of the unravelling of the epic ‘Fed bubble’.

Let us return to the question posed above: Where has all this ‘monetary inflation’ gone, especially since the trend of massive monetary inflation since 2008?

We May Be At The Starting Point Of An ‘Inflationary Depression’

As readers can see, there has been a significant divergence between monetary inflation and consumer price inflation since the Great Recession of 2008. How do we explain this?

The CPI number reported is a process of self-appraisal by central banks and so they have a strong motive to underreport the actual numbers. There is no conspiracy theory in this but the way CPI calculations have evolved since the 1970s using substitution, hedonic adjustments, owner’s equivalent rent, etc, ensures that there is an in-built bias towards under-reporting of numbers.

There are number of economists who calculate CPI using the same methodology as was done during the 1970s (John William of Shadow Statistics, for example) and those numbers show inflation in high single-digits or low double-digits, which would be consistent with the monetary inflation that we have observed.

But there is a far more important reason — one that Austrian economists refer to as the “Cantillon Effect”. What this essentially means is that money supply growth will cause the price of different assets to go up in different proportions.

Indeed, it is even possible during times of even relatively high money supply growth for one category of assets to go up while the others go down, not only in relative terms but in nominal terms as well.

What this Cantillon Effect implies is that all of the monetary inflation has gone into financial assets — stocks, bonds, real estate, bitcoin, Nasdaq 2.0, etc — which do not show up in the CPI numbers.

In fact, any rational investor who understands the basics can observe a sea of hyper bubbles in these asset classes that have been propped by artificially low interest rates.

The 10-year treasury that underlines the valuations of all of the above asset classes has been suppressed by the US Fed so much that there really is no basis for rationally valuing these assets any longer.

Courtesy, the US Fed, nominal interest rates are at a 5,000-year low and it is the inevitable increase in rates that will cause these bubbles to unwind.

We May Be At The Starting Point Of An ‘Inflationary Depression’

The only asset class that remains undervalued, almost by definition, is commodities. In fact, commodities in a relative sense, have never been cheaper in the last 100 years than they are today. So, virtually all the money printed has ended up driving the prices of all other asset classes to valuations hitherto unheard of.

So What Gives?

So, what has accompanied the high M2 growth since 2008 is the price of stocks, bonds and real estate. And what has gone down in relative terms are commodities. This largely explains why the CPI has stayed muted over the last decade. So, why can’t this situation continue for a few more years or another decade…?

In this epic battle between the US Fed and sound money (gold and silver), we crossed the rubicon when the CRB Index bottomed out in April 2020. Gold has always been a leading indicator and has been on an uptrend since early 2016. Since the index bottomed out more than a year ago, it is up more than 50 per cent, albeit from historically very low levels.

We May Be At The Starting Point Of An ‘Inflationary Depression’
Source: Stifel Report June 2020. Note: Shown as 10-yr rolling compound growth rate with polynomial trend at tops and bottoms. Blue dotted line illustrates a forecast estimation. Source: Warren & Pearson Commodity Index (1795-1912), WPI Commodities (1913-1925), equal-weighted (1/3rd ea.) PPI Energy, PPI Farm Products and PPI Metals (Ferrous and Non-Ferrous), ex-precious metals (1926-1956), Refinitiv Equal Weight (CCI) Index (1956-1994), and Refinitiv Core Commodity CRB Index (1994 to present).

All commodities — lumber steel, zinc, soybeans, corn, etc — are up significantly over the last year. While this is attributed to the Covid-induced supply reductions, the cause for all inflation is the same every time — an excess supply of money.

It is this increase in commodity prices that is causing the CPI in the US to levels of 5 per cent plus. An interesting observation would be that Richard Nixon, who closed the gold window, introduced wage and price controls when CPI crossed 4 per cent, never bothering to consider inflation’s possible ‘transitory nature’.

Forget the future monetary inflation, which I am sure will make the monetary expansions since 2019 look like another misdemeanor, but we have already created sufficient monetary inflation that guarantees a commodity uptrend for the next several years. This will ensure that the dream of the US Fed that these CPI increases are transitory remain just that — a dream.

In fact, I would not in the least be surprised if CPI doubles from the current 5 per cent plus to reach a double-digit number within a 12-18 month timeline.

Does The Fed Really Believe That CPI Is Transitory?

I don’t in the least believe that to be the case. What should the appropriate actions of the US Fed be if CPI is 5 per cent plus and showing an increasing trend on a month-on-month? In the normal scenario, the interest rate ought to be such that real interest rates are positive and that would imply an interest rate of at least 5 per cent.

But where is the interest rate today? Zero. Or very close to that. After more than eight years at near zero, when the US Fed under Jerome Powell tried to reverse course and increased it to 2.5 per cent over a three-year period (between 2016 and 2019), the junk bond pretty much froze and threatened to unravel the entire US financial system. Predictably, in very short order, Powell took it back to its original levels.

If the US Fed could not raise rates when the national debt was less than $20 trillion, what chances are there for a similar action when the debt is expected to cross $30 trillion in the next few months?

The threat of a market collapse that happened at a 2.5 per cent rate in 2019 will probably happen even at 1-1.25 per cent rate today.

The leverage in the system is so much higher than the probability of having positive real interest rates in the US for the foreseeable future is zero. There can be no two ways about it.

We May Be At The Starting Point Of An ‘Inflationary Depression’

Given that the US Fed cannot have interest rates at a level that will curtail monetary inflation, what can they do? The only option for them is to pretend that the current consumer price inflation (which is the end result of decades of monetary inflation) is transitory so that they need not embark on a course of action that is guaranteed to collapse the US stock, bond and real estate markets.

The End Game

As said, we are at the early stages of an inflationary depression in the US and something that will run for a decade if not longer. Given this, the dual mandate of the US Fed, ie, maximum employment and price stability, cannot be pursued any longer.

They will have to choose between controlling consumer price inflation with markedly higher interest rates and persisting with the illusion of a stable economy for a few more months with this artificially low interest rate regime.

Decades of artificially low interest rates have led to tremendous malinvestments in the US with excessive debt-fuelled consumption and very little of savings-led production. The only solution is put interest rates at high enough a level that will dramatically shrink the growth in money supply as well as reduce the national debt. That of course will immediately plunge the US economy into a massive recession.

Readers should remember that Paul Volcker did not put the US interest rates at 20 per cent-plus in the early 1980s for amusement or because he wanted the US to suffer a recession. That was the only choice in front of him at that stage — ie, to save the US dollar or prolonging malinvestments.

The choice is even more stark today. If the US Fed tries to prolong the bubble economy by maintaining these deeply negative real interest rates, it is going to end up destroying the US dollar.

That unfortunately is the most likely course of action for the US Fed as well. Predicting the exact timing of the US dollar crisis is fraught with danger. But given the imbalances, the size of the bubbles in the US economy and the rather early stages of the commodities bull market, I think we will witness the collapse before Joe Biden completes his term.

What About The Indian Economy?

The less said the better, I guess. When Nirmala Sitharaman and Shaktikanta Das occupied the positions of Finance Minister and RBI Governor — the two most critical positions from an economic perspective — I had some hope.

Both these people knew little about economics from an Austrian perspective, and were starting at ground zero. When you know little, there is a chance that you will look at the problems with an open mind. This could have led them to the altar of the Mises Institute.

But, instead, they have allowed the neo-Keynesians within these institutions to run on steroids and they have done the exact opposite of what they ought to be doing — ie, raising rates, encouraging savings, curtailing government expenditure, deregulating, etc.

If you think the Indian government bungled big time on Covid, just wait till we face the full consequences of the actions of our economic planners. The Covid missteps will appear like a misdemeanour.

Shanmuganathan N is the CIO at Plus43 Wealth Advisors. He can be contacted at shan@plus43capital.com.

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