Imperial Tribute

A government with budget deficits around 6% of GDP, debt above 120%, and a worker-to-retiree ratio under three is headed for a crisis. In recent years, our model has been to expect that governments will generally choose the path of least resistance from among the options available.

In the spirit of Herman Kahn, we thought it would be useful to make a list. Kahn's approach to difficult problems was to begin with a blank whiteboard and write down every possible solution, even the unlikely ones.

There are basically four ways to solve an overindebtedness problem: cut expenses, grow out of it, broaden the tax base, or keep borrowing and kicking the can.

The government could reduce expenses in two ways: cutting waste and fraud, and through major improvements in public health. Universal Ozempic could save quite a bit of money. But the largest obligations are Social Security and Medicare, and those promises are not even included in that public debt figure that now exceeds 120% of GDP. An expense cut large enough to materially change the trajectory would amount to a partial default on benefits owed to taxpayers who paid into the system their entire working lives. Outright default on Treasury debt seems even less likely and certainly not the path of least resistance when you issue your own fiat currency.

Growing out of the problem would be the best outcome. Productive investment raises output and helps keep inflation and borrowing costs under control. Recently we have found ourselves thinking that Claude and other large language models may help. LLMs could prove to be a genuine general-purpose technology that raises the economic growth rate via increased productivity. 

The demographic backdrop, however, is daunting. If debt is 120% of GDP and the government is running a meaningful primary deficit, growth does not merely have to exceed interest rates. It has to exceed them by enough to offset the primary deficit as well. At 120% debt-to-GDP, every percentage point by which interest rates exceed growth adds roughly 1.2% of GDP to the annual debt burden before accounting for the primary deficit. Growth would have to be extraordinarily strong to solve the problem by itself.

Still, growth is the one genuinely optimistic path. AI is also the one development on the horizon that might allow capital to substitute for workers who were never born. If there is a way out that does not involve financial repression, it runs through productivity.

We also considered a more unconventional solution. Call it "broadening the tax base" by broadening it very far. The Trump administration's National Security Strategy last year placed the combined economic weight of America's treaty allies and partners at roughly $35 trillion, in addition to our own $30 trillion economy. If the United States could somehow collect 5% of that allied output, it would amount to roughly $1.75 trillion per year, about equal to the current deficit. 

We jokingly called the idea "Imperial Tribute."

People who dismiss foreign extraction by saying that tariffs just tax Americans are thinking too small. The hegemon does sit on top of an immense foreign income base, and a few percentage points of it really would change everything. 

The problem is that Imperial Tribute is really a bet on coercive power: pay, or we hurt you. This year that power was tested at the easy end of the scale and fell short. Iran closed the Strait of Hormuz, mined it, and declared allied shipping a target, and traffic through the strait dropped by more than ninety percent. One medium-sized country, with its leader dead and its territory hit at will, was still able to fight the U.S. to a standstill by closing the Strait of Hormuz with cheap drones and setting off a global fuel crisis. 

When Trump asked allies to help reopen the strait, Germany, the UK, Japan, South Korea, Australia and others flatly refused, with Berlin saying it wasn't their war. The junior partners wouldn't even share the burden of a shared-interest oil crisis, let alone hand over a surplus. (And the failed extraction didn't just fail, it produced an oil price spike and higher interest rates on government debt, tightening the overindebtedness spiral.) If the hegemon can be forced to back down by a country with 1% of its GDP, it's over for Imperial Tribute.

The failed attempt would also have highlighted a second problem. Coercive pressure does not merely risk failure. It can backfire. Higher energy prices, weaker growth, and higher interest rates would worsen the fiscal position they were intended to improve.

The closest precedent for taxing sovereign allies is the Delian League. It started as a voluntary alliance, with members paying into a shared fund to defend against Persia. (That's more or less the ancestor of the burden-sharing we now demand from NATO.) Athens turned those payments into tribute, moved the treasury to Athens, spent the money on its own temples, and put down the members who tried to leave. The resentment that built up helped cause the war that ended Athenian power.

Britain taxed India, but Britain governed India, with an army, a civil service, and a hundred years of administration. Even then the take was modest next to the cost of holding the place, and it reversed the moment the navy could no longer back it up. Britain never taxed sovereign France, because nobody can. 

The Trump administration strategy paper is not a plan for empire and tribute. It is a plan for pulling back. Its authors say outright that the days of "propping up the entire world order like Atlas are over," and they say it because they already know a coercive surplus cannot be collected. 

The U.S. cannot solve a trillion-dollar fiscal problem by directly extracting resources from nominal allies. Reserve currency status, Wall Street intermediation, technology rents, and geopolitical influence may all be worth something. Hegemony is not a fiscal free lunch large enough to close a 6%-of-GDP deficit. 

The path of least resistance is inflation, or more exactly financial repression: holding nominal rates below the rate of nominal growth. That is how the country took its debt from about 120% of GDP down to 30% over the thirty-five years after 1945. The bondholder was the designated loser. He lost much of his real principal without a formal default ever occurring.

Inflation is the tax nobody votes on, which is why it is the path of least resistance. Explicit taxes will do some of the work (a point or two of GDP), but they can't close a six-point gap. And inflation is itself a tax, since it quietly raises real revenue through brackets and nominal gains that are not indexed. So taxation and inflation are not really rivals. (See The Missing Billionaires!) They tend to work together.

One thing about our situation is different from the postwar version, and it points to more inflation rather than less. As Carmen Reinhart and M. Belen Sbrancia observed, the postwar liquidation of debt occurred within a system of capital controls, interest-rate restrictions, and regulatory structures that created a captive audience for government debt. The government could repress financial claims gradually because investors had fewer places to go.

