“Inflation is a disease of money…thus inflation may have become the oldest form of government finance. It may also have been the oldest form of a political confidence game used by leaders to exact tribute from constituents, older even than taxes, and inflation has kept those honored places in human affairs to this day….For four thousand years of recorded history, man has known inflation.” –Jens O. Parsson, Dying of Money
Life as we know it will never be the same. Travel, vacation, shopping, sports, social interaction will all change as we go forward and the threat of coronavirus recedes over time. We will not be going back to the way things were before the pandemic swept the globe. The pandemic has accelerated trends that were already in place before the breakout of the virus appeared on the global stage.
Supply chains will be reoriented and become more local to the markets they serve. The risk of concentrating all manufacturing in one country like China has been exposed with severe consequences. Essential protective equipment is made in China along with a long list of pharmaceutical drugs and vaccines, which presents a problem when all nations are seeking to obtain the same goods made in only one location. Online retailing will now accelerate at an even faster pace and many brick and mortar stores will disappear or morph into online retail in order to survive. There will be fewer stores and they will be smaller in size outside the big box stores who have already made the transition to online orders. Many of the country’s shopping malls will simply disappear or be converted to other purposes. Think universities or trade schools.
Social interaction will also change. Large events such as basketball or football games may be watched more indoors along with musical concerts. Home gardening may come back in vogue. Restaurants may be more spacious inside, less crowded and do more business online and in takeout. Online education will accelerate and many brick and mortar schools may fail or apply for subsidies and a government bailout.
Social interactions will also change from public displays of affection, handshakes and hugs, to a kiss on the cheek. In person events will still be rare. Instead of asking “Is there a reason to do this online?” We’ll be asking, “Is there any good reason to do this in person?”
As a society, we will become more skeptical and distrustful of the news and our leaders. The wearing of masks is a present example. First we were told we shouldn’t wear them as they were unnecessary—though extremely necessary for healthcare workers. If there is one piece of medical advice to protect yourself from COVID-19, it is to wear a mask when going out in public.
The coverage of COVID-19 by the media has been appalling and strewn with misinformation with an agenda far more interested in engendering panic than informing the public to echoing the sentiments of Chinese propaganda. How else can you explain the hoarding of toilet paper in defense of a respiratory disease? Just imagine media coverage of a gastrointestinal virus. The stores would have a run on nasal sprays.
Another change that will accelerate during the pandemic is the return of big government. Government powers will expand and become more intrusive in our lives, regulate much of what we are able to do, from business practices to social interaction. Just consider the power to shut down the economy from restaurants to bars, to being quarantined to our homes.
We are already seeing this in the extraordinary measures taken by the Federal Reserve mentioned in my last letter, to the recently passed $2.2 trillion stimulus bill. Stimulus is really the wrong word to use here as it is more of a measure to fill the vast hole blown through the economy by quarantine and business shutdowns. Congress is already working on another stimulus bill which may also involve trillions of new spending by the time we get to stimulus two and three. We have seen drastic edicts issued by governors to mayors threatening anyone that doesn’t comply with arrest even as they release prisoners from jail. It is the consequence of this new expansion of power that I would like to address now.
Even before the pandemic, the stage was set for vast amounts of new government spending programs. Prior to the pandemic, the economy was growing at a healthy clip and unemployment was at the lowest point in over six decades. Despite good economic numbers, the budget deficit for fiscal year 2020 ending in September was coming in at over a trillion dollars. Now that deficit will be in the range of multiple trillions. The philosophical or academic justification for this is MMT (Modern Monetary Theory). The tenets of MMT are a government that issues its own money:
- Can pay for goods, services and financial assets without the need to collect taxes
- Can’t be forced to default on debt denominated in its own currency
- Is only limited in money creation by inflation
- Can control demand-pull inflation by taxation and bond issuance
- Does not have to compete with the private sector for scarce savings by issuing bonds
This economic philosophy has been advocated by academics in universities that have no understanding of inflation and has now been embraced by both parties. Among all this talk about spending money, do you hear any talk or worry about deficits? There are no more deficit hawks and if there are, they’re rare and hibernating.
Now, let’s move on to the inflationary aspects of how this unfolds. For that, some forbearance is necessary as a bit of background is required. To begin with, we are truly living in historical times. Interest rates have never been this low in 5,000 years of recorded human history.
Interest rates were as high as 20% during Babylonian times, a brief period in the late 70s and early 80s but averaged between 3-6% throughout much of history. In times of war or during a period of inflation as under the Romans they got as high as 12%, but 3-6% was the average norm throughout the ages. Interest rates on sovereign debt are lower today than the depths of the financial crisis as shown in the table below.
Global 10-Year Interest Rates
It is not as bad for savers or investors in the U.S., but still pretty dismal if you are looking for income, and if you are looking to park cash, it will cost you money to do so with short-term T-Bills (last week 3- and 6-month T-Bills were negative).
US Treasury Yields
To put this in perspective for those who are flocking into cash, if you put a million dollars into a three-month T-Bill you’ll earn $640 of income on your million-dollar investment. A one-year bill will earn a measly $1,880 and a 10-year note $6,650.
By contrast, in the year 2000 you could have received anywhere between $60,000 and $65,000 in safe Treasury investments. During the bursting of the tech bubble in 2000 I had our clients invested in sovereign bonds of Europe, Canada and Australia earning 4-5% in interest. Today investments in France, Germany and Switzerland are guaranteed to lose you money anywhere from 0.25-0.50% in contrast to the 4-5% returns I could get in 2000. Even before the financial crisis, it was possible to get 4-5% returns on Treasury securities—not anymore.
So why have interest rates fallen this low? Very simple, as shown in the two graphs from the Federal Reserve of St. Louis. The nation’s debt has been compounding and growing exponentially. Debt is now growing at levels faster than economic growth and at a faster pace than income. It is now necessary to keep interest rates muted and low in order to sustain debt or the whole financial system would implode.
A final graph will put this into perspective of how far we have come since the recession of 1981 when interest rates peaked.
As debt compounds at a rate of multiple trillions per year, we will soon arrive at a national debt of $30 trillion. If interest rates were to normalize at historical rates between 5-6%, annual interest on that debt would run between $1.5-$1.8 trillion per year or roughly half of the government’s annual budget. The government will deploy a strategy of financial repression—the artificial suppression of interest rates by the Federal Reserve—put in place after WWII when debt loads grew to 250-300% of GDP.
But that won’t be the end of the story. A debt resolution will be necessary because this strategy won’t work forever. Sovereign nations have three ways of resolving their debt issues:
- Pay it down
- Default
- Inflate it away
Throughout history, governments from Egyptian pharaohs, Roman emperors, kings, prime ministers and presidents have chosen the inflation way out. President Roosevelt devalued the currency after confiscating gold from citizens before he devalued the dollar by raising the price of gold from $20 an ounce to $35 an ounce until President Nixon devalued the currency again in August of 1971 by removing gold backing of the greenback. The age of deficits and debt compounding in the U.S. had begun, and now it’s in the process of accelerating.
In the not too distant future, an American president will have no other choice but to devalue the currency as a means of debt forbearance. He or she will have no choice. Interest payments will be too large, and taxes will not be sufficient to pay interest. It will be declared as a debt jubilee in the same way Nixon defaulted on gold backing of the dollar. At this point, a devaluation of the dollar is baked into the cake as it has not become a question of “if” but “when.” It is simply math at this point. You cannot have the level of debt growing at twice the rate of income and GDP growth. Mathematically that is impossible, so devaluation lies ahead in our future. One day you will wake up and it be will be done by executive fiat. The money you own in either cash or fixed investments will be worth half or one-quarter of their value than the day before. It will be that quick and sudden.
I saw this firsthand in the early 1980s with Mexico. As the Fed began to aggressively cut interest rates in the US, I saw clients put their money in Mexican banks because they could obtain 30% interest on their CDs. Mexico’s President, Miguel de La Madrid Hurtado devalued the currency overnight without warning and the value of those CDs in American dollars was immediately cut in half. That is the way devaluations occur. They come without warning and with immediate consequences.
If you would like to see what this might look like I highly recommend reading the book The Mandibles: A Family, 2029-2047, by New York Times best-selling author Lionel Shriver who I interviewed on our podcast September 17, 2016.
Now let’s move on to the inflation part. The inflation formula is as follows:
More money + fewer goods and services = inflation
I will have more to say about this in future articles as I have dusted off my writing pen and will be returning again after a long absence from writing. Forgive the digression and back to the inflation stuff. We already know about the more money part as shown below. The Fed’s balance sheet is growing exponentially and, at the present rate, will be ballooning to $10 trillion shortly as they backstopped just about everything from government deficits and bonds, to corporate debt and ETFs, money market funds, commercial paper, to direct loans to business. That is the money part.
Federal Reserve Balance Sheet
The goods and services part is unfolding before our eyes as supply chain disruptions from China are already wreaking havoc with companies’ abilities to produce goods from Apple to GM. The service industry has been furloughed and many businesses will go under and not return as a result of the virus shutdown by government. Who will replace the workers who have been laid off, furloughed or simply not return? Many companies like Amazon, Walmart and Target need to hire more than 500,000 workers but must now compete with unemployment insurance. If these companies want to compete, they will be forced to raise wages even higher which is inflationary.
Many are wondering why there will be inflation now when it wasn’t around in the last financial crisis with many of the same tactics in use. The difference is the monetization of fiscal policy. During the financial crisis, much of the money the Fed created remained on the balance sheet of the Fed, earning interest as banks rebuilt their balance sheets. The money did not enter the economy in the form of credit. It stayed at the Fed. Had it been lent out, it would have multiplied, creating more demand for goods and services which would have been inflationary.
You have heard that this economic recovery has been anemic both under the Trump and Obama administrations. The reason is that household debt was at historical levels and many families and individuals were unable to borrow during the early stages of the recovery. Most of them were leveraged to the hilt and upside down on their mortgages. The real inflation took place in financial assets which rose nearly 450%. Money poured into stocks and bonds and both inflated.
The price of gold is already sniffing out the inflationary wave that lies ahead. But first comes the whiff of deflation. In downturns, especially economic ones in the economy or financial markets, it creates a whiff of deflation as prices fall and the economy contracts as it’s currently doing. Then comes the government response which is unfolding and is growing exponentially from both a fiscal and monetary perspective. The Fed issued multiple salvos from its monetary bazookas as highlighted in my last letter. We just got MOAB (the mother of all stimulus bombs), with a sequence of more bombs and helicopter money drops still to come.
What does this mean for investors? There will be no sources of guaranteed income. T-Bill rates may go negative as they briefly did last week and as they have globally. Money market funds and CDs will drop to near zero. Bond yields will also drop unless you do what we’re doing: waiting for panic selling and picking up bargains. We’ve done this in individual bonds, stocks and discounted ETFs. But as inflation picks up, it’ll be necessary to switch over to hard assets and currencies if there are any left. This is what we did in the last decade when we rode the precious metals and commodity boom. It will return again as smart money leaves paper assets and shifts to hard assets. It is one reason we have returned to gold after a long hiatus since late 2011. This also means real estate, raw materials, agriculture and companies that have strong monopolistic pricing power, strong balance sheets and competitive moats—as many of our dividend aristocrats in our portfolio do.
I want to end with a graph of the devaluations and stock markets of Argentina to illustrate my point of what happens when a government devalues its currency. The stock market rises in the same terms of the inflation rates while the value of the currency falls. The following graph shows the stock market rising as much as the currency devalues. The graph below can be replicated in other countries that have devalued their currency as well from Brazil, Russia and Turkey.
Perhaps no better example of this was the Weimar Germany inflation in the 1920s following WWI as shown in the graph below.
The rich and wealthy protect themselves from the forces of inflation by investing their wealth in stocks, real estate or their own companies (stocks like Amazon and Microsoft). Listed below are the top ten richest Americans.
Let us not forget our current president who made his fortune in real estate. I would challenge my readers to find anyone on the list of Forbes richest Americans who got there by investing in T-Bills, CDs, or money market funds.
I will close with my favorite quote on inflation from the book Dying of Money, by Jens O. Parsson. Jens O. Parsson was his nom de plume as his real name was Ronald Marcks. I had the privilege of interviewing the author in August of 2013 after learning his real name.
“Everyone loves an early inflation. The effects at the beginning of an inflation are all good. There is steepened money expansion, rising government spending, increased government budget deficits, booming stock markets, and general prosperity, all in the midst of temporarily stable prices. Everyone benefits, and no one pays. That is the early part of the cycle. In the later inflation, on the other hand, the effects are all bad. The government may readily increase the money inflation in order to stave off the later effects, but the later effects patiently wait. In the terminal inflation, there is faltering prosperity, tightness of money, falling stock markets, rising taxes, still larger government deficits, and still roaring money expansion, now accompanied by soaring prices and the ineffectiveness of all traditional remedies. Everyone pays and no one benefits. That is the full cycle of every inflation.” –Jens O. Parsson, Dying of Money
I will have more to say about the inflation that’s building up in the pipeline and is ready to catch the markets by surprise. Until then, stay safe and wear a mask, even a makeshift one when going out in public.
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