Insights, The Bridge
Jason Hsu, PhDScroll down
For the past decade, many investors have been living in the Matrix. Buoyed by extensive quantitative easing and overseas production, their portfolios have ballooned. They believe in their illusory world, a place they have the ability to grow wealth unimpeded and without consequence. Unfortunately for them, this is the real world—and inflation is the blue pill.
Reality can be sobering. The Fed will attempt a soft landing, but I hold little near-term hope for today’s inflated asset prices. And although there are degrees of possible outcomes, none of them will feel good. But don’t despair! A return to the real world—a place where asset prices and value creation move together—is not so bad. In this article, I will try to explain why.
This is a challenging and nuanced topic. I’ve sought to be concise, but I’m also striving for more than superficial commentary. To make navigating this article easier, let me provide a brief outline:
I hope you will bear with me as I seek to do justice to this important topic. The real world can be challenging, it is true; it might feel painful to read this article. But please read to the end—there is reason for hope! Because at the end of the day, most people prefer real wealth to a simulation of riches.
Many investors don’t understand how “money printing” works and the channels through which it impacts our real economy. Printing money is simply the central bank (the Fed for the US) borrowing money from God (I say this tongue-in-cheek) to finance government spending and to inject cheap capital into our economy.
God is a unique lender; He offers generous sums with infinite repayment terms; you can borrow as much as you like for as long as you like. When the Fed borrows 1 trillion dollars from God, its balance sheet simply expands by a trillion. On the liability side, it now has a $1-trillion debt to God that it can pay back whenever it pleases. On the asset side, it now has cash that it can use to finance the government or inject cheap capital into financial institutions.
“In God we trust” isn’t just a motto on our dollar bills. Our monetary system is literally dependent on borrowing from this lender of last resort. It is the only way for government to finance things that no one else—banks, savers and taxpayers—is willing to back. When the Fed borrows money from God, we politely say, “the Fed is expanding its balance sheet.” When we pay back the debt to God, we call it shrinking the balance sheet. So, how much money have we been borrowing from God lately?
Looking at Chart 1, the Fed’s balance sheet has continued to expand since the Global Financial Crisis. It doubled from 2T to 4T during the quantitative easing (“QE”) of the Great Recession and again from 4T to 9T during the COVID crisis.
Note that the Fed’s QE is always in conjunction with interest rate cuts. The whole point of borrowing money from God is to inject artificially low-cost capital into the economy—to aggressively manipulate the natural working of a competitive economy, to push aside Adam Smith’s invisible hand in favor of the visible hand of the government. In this sense, the Fed’s balance sheet can be interpreted as a proxy for the level of intervention needed to manipulate capital markets to subsidize economic activity. (Note, it is either with great hypocrisy or ignorance that we Americans blast other countries for interfering with the market mechanism.)
To be fair, there is nothing inherently wrong with this Keynesian approach to “managing” the economy. The economy certainly does seem to suffer from consumer/investor overconfidence and manic depression as it traverses business cycles and deals with occasional black swan shocks. Printing money does not, on its own, lead to inflation. Inflation is only caused when that newly minted money is spent inefficiently.
So, how does the Fed spend the money it borrows from God? Well, the Fed can only do two things with newly printed money: 1) it can lend money to the government, and 2) it can lend money to banks (who in turn lend it to businesses and households).
Let’s start with government spending before examining quantitative easing. Many readers have probably heard of Milton Friedman’s “helicopter money” thought experiment. Friedman conceived a government-sponsored program to drop money from helicopters all over the country. At first, everyone celebrates. But as people begin spending their sudden windfall, they find prices gradually increasing. Friedman’s thought experiment led to the common expression that “printing money causes inflation.”
But this expression is not quite complete.
What Friedman’s illustration really shows is that prices will rise when wealth is created without a corresponding increase in production. This occurs because there is more money in the economy, but there aren’t more goods and services available for purchase. No one is better off from a nominal wealth increase precisely because real wealth does not change. Stated simply, the wealth increase is illusory. It isn’t real because real value has not been produced.
Inflation will always offset new wealth that isn’t accompanied by new production. This is why governments often spend to improve infrastructure (which helps reduce supply chain costs) or to increase funding for R&D (which improves productivity). When the Fed prints money to finance high ROI expenditures, it does not to lead to inflation.
On the other hand, when governments spend on unproductive projects—be they corrupt “pork” spending, unnecessary bureaucracy, or military aggressions—the spending tends to be inflationary. Insofar as we suspect government spending is generally inefficient, then the printing of money to finance the government will lead to inflation. The more inefficient (corrupt and wasteful) a government, the greater is the relationship between government spending and inflation.
In practice, government spending is rarely “free money” for all (the recent COVID crisis is a stark exception). Governments usually spend money in a more targeted way—and who those targets are has a big impact on inflation. For example, if the US spends trillions in foreign aid (e.g., money to Ukraine to defend against Putin, or to the World Bank to finance impoverished African countries) that expenditure won’t create inflation in the US. And if the government spends trillions to benefit the ultra-rich (cap gain tax reduction, tax holiday for repatriating offshore profits, estate tax reduction, etc.) this will also have little impact on CPI inflation. The top 1% are simply too few to impact broad consumption. Additionally, their consumption profiles are very different from the average; the likely outcome are price increases for fine art, private jets and other luxury goods.
But if the government prints new money and funnels it to Main Street America through public construction projects and increased government employment, it will create upward pressure on everyday goods and services on a broad scale. Therefore, to understand inflation and to manage it, we have to identify how and for whom is the government creating “nominal wealth.”
To understand inflation, it is also useful to be aware of the relationship between the increase in wealth and its resulting consumption growth. Recall that the Japanese government tried unsuccessfully to send free money to its citizens hoping to create inflation. Instead, Japanese households simply saved all the free money and exhibited no increased willingness to consume—as a result, no inflation was created.
It should now be clear that CPI inflation occurs when 1) Americans become nominally wealthier and increase consumption, and 2) there is no corresponding increase in the production of goods and services. To illustrate this point, if the US government printed $1 trillion dollars simply to repay debt to the Chinese government (the US actually does owe about $1 trillion to the Chinese) there would be no inflationary pressure in the US. Wealth effect, as it turns out, is the primary channel through which CPI inflation occurs.
By contrast, the 2020 and 2021 COVID relief funds are a textbook example of helicopter money. People received money specifically for not producing goods and services. All accounted for, the government distributed roughly $4 trillion dollars in relief funds to American households. That was certainly inflationary. What’s still unclear is the consumption impact of the government’s nominal wealth creation.
It’s not just government spending that we need to look at to understand inflation. From the start of 2019 to 2021, the aggregate net assets of the bottom 90% of American households increased from $30.5 trillion to $43 trillion dollars—an increase of $12.5 trillion. Thus, the $4 trillion dollars in helicopter money likely only accounts for one-quarter of the inflationary pressure.
But there is a second channel for inflationary wealth creation: quantitative easing. To fully understand all the factors driving the inflationary pressure in the US today, we must examine the Fed’s effort to flood the economy with cheap capital.
Injecting capital into the economy provides easier access to capital at a lower cost. It is this latter element—cheapness—that has the greatest impact on wealth creation.
There is an automatic inverse relationship between asset prices and cost of capital (also known as the discount rate). When the discount rates decline, all assets increase in value. For example, when mortgage rates decline, real estate prices go up. When investment funds are willing to provide funding at great terms—competing to invest billions into the likes of WeWork, SEA, Crypto.com, etc.—earnings multiples skyrocket. In the last three years, the Fed has blessed us with government-subsidized cheap capital, which has driven record high valuations for assets.
Charts 3 and 4 show the natural inverse relationship between changes in the Fed fund rate and the S&P 500 P/E ratio. The lower the discount rate, the higher the P/E ratio for the same stocks. Simply put, the Fed’s use of quantitative easing to artificially depress rates has yielded stock market wealth without creating correspondingly valuable goods and services. This is a critical point to understand our recent market cycle.
Because this point is so important, I’d like to expound further.
In equities investing, stock prices could increase because 1) cash flow has increased (i.e., the company has produced more goods and services that correspond to increased earnings per share); or 2) P/E multiple has expanded (i.e., the market is suddenly willing to pay a higher price for exactly the same business). Similarly, in real estate investing, property prices can increase because: 1) unit upgrades are leading to higher rents; or 2) mortgage rates for financing the property have declined. Low mortgage rates make even unreasonably priced rental properties “affordable!”
Investors should note the immortal words of Warren Buffett: A higher price does not necessarily reflect a higher value in the asset acquired. Notice that over the last 10 years, the US stock market P/E has more than doubled; it increased from about 15x to 38x at its height in 2021. Mathematically, this suggest that more than 50% of the increase in stock market wealth is driven by the willingness of speculative investors to pay more for the same asset (the second factor identified above); less than 50% of the increase is driven by growth in the underlying fundamentals (the first factor identified above).
When an economy’s asset prices are driven by declining cost of capital instead of improving cash flows, that is a textbook example of wealth increase without a corresponding increase in the production of valuable goods and services. The last round of money printing simply inflated asset prices by injecting of cheap capital into financial markets. This has led to record high property prices, bond prices and stock prices—all of which combined to create an enormous increase in household wealth.
In the last three years, rising asset prices have contributed to the top 10% of households increasing their net worth from 67.4 trillion to 99.2 trillion (47% increase) while the bottom 90% increased 30.5 trillion to 43 trillion (41% increase). This has in turn fueled a healthy increase in consumption as well as an increased people’s willingness to “not work” and just live off of investment gains. For comparison, GDP, which measures the production of goods and services, grew only by a cumulative 4.4% in real terms over that same time period.
Across the board, Americans all became a lot wealthier without producing more!
As we’ve just discussed, the primary source of our current inflation is the “inflation in asset prices” driven by Fed-subsidized low cost of capital. Thus, to undo inflation will require the Fed to undo the existing asset price bubble. While it might be hurtful to some, we must acknowledge that much of the stock market and real estate wealth from the last three years were not the product of workers and business operators; that growth has been a manifestation of the Federal Reserve. Prices for assets have gone up tremendously while their underlying value have not. As a result, that wealth will evaporate as the Fed hikes the cost of capital and takes back the easy liquidity that God has been providing.
So, what does that mean for our economy? The Fed is seeking a soft landing for the economy as it hikes rates to fight inflation. While avoiding a recession and the associated high unemployment are desirable, a massive equity bear market has already been triggered.
As I mentioned before, government-led wealth creation does not impact the population equally. Welfare transfers and government job creation generally creates wealth for the lower half of the population. However, massive wealth creation due to stock market and real estate valuation expansion driven by cheap capital—that disproportionally benefit the top 10%.
Since COVID, the top 10% increased their total wealth by $32 trillion (roughly $2.5 million per household) while the bottom 90% increased their wealth by $12.5 trillion (or $100 thousand per household). The rising wealth inequality driven by the Fed policy is thus less inflationary than one should assume. This is not helicopter money raining down on all. It is wealth creation for the already very wealthy. Thus, the price inflation for luxury consumption—rare collectibles, fine art, fine wine, luxury goods, private school tuition, liberal arts college tuition, high end concierge health services, etc. have far outpaced average consumption goods found in our CPI basket.
Can we manage inflation without the Fed taking back the wealth it created for property owners and equities investors? Is there another way? Can we take the red pill and stay in the Matrix?
You can contain price increases by reducing demand or increasing production. The first option—reducing demand—is painful. Demand growth comes from wealth growth, and destroying wealth by bloodying the stock market hurts like hell.
This is why, historically, the US has relied on the second option to relieve inflationary pressure—increasing production. The primary method to increase production has been to access cheap production through immigration (legal and illegal) or outsourcing to low cost-of-production economies—primarily manufacturing in China. A strong dollar policy, coupled with tremendous Chinese productivity increases, has been critical to keeping US CPI inflation in check. In the last 10 years, without China, the strong growth in US consumption would have long ago resulted in high inflation. COVID, which has shut down Chinese manufacturing and logistics, has simply reminded us just how critical a role China plays in relieving US inflationary pressure.
The role that Chinese manufacturing and shipping has played in controlling US inflation does not relieve the Fed of its responsibility. The Fed-induced increase in nominal wealth is at the heart of US inflationary pressure. I am merely noting that, this time around, we don’t have cheap Chinese imports to absolve the sin of our excessive money printing. There is no easy and painless way to get bailed out. For the first time since globalized Asia became our outsourced manufacturing hub, we will need to contain inflation the painful way—through demand and wealth destruction. It’s time to take the blue pill.
Traditionally, economists have referred to cost-push inflation—increases in key input prices driven by energy shock, war, natural disaster, etc. as transitory and separate from monetary inflation. We’re unlucky enough right now to be dealing with both at the same time. And it’s unclear how “temporary” our current supply shocks may be.
The war in Ukraine appears to have no end in sight. China’s zero COVID policy could run until the end of 2022. Regardless, cost-push—or shocked-induced—inflation is not the inflation that central banks usually worry about. This is not because it’s unimportant or that it is any less painful on the end consumer. It’s because there is very little the central bank can do to drive down input costs driven by disasters. Food and energy price shocks due to the war in Ukraine, the increased cost in manufactured goods due to the COVID lock down in China—rate hikes simply will not have any impact on these issues. What the Fed canaffect is monetary-policy-driven inflation.
It is possible that normalizing Chinese manufacturing and achieving peace in Ukraine would reduce the observed 8% inflation down to 4%. Then, the Fed would need to inflict far less pain on American households to address the remaining 4% and bring it down to 2.5%. However, it is another level of pain and suffering entirely to bring 8% inflation down to 2.5% solely through rate hikes.
Of course, US politicians and their voters don’t care about the fine distinctions between monetary policy driven inflation vs. cost-push inflation. Certainly, the observed 8% inflation is driven by both easy money and global supply shocks. However, if we lean on the Fed to undo the inflationary pressure created by both factors, we risk inflicting far more injury than we bargained for. This is akin to chemotherapy that kills the patient before it cures the cancer.
After all, the Fed can only impact the part of inflation that is driven by monetary policy. If it seeks to use one tool to fix both problems, the Fed will be unwisely draconian. The Fed can’t make energy prices fall nor entice China to abandon its COVID lock down. If it tries to address these issues through monetary policy alone, the Fed will hike rates more aggressively. This will destroy wealth unnecessarily and to little effect.
In light of recent events, it’s easy to point fingers at the Fed for creating inflation through money printing. But let us not forget that the Fed didn’t just give us inflation; it also gave us tremendous wealth by subsidizing the economy with artificially low costs of capital. If we could rewind to early 2022, would we ask the Fed to rein in inflation? Would we still ask if we knew it would destroy much of the wealth that was created through the initial easing? We are indeed much like Neo, caught between wanting to live in the “real world” but still craving the comfort and control of the Matrix.
Let us feel compassion for our central bankers—even though, for the past 20 years, their job to control inflation has largely been performed by the hardworking factory operators and laborers in China. But they have taken us along the path to inflation using the most pleasurable route possible. The Fed’s easy money policy has doubled our investment portfolios and home equity. We have been given an enormous wealth boost without any effort on our part.
Naturally, some people want to stay in the Matrix. They want to believe, out of hubris or ignorance, that they are investment geniuses. They want to believe their wealth increase was generated through brilliant investment acumen. But that’s not the real world. Many investors have done well over the past decade primarily because of cheap capital from the Fed and cheap production from Asia. These dual spigots are now dry; we must face reality head-on.
Still, we aren’t actually worse off! It’s wrong to think this Fed-caused inflation is destroying our wealth. It shouldn’t be so hard to be at peace with the fact that real wealth (inflation adjusted) must reflect value creation. The truth is that the current inflation simply moves us back towards reality, deflating the illusory wealth that was given to us through no merit or effort of our own. And in the real world, the things that should matter—fundamentals, value, productivity—will matter once again.
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