Those conditions no longer exist. Capital moves freely. Investors have alternatives. Much of the debt reprices relatively quickly. There is less opportunity to inflate away long-term obligations slowly and only once. The work therefore has to come from either sharper episodes of inflation or from rebuilding some version of the repression machinery.

The only thing that could alter this conclusion is faster economic growth. Even then, a productivity boom would probably not eliminate repression entirely. It would simply improve the arithmetic by widening the gap between growth and interest rates while reducing the primary deficit. 

AI may be the one technology capable of putting capital to work in place of the workers who were never born. So far, however, the promised productivity gains from LLMs have not yet appeared in the aggregate data. For now, growth remains a hope rather than a forecast.

The conclusion is that the government will probably run negative real rates against paper claims for a very long time. Growth may help. Taxes may contribute. Entitlements may eventually be trimmed at the margins.

But there are not enough politically feasible claimants available to absorb the adjustment except holders of nominal claims. 

For investors, that creates an uncomfortable problem. Bonds are the obvious target of repression, while large public equities increasingly trade at valuations shaped by passive flows and benchmark inclusion. That is why we have spent so much time looking at assets that are too small or too oddly structured to be swept into passive indexes. If the adjustment must fall somewhere, we would rather own the assets that politicians cannot easily print.

You Cannot Grow an Acre

Right now, there are nine companies in the S&P 500 with market capitalizations over one trillion dollars: NVDA, AAPL, GOOGL, MSFT, AMZN, AVGO, TSLA, META, and MU. (SpaceX has not been added to the index.) These nine trade for 32 times earnings and throw off a 1.5 percent free-cash-flow yield on enterprise value. (All free-cash-flow figures here are net of stock-based compensation.)

We were wondering whether you could hide from this overvaluation elsewhere in the S&P index. The first, obvious thought would be to skip the top nine and own the other 491. They trade for 27 times earnings and throw off 2.6 percent on the same basis. Cheaper, but still expensive.

So we looked at various ways of slicing up SPY. We screened out every company with meaningful stock-based compensation, on the theory that the companies paying employees in stock also have the most overvalued shares. (This line of thought actually gave us a good Apple entry point in April 2024.) The low-SBC survivors yielded 2.1 percent, worse than the index, because the screen mostly caught the bid-up defensive complex: utilities, staples, telecom, the names people own for safety. We tried another screen, keeping only the companies that have shrunk their share count over the past five years. That group was the best of the lot at 3.2 percent, but it is not a number worth writing home about.

Put the four cuts together and the ladder of free-cash-flow yields runs from 1.5 to 3.2 percent of enterprise value. None of them are "cheap." Unfortunately, the 491 are not a bargain hiding behind the nine. They are slightly lower-quality businesses, on average, at a quality-adjusted price that is roughly the same. There is no secret cheap slice in the index, because the index as a whole is pretty expensive on the cash that actually reaches an owner.

One option would be to sit in cash and bonds and wait. If the correction doesn't come in a year, you'll be rooting for the world to end. Also, the U.S. federal debt to GDP and the deficit are both high enough that the government will be sorely tempted to inflate its way out, and a government that wants inflation usually gets it. In that world, cash and bonds hand you a negative real return after tax. 

That is the box. Stocks are expensive, but bonds are expensive too. We need a "third way."

There are two ways for a good business to slip through the cracks and be excluded from the passive, indexation bid. One is structure: a master limited partnership or other pass-through cannot go into the index, because the funds that track it cannot hold those companies without tax problems. The other is size: a company too small to move the index gets no meaningful flows. Either way the price is set by people doing valuation arithmetic rather than by a machine that has to buy. These have been called "orphaned securities."

Take Enterprise Products Partners. EPD is a partnership, so the index cannot own it, trades for 11x ttm EBITDA, which allows a 5.9% dividend that is largely tax deferred to be well covered. That is several times the owner yield of the index, for a toll road whose revenue is largely contracted. The standard objection is obsolescence: pipelines are a melting ice cube in an electrifying world. But a large share of EPD's business is natural gas liquids and petrochemical feedstock, and petrochemicals are a secularly growing market, not a shrinking one. Demand for plastics and chemicals rises with population and income whether or not anyone buys another gallon of gasoline. The terminal-value fear is priced as if the whole franchise rides on crude oil. It does not.

Or take a land base. Rayonier (RYN) owns timberland and trades below what the dirt would fetch in the private market. It is a real-estate trust, so in theory it could be indexed, but it is far too small ($6 billion market cap) for the popular indices. Natural Resource Partners owns mineral and royalty land and is orphaned twice over, a partnership and tiny (only $1.3 billion market cap). Neither one has factories to run or fashions to chase. They own real assets that throw off cash, with no large operating or capital budget to eat into the return. In a world where the currency is being diluted, a perpetual claim on an acre or a ton is exactly the thing to own. 

Something falls out of this search that we did not go looking for. The orphans are close to the perfect assets for a great inflation. In many cases they are inflation-protected bonds wearing equity clothing, and  the index-ignored corner of the market is not where you would expect to find them.

It is not a coincidence. A land or royalty asset returns its cash because there is nothing to reinvest in. You cannot grow an acre. That single fact is why it is the right thing to own in an inflation: a real claim paying a real coupon, with no plant or equipment whose replacement cost keeps climbing. And it is the same fact that orphans it. Cash that has nowhere to compound has no reason to sit inside a corporation paying the double tax, so the asset is wrapped in a partnership. An asset that never reinvests never swells into something the index notices, so it stays small. Return your cash and you are orphaned twice, by structure and by size.

So the index runs an inadvertent filter. It bids up the businesses that retain and reinvest, which is most of what is expensive, and it leaves alone the ones that pay everything out, which is where the yield is. That is the bargain. You collect a real yield on the assets best built for the world the deficits are inviting, and you collect it precisely because the largest pool of money in the market is forbidden to bid against you. The only thing asked of you is the willingness to buy what no one is forced to buy, and to hold it on the days when no one is forced to buy it back.

Paper: "Fiscal Dominance and the Return of Zero-Interest Bank Reserve Requirements"

We have been arguing for the past two years (see also) that the path of least resistance for the central bank would be to do what is known as yield curve control. That concept dates back to WW II, when the Federal Reserve bought the debt issued by the U.S. Treasury, which had the effect of capping rates on longer-term Treasuries. This lasted almost a decade, from 1942 until the Treasury–Federal Reserve Accord in 1951.

Our "path of least resistance" thesis supposes two things: number one, that the government (meaning the Fed and the Treasury) will likely take the easy path in response to a challenge rather than something hard that might have greater long-term benefit. In other words, that the government has a very high discount rate or low pain tolerance. And number two, that printing money - in whatever euphemism you want to use to describe it - would be that easiest path.

In our review of Nick Timiraos' hagiography of Federal Reserve chair Jerome Powell, we observed that Powell has been closely involved in the response to six financial embarrassments or crises, and he has recommended, advised, or chosen the bailout every time. Had he chosen different courses, for example to discourage moral hazard, it would have been at the cost of greater short term pain. But we are aware that Powell's commitment to bailouts has never been tested against conditions of rising inflation. He sure has been talking tough about inflation for the past year. How can we predict what he is actually going to do?

Along comes a paper by an academic economist named Charles Calomiris titled Fiscal Dominance and the Return of Zero-Interest Bank Reserve Requirements, just published by the Federal Reserve Bank of St Louis. Calomiris is a "system man," a baby boomer economist who went to Yale and got a PhD in economics from Stanford, before being part of a number of think tanks. He has had four commentaries published by the Wall Street Journal in the past year. For all we know, he was in Skull and Bones. The abstract of his article:

As a matter of arithmetic, the trends of US government debt and deficits will eventually result in an outrageously high government debt-to-GDP ratio. But when exactly will the United States hit the constraint of infeasibility and how exactly will policy adjust to it? This article considers fiscal dominance, which is the possibility that accumulating government debt and deficits can produce increases in inflation that “dominate” central bank intentions to keep inflation low. Is it a serious possibility for the United States in the near future? And how might various policies change (especially those related to the banking system) if fiscal dominance became a reality?

What is utterly fascinating about this paper is that he is looking at an impending crisis - the over-indebtedness of the federal government - and reasoning through the possible responses, looking for the easiest one: the path of least resistance. Broadly speaking, he sees three possible choices:

First, reduce fiscal deficits. He confesses that it "may be a hard policy to enact," since the main contributors to the deficit are Medicare, Social Security, and the defense budget. Look at a long term chart of Unitedhealth Group or Lockheed Martin. Does the market seem worried that those budgets are going to get axed? Social Security and Medicare are the only benefits that normal, hard working people get from a lifetime of federal income taxation. It says a lot about Paul Ryan that his main political priority was to try to cut these benefits. Anyway, Calomiris does not think that this would be a path of least resistance.

Second, increased income taxation. Calomiris says that it is an unlikely path, "not only because of the lack of political consensus about taxation but also because it would reduce growth in income, which would partly offset" any benefit that it might confer. 

The third choice is what the paper is really about. Calomiris thinks that the path of least resistance would be "inflation taxation," which is implemented by large and inflationary purchases of government debt.

"To be specific, here is how I imagine this occurring: When the bond market begins to believe that government interest-bearing debt is beyond the ceiling of feasibility, the government's next bond auction 'fails' in the sense that the interest rate required by the market on the new bond offering is so high that the government withdraws the offering and turns to money printing as its alternative."

The Federal Reserve would buy the bonds that the Treasury issues, thereby funding government budget deficits. It is the same as printing money to fund the deficit, but with a fig leaf of euphemism and confusion. The "inflation tax" refers to the amount of real value that government bondholders lose to inflation. If there is $25 trillion of federal debt held by the public and there is a ten percent inflation (devaluation), then the inflation tax raises $2.5 trillion, a healthy amount in relation to the current annual expenditure level of $6.5 trillion.

The euphemism and confusion part of the inflation tax is actually very important because it allows the government to collect more than it would be able to if it were honest about what was happening. Here is how Calomiris explains it:

"When fiscal dominance hits and leads to monetization [printing money], if this is not anticipated sufficiently far in advance, it also causes some or all existing bonds (long-term bonds with existing low coupons that aren't indexed to inflation) to fall in nominal value. This is a one-time gain to the government because, going forward, the government will pay a market interest rate on all new debt issues that incorporates the future rate of inflation. If the average duration of government debt is sufficiently long, and fiscal dominance is not anticipated years in advance, the government could benefit from a substantial capital gain from the unexpected inflation tax, which increases its real capacity to issue new interest-bearing debt by a similar amount."

Calomiris thinks that the inflation tax is the path of least resistance because people "are not aware that they are actually paying it, which makes it very popular among politicians." 

If you were running things, how would you maximize the amount you could raise via the inflation tax? You need to trick bondholders, otherwise the market interest rate on new debt issues will reprice higher for inflation. This seems to imply that the best strategy is periodic, large devaluations with the rest of the time spent talking very tough about inflation.

Fed Tightening (April 13, 2022 - March 8, 2023)

We wrote in our Energy - Q4 2022 Earnings Season post that we have been fighting two headwinds for the past year in our investments: tightening by the central bank, and releases of crude oil from the Strategic Petroleum Reserve.

The Federal Reserve began shrinking its balance sheet the week of April 13, 2022, after it had just hit an all time high of $8.96 trillion of assets. (The Federal Reserve prints money to buy the assets that it owns, which are mostly U.S. Treasury and mortgage-backed securities, so the size of the balance sheet essentially reflects the cumulative amount of money printed since the inception of this central bank.)

Prior to the bank failures last week, the size of the balance sheet had been reduced to $8.34 trillion, a reduction of about seven percent. The latest release shows that the assets have started to grow again:

The balance sheet now has $8.64 trillion of total assets. That is a weekly increase of $300 billion, or 3.6%, which means that it retraced half of the total reduction of $600 billion that took almost a year (from April 13, 2022 - March 8, 2023) to accomplish.

We have seen since 2008 that the Fed's attempts to shrink its balance sheet (i.e. "taper") are bearish for risk assets, and that they have been short lived, and also associated with rebounds that are much larger than the amount of reduction. That is why the balance sheet has grown over time and is an order of magnitude larger than it was twenty years ago.

As we wrote over the weekend, it seemed likely that the bank failures of Silicon Valley Bank and Signature Bank (and threatened failures of several other big, important banks) would bring this episode of tightening to an end:

Ultimately, though, it seems unlikely that this will stop until the Fed stops tightening. Continued interest rate increases have been widening the gap between what bank deposits pay and what customers could earn by buying Treasuries directly. At some point, the dam would just burst and deposits would get converted to direct Treasury investments, never to return. Also, higher interest rates have already basically wiped out the equity in commercial real estate (just look at a stock chart of an office REIT like BXP or VNO), and if the rates increase further, these properties will start getting handed back to the banks.

But once the Fed pauses, then no one will think that their bank deposits are at risk because of the interest-rate related decreases in value of assets which are still performing. Banks can then continue to earn their way out of their liquidation value hole, as they had been doing and as has normally happened at various points in past economic cycles.

However, the caveat here is that inflation will come back. They have to give up on trying to get it back down using monetary policy. Maybe they raise taxes, maybe they put a sumptuary goods tax on Ferarris and private jet flights. Maybe they stop printing money to send to Ukraine. There are all kinds of fiscal and regulatory things that could be attempted. Inflation would have been better over the past two years if we had more sawmills and oil refineries and fewer cryptocurrency startups.

We have only one data point to go on, but we seem to have reached the point where the path of least resistance is to go back to printing money. Our cynical view was that it was only a matter of time until they reached this point:

We like ConvexityMaven's theory that the Fed is going to do yield curve control. Instead of letting the bond market crash and taking everything else with it, print money and buy bonds - keep the yields capped. But as the Maven says, in this scenario, "the other side of the balloon gets squishy" - meaning inflation.

If you look around the world, you will notice tons of countries with fiat currencies are running high inflation rates. Meanwhile, deflationary collapses are rare. Can you imagine the central banks of Brazil, Argentina, or Ghana tightening enough to cause a deflationary collapse? It has never happened, because the path of least resistance is inflation.

Betting on inflation is the cynical bet. But we have to be cynical enough to realize that the central bank doesn't want us hoarding real assets and is going to try to trick us with jawboning talk. People will believe the talk and there will be violent selloffs. This is why we like "first class" inflation protected assets and not leveraged junk.

We actually mentioned back in October 2022 that banks would be a casualty from tightening that might force the Fed to stop:

Banks own tons of treasuries, and their balance sheets have been devastated by the increase in the ten year bond yield, something that is being chronicled over at Oddball Stocks. Higher interest rates also mean that the interest on the $31 trillion federal debt grows, which is a positive feedback loop since the debt is not being serviced. And high interest rates choke the economy, which is unpleasant and also lowers tax revenue - worsening the debt spiral - and causes banks' loans to default. So it has seemed clear to us that printing money to buy bonds (yield curve control, capping bond yields) is the path of least resistance, "kick the can" approach that the regime will choose.

This cynicism about the Fed taking the path of least resistance dates back to our "Rethinking Inflation" post from September 2021:

So it starts to seem that the people in this country who make the decisions are not even interested in playing the old deflationary squeeze game because, even if their precarious balance sheets could withstand it, their political Mandate of Heaven probably couldn't. Plus, baby boomer rich are very unlike the old school rich - they do not like seeing things marked down on their net worth spreadsheet. (Every baby boomer has a net worth spreadsheet.) If a big devaluation is going to happen, it would be best to own attractively priced assets that will grow earnings at least as fast as the currency is devaluing. Luckily for us, a major inflationary shock is brewing at the same time that people allocating capital are under the delusion that electric vehicles have "disrupted" oil.

Retracing half of the balance sheet reduction that took a year in only one week is consistent with the results of the previous attempts at tightening.

Note also that Berkshire was buying Occidental Petroleum every day this week while the market (and particularly energy stocks) were crashing.

Bank of Ghana Redenomination Song

Review of The Great Demographic Reversal: Ageing Societies, Waning Inequality, and an Inflation Revival

We have known for a long time that the population of developed countries is aging. This is set in stone because of the decline in fertility rate and rise in longevity that occurred during the 20th century. The result will be an age structure diagram, or population pyramid, that is heretofore unknown in history (and which is not a pyramid).

We used to think, we now realize mistakenly, that having an inverted (aging) population pyramid would be deflationary. After all, have you ever visited a house owned by (or vacated by) an octogenarian? One of the things you notice is that they have not bought anything in years - their houses are time capsules from an earlier decade, the decade of that person's peak consumption of home furnishings. So we figured that an aging population would decrease the demand for all sorts of goods: deflationary.

Except that is not quite right. Sure, the retired and elderly probably buy fewer jet skis, couches, and cars. But they eat the same amount and they consume much more health care and living assistance. And, most importantly, they do not produce anything. From a monetarist perspective, having an aging population producing fewer goods but with money supply remaining the same (or higher) should cause inflation.

William J. Bernstein wrote an important essay almost 20 years ago called "Retirement Calculator from Hell, Part IV: A Nation of Wal-Mart Greeters," which explains this very powerfully:

At base, what we have is x number of workers supporting y number of retirees with goods and services. The retirees may be paying the workers with saved dollar bills, stock certificates, or Krugerrands, but at the end of the day, the method of savings/payment is irrelevant. As the number of retirees increases, the goods and services produced by the remaining workers become thin on the ground. In this case, it does not matter how much retirees have saved—the value of their dollar bills, stock certificates, and Krugerrands will fall to the point where the workers are finally willing to take them in exchange for those goods and services.

The world’s first government-sponsored retirement system was Bismarck’s, begun in Germany in 1883. The Iron Chancellor, wishing to co-opt the Socialists, decided on sixty-five as the retirement age, and we have been stuck with it ever since. In an age without adequate nutrition, antibiotics, high blood pressure medicine, and rudimentary occupational safety, only a few percent made it past the finish line, and those that did survived only a few years. Even when Franklin Roosevelt signed the Social Security Act in 1935, relatively few lived to qualify—in that year, there were forty workers for every beneficiary.

How things have changed. Today, the median life expectancy for men is seventy-five years; it’s eighty for women. Currently, there are three workers for every retiree; by 2050, there will be only 1.5 workers supporting each retiree.

Imagine, if you will, a desert island on which there are only five inhabitants—four workers and one older retired person. Each of the four workers does several odd jobs: growing various foodstuffs, building shelter, providing rudimentary medical care, and the like. The medium of exchange is coconuts. Every month, each of the four workers gives a few of his coconuts to the retiree.

One day, one of the remaining four workers turns sixty-five and decides that he, too, wishes to retire. If he does so, instead of each worker supporting 0.25 retirees, each would be supporting 0.67 retirees. Not only that, but the total GDP of the island would fall by 25%; so would per capita GDP. What do you suppose the response of the remaining three workers will be to an apparently healthy-looking colleague who demands that they support his idleness?

Let us further assume that the candidate-retiree has planned for his nonproductive years by accumulating a disproportionate number of the coconuts. In doing so, he has done nothing to increase the productivity of the island. Now that he must spend the coconuts, the island will find an increased number of them chasing 25% less goods and services. The result is a predictable bear market in coconuts and dramatically more expensive goods and services.

Worse yet, to the extent that he has planned ahead and saved, he sows social discord, for even if he himself has accumulated enough coconuts to counteract the effects of higher prices, he has raised prices for everyone else in the process.

This example was not arbitrarily chosen. The 4:1 and 3:2 ratio of workers to retirees is about what was the case in 1990 and what will be the case in 2050, respectively.

In an era when a small number of people lived past sixty-five, society could easily support them for the very few years they survived beyond that point. Now that citizens are routinely living two decades longer, it is simply not mathematically possible, let alone politically feasible, to expect each worker to support 0.67 retirees, no matter how many coconuts, dollar bills, stock certificates, or Krugerrands they save up in the meantime. It is also not reasonable to expect productive younger individuals to support large numbers of healthy older non-workers.

As Arnott and Casscells succinctly conclude, what we have is not a savings crisis, but rather a demographic crisis. We will not be rescued by increased voluntary or enforced savings. The idea of investing Social Security funds in stocks, so fondly embraced by right-wing think tanks, is a prescription for capital-market instability. (The most salient feature of the American Enterprise and Heritage Institutes is just how little thinking actually goes on inside them.)

The solution, then, is for folks to retire later. We’ve already started down that road by raising the retirement age for future retirees to sixty-seven. Unfortunately, we have a ways to go. In order to keep the current worker-to-retiree ratio at 3:1, Arnott and Casscells estimate that the retirement age will gradually have to be raised to seventy-three. Of course, the government need take no action; politically, it will prove far simpler to let poor asset-class returns and low savings force older Americans to postpone their retirements. In the past few years, millions rudely awakened to the fact that they weren’t going to retire at forty. Over the next few decades, most of the remainder will discover they won’t be doing so at sixty-five, either.

Another person who believes that aging populations (and as a corollary, current developed country demographics) are inflationary is "inflation guy" Michael Ashton:

It seems to me that people who argue that aging populations are disinflationary don’t really have a useful model in mind. If they do, then it revolves only around [the idea that a higher retiree/non-retiree ratio probably implies lower spending], and [thus] that spending will diminish over time; if you believe that inflation is related to growth then this sounds like stagnation and deflation. [...]

The decrease in potential growth rates due to the graying of the population is real and clearly inflationary on its face, all else equal. Go look at our MV=PQ calculator and see what happens when you lower the annual real growth assumption, for any other set of assumptions.

Economists Charles Goodhart and Manon Pradhan have come to the same conclusion, that an aging population is inherently inflationary, and they wrote a book before the pandemic to make the case: The Great Demographic Reversal: Ageing Societies, Waning Inequality, and an Inflation Revival. A summary of their key points:

• "The rise of China, globalisation, and the reincorporation of Eastern Europe in to the world trading system, together with the demographic forces, the arrival of the baby boomers into the labour force and the improvement in the dependency ratio, together with greater women's employment, produced the largest ever, massive positive labour supply shock. The effective labour supply force for the world's advanced economy trading system more than doubled over these 27 years, from 1991 to 2018."
• "We are in a debt trap. Debt ratios are so high that increases in interest rates, especially at a time in low growth, may drive exposed borrowers into an unsustainable state. As a result, the monetary authorities cannot raise interest rates, either sharply or quickly, without running into the danger of provoking another recession, which itself would make everything worse. But that will leave interest rates, and the accompanying flood of liquidity, sufficiently expansionary (accommodating, in Central Bank speak) that debt ratios are likely to increase even further."
• "The basic problem is that ageing is going to require increasing amounts of labour to be redirected towards elderly care at exactly the time that the labour force starts shrinking. [...the] portion of the labour force looking after the elderly will produce service for immediate use rather than durable consumption. These services [...] are unlikely to be replaced by automation [and] cannot be offshored the way the lowest value-added activities in manufacturing were offshored."
• "Ageing is inflationary empirically, too. Juselius and Takats (2016) uncover an empirical relationship - 'a puzzling link between low-frequency inflation and population-age structure: the young and old (dependents) are inflationary whereas the working age population is disinflationary'."
• "If the growth rate of workers in the economy outweighs that of dependents (as was the case during the demographic sweet spot), the world will go through a period of disinflation as it has for the last few decades. Over the next few decades, [however] the rate of growth of dependents will outstrip that of workers."
• "[The] Great Reversal of demography and globalisation will lead to more inflation. When this takes hold, though it may be a few years from now, and expectations adjust, then nominal interest rates will rise. Of that, we are confident. But the more difficult and interesting question is whether nominal interest rates will rise by more than inflation, i.e. whether real interest rates will rise, or whether the reverse will happen and real interest rates will fall."
• "[G]rowing inequality within countries has been mainly caused by the unprecedented surge in labour availability, caused by globalisation and demography, leading to a dramatic decline in labour's bargaining strength. If so, Piketty is history. But we could, of course, be wrong."
• "But what will then happen as the lock-down gets lifted and recovery ensues, following a period of massive fiscal and monetary expansion? The answer, as in the aftermaths of many wars, will be a surge in inflation, quite likely more than 5%, or even on the order of 10% in 2021..."
• "What will the response of the authorities then be? First, and foremost, they will claim that this is a temporary, and once-for-all blip. Second, the monetary authorities will state that this is a , quite desirable, counterbalance to the years of prior undershooting of [inflation] targets, entirely consistent with average inflation, or price-level targeting. Third, the disruption will have been so great that it will take time to bring unemployment back down towards 2019 levels and large swathes of industry, (airlines, cruise ships, hotels, etc.), may still be in difficulties. Does it make any sense, having propped up industry in such a widespread manner in 2020, to let much of that same industry go to the wall in 2021 as a result to rising interest rates and fiscal retrenchment? In any case, the borrowing lobby (government, industry, those with mortgages) is much more politically powerful than the savings lobby." 
• "The balance of bargaining power is now swinging back to workers, away from employers; current, more socialist political trends are reinforcing that. Following the recovery, whenever that happens, wage trends will change. The likelihood is that wage demands will then match, or perhaps even exceed, current inflation, despite the inevitable pleas for moderation in the context of a 'temporary blip' in inflation. The coronavirus pandemic, and the supply shock that it has induced, will mark the dividing line between the deflationary forces of the last 30/40 years, and the resurgent inflation of the next two decades."
• "The losers will be savers, pension funds, insurance companies, and those whose main financial assets take the form of cash."
• "Inflation will rise considerably above the level of nominal interest rates that our political masters can tolerate. The excessive debt, amongst non-financial corporates and government will get inflated away. The negative real interest rates that may well be necessary to equilibrate the system, as real growth slows in the face of a reversal of globalisation and falling working populations, will happen. Even if central banks feel uncomfortable with such higher inflation, they will be aware that the continuing high levels of debt make our economies still very fragile. And if they try to raise interest rates in such a context, they will face political ire to a point that might threaten their 'independence'. Only when indebtedness has been restored to viable levels can an assault on inflation be mounted.""
  

In the wake of the pandemic, we are all noticing inflation, higher interest rates, and most oddly, a strange shortage of labor. You may try to eat at a restaurant and find that while there are empty tables, you have to wait because there are no waiters available. Are we already noticing the falling worker-retiree ratio?

If the authors are right that the falling worker-to-retiree ratio will lead to higher low-skilled wages and then to falling inequality, it may be bearish for luxury goods companies that have been benefiting from the rising inequality. Think of Ferarri. Investors think that it is a "perma-compounder" that will keep on doing well forever, but this implicitly assumes that wealth inequality is a one-way trade? 

It trades for 40 times earnings. If leverage shifts from capital to labor, the oligarchs' profits will decline and it would presumably be bearish for Ferarri. In that case, the current valuation would be a classic case of double counting: trading at a high multiple on peak earnings.

On the other hand, there are companies that seem to connote "luxury," but which are not only not exclusive, but in fact derive their customers from the underclass. Just this year, we have been noticing lines out the door at Louis Vuitton and Gucci stores. We can tell by looking at the customers in line that they are most certainly labor, not capital. Could LVMH actually benefit from power shifting to wagies - is it perhaps even already benefiting from this shift, since we have only noticed the packed stores post-pandemic?

The authors devote quite a bit of effort to the counter-argument to their thesis that Japan did not experience inflation when its population began seriously aging. Mike Ashton ("Inflation Guy") also felt the need to address this in his 2018 post:

I think that most people who think the demographic situation of developed nations is disinflationary are really just extrapolating from the single data point of Japan. Japan had an aging population; Japan had deflation; ergo, an aging population causes deflation. But as I’ve argued previously, the main cause of deflation in Japan was overly tight monetary policy.

He thinks it is because of monetary policy; Goodhart and Pradhan think it is because the labor glut was worldwide. (Note that Inflation Guy wrote a review highly recommending Great Demographic Reversal.) So it is interesting that Japanese inflation is starting to rise at the same time that it is everywhere else in the world. That is what you would expect to see if the great disinflation had been caused by the worldwide glut of labor which is now reversing.

It is also interesting that Goodhart and Pradhan address how this will affect interest rates: "monetary authorities cannot raise interest rates, either sharply or quickly, without running into the danger of provoking another recession, which itself would make everything worse." If you recall our Rethinking Inflation post, we quoted Harley Bassman (@convexitymaven) 

Why do rates have to go up? The Fed can keep them down. They kept them down post-World War II. Maybe that is what the plan is. They will just buy like Japan. They’ll just buy the bonds and balance sheet them and keep rates at one, one and a half. Even if we have 4% inflation, you’ll have a massive negative rate. That’s really the question here is that once you break the linkage of inflation to rates, a whole lot of things are possible. Now, the answer I think is this. Let’s say they have the three or four-handle inflation. Let’s say the Fed or the government or someone, I mean the government could do it by demanding that banks buy treasuries. They could force banks to do that because they’re regulated entities. So there’s a whole lot of ways for the government to keep rates at the current levels, if they want to. So what happens then, the other side of the balloon gets squishy, which means currency devaluation possibly. We don’t become the reserve currency of the world anymore, which seems unlikely, but whatever. There’s a whole other host of things that could play out where you keep a massive negative interest, real interest rate, which is unclear. But the usual game, if we weren’t the world’s reserve currency, we’d have a devaluation.

Banks own tons of treasuries, and their balance sheets have been devastated by the increase in the ten year bond yield, something that is being chronicled over at Oddball Stocks. Higher interest rates also mean that the interest on the $31 trillion federal debt grows, which is a positive feedback loop since the debt is not being serviced. And high interest rates choke the economy, which is unpleasant and also lowers tax revenue - worsening the debt spiral - and causes banks' loans to default. 

So it has seemed clear to us that printing money to buy bonds (yield curve control, capping bond yields) is the path of least resistance, "kick the can" approach that the regime will choose:

The Fed talks a lot about tightening but hasn't done much tightening.

We like ConvexityMaven's theory that the Fed is going to do yield curve control. Instead of letting the bond market crash and taking everything else with it, print money and buy bonds - keep the yields capped. But as the Maven says, in this scenario, "the other side of the balloon gets squishy" - meaning inflation.

If you look around the world, you will notice tons of countries with fiat currencies are running high inflation rates. Meanwhile, deflationary collapses are rare. Can you imagine the central banks of Brazil, Argentina, or Ghana tightening enough to cause a deflationary collapse? It has never happened, because the path of least resistance is inflation.

Betting on inflation is the cynical bet. But we have to be cynical enough to realize that the central bank doesn't want us hoarding real assets and is going to try to trick us with jawboning talk. People will believe the talk and there will be violent selloffs. This is why we like "first class" inflation protected assets and not leveraged junk.

If this theory of yield curve control is correct, holders of CD's or investment grade bonds may not lose too much more in nominal terms, since yields will be capped at some level. But they will lose a tremendous amount in real terms due to the inflation. And their loss will be the gain of equity investors in leveraged enterprises with pricing power, like Magellan.

But again, the Fed is not going to make it easy. With their tough talk (lots and lots of talk) they have convinced many people that they are "serious about winning this inflation fight." Even good ol' ConvexityMaven believes it. 

The one person we follow who really vocally (and enthusiastically) makes the case that the Fed is bluffing is Kuppy. He calls the moment that their bluff is revealed "The Pause," as in the announcement that they will be pausing the tightening program:

the Fed has followed through much as I expected they would. Look back to my prior posts that warned that they’d turn against the markets for a bit (Post 1, Post 2, Post 3). They’ve done a whole lot of talking, but precious little in terms of concrete actions. They got people convinced that they’d go full-Volcker and take rates into the teens, but we all know that they won’t. A pause is inevitable.

Of course, they will do the bare minimum to try and regain some credibility, but it is all for show. These guys don’t actually care about inflation—they care about enriching their buddies in Private Equity while pretending to care about “inclusive economic policy” and other woke-word-salad nonsense. Of course, they’ll pause on rates at the first sign of real economic pain. The history of the Federal Reserve for the past few decades is that they overstimulate, then try to reign things in; until they break something, leading them to overstimulate again. Once on the hamster wheel, their only choice is to spin it faster. Meanwhile, the fiscal side is already preparing for another trillion in stimulus to supposedly fight inflation—they clearly have even less stomach for a pullback.

Therefore, I find it baffling that so many investors got so bearish back in June and July. Look, we all have PTSD from 2008. It was a miserable experience that I never want to repeat. That said, this isn’t 2008. Anyone who thinks that it is, is asking to get their portfolio debased by “Project Zimbabwe.” The lesson that the Fed learned from blowing up the financial system back then, is that once it starts to unravel, it’s harder to put it all back together again—just look at how extreme their response in March of 2020 was. Even after it was obvious that they had flooded the market with too much liquidity and inflation was spiraling out of control, the Fed wasn’t taking any chances—they kept plowing ahead with QE until the first quarter of 2022.

It is clear that they prefer inflation to another lost decade of patching up the financial system like in the 2010’s. Oddly, investors think that the Fed will take rates to a level where it detonates things

Kuppy also agrees that energy is the best way to play inflation and the pause. It is simply incredible that first the electric vehicle delusion and now a credulous belief in the Fed's hawkish talk have made hydrocarbons available for investors to buy so cheaply.

We give The Great Demographic Reversal a 3/5. While we agree with the thesis that an aging population is inflationary, we can think of at least three other major reasons to expect that we are entering a new secular cycle of inflation. Stay tuned for our upcoming post about this.

Rethinking Inflation

Last year our correspondent @pdxsag wrote up his notes on Grant Williams and Bill Fleckenstein's podcast interviews of Russel Napier and Lacy Hunt. I called his services, "siting through podcasts so I don't have to." Grant Williams has two new interviews on his own podcast with two guys that I already follow: James Davolos from Horizon Kinetics (he manages their Inflation Beneficiaries ETF, $INFL) and Harley Bassman (aka @convexitymaven).

First, some highlights from his interview with James Davolos:

• [T]here’s another area that we’ve actually been working on at the firm, in some cases for 30 years, and also in particular in the past five years, which has been different areas within the commodity complex. There’s been a lot of changes compared to the past cycle. We looked at upstream producers in the commodity complex, thinking well, under an inflationary scenario they have to do well. We do differentiate fundamental outlook on these markets, which I think we can discuss later, but the biggest deficiency of these names, whether it be an upstream E&P company like a Chevron or a Barrick Gold or Rio Tinto or Vale or BHP, is that they are incredibly capital intensive, both in the sense that they have a lot of working capital requirements, and they also have a lot of balance sheet leverage to lever up an inherently low return on assets.
• Basically what ends up happening is unless you time the cycle perfectly, you can have a really miserable experience going upstream into these companies, which should ultimately be inflation beneficiaries but very difficult to time the cycle. I think a lot of people have been hurt. Some good historical examples going back to the past peaks in these end markets. What we arrived at was a method of trying to look at asset-light ways of playing these hard asset end markets. Hard assets have been something that Murray and Steve and these guys have been focused on, as I mentioned, for decades, but particularly so in the last five to 10 years.
• We begin with the hard asset mindset. What a hard asset is, is just simply a finite high quality asset that there is a very large base of fundamental demand for. Think land, raw land, or energy, precious metals, base metals. And there’s unique fundamentals to all of these hard asset end markets today that I think are really different from past cycles. But we begin with the premise of identifying these quality finite hard assets with a requisite amount of fundamental demand, and then trying to figure out a way to express that view in the most efficient manner possible in a portfolio.
• What we arrived at is these asset-light companies, where they have exposure to these hard assets, but through a business model that has very little working capital requirements, has very low variable costs, and does not require and/or has zero leverage.
• What this has created is these businesses that not only survive but can actually thrive during the down cycle. You never have the insolvency risk. You don’t have the necessity to divest core assets. And then you can compound in the up cycle. That’s why it’s a very efficient mechanism to play an otherwise volatile, precarious industry, rather than going into the higher beta, higher risk upstream names.

And then his interview (with Bill Fleckenstein) of Harley Bassman:

• Why do rates have to go up? The Fed can keep them down. They kept them down post-World War II. Maybe that is what the plan is. They will just buy like Japan. They’ll just buy the bonds and balance sheet them and keep rates at one, one and a half. Even if we have 4% inflation, you’ll have a massive negative rate. That’s really the question here is that once you break the linkage of inflation to rates, a whole lot of things are possible. Now, the answer I think is this. Let’s say they have the three or four-handle inflation. Let’s say the Fed or the government or someone, I mean the government could do it by demanding that banks buy treasuries. They could force banks to do that because they’re regulated entities. So there’s a whole lot of ways for the government to keep rates at the current levels, if they want to. So what happens then, the other side of the balloon gets squishy, which means currency devaluation possibly. We don’t become the reserve currency of the world anymore, which seems unlikely, but whatever. There’s a whole other host of things that could play out where you keep a massive negative interest, real interest rate, which is unclear. But the usual game, if we weren’t the world’s reserve currency, we’d have a devaluation.
  

I've been thinking about inflation and hard assets a lot recently. "Inflation or deflation?" is a political question; you can't determine the outcome from modeling of macroeconomic variables without reference to what the people who control the central bank want.

In the past when we have had deflationary episodes, elites were much more conservatively invested. The book The Framers' Coup (see notes) by Michael Klarman (brother of Seth) says that the supporters of ratification of the U.S. constitution were creditors who were "determined to suppress state debtor relief laws and inflationary monetary schemes." 

In other words, the wealthiest colonists with political power were fixed income investors. They felt that their economic interests as wealthy people would have been hurt by inflation, and so the overriding goal of the constitution was to prevent inflation and legal abrogation of debt contracts, while also preserving the existing balance of power between north and south and big and small states.

Later on in the country's history, the rich were invested in government debt and also debt issued by the big private enterprises of the day, the railroads and canals that had not only big fixed costs but also big operating costs. Forget about owning equity in something that would go bust during the next panic, the old money wanted a first mortgage so they could get their principal back with reasonable interest. When money was sound, that really meant something. 

It even looks like deflationary panics were deliberate squeezes of the middle class, by the rich, who could relieve them of their assets at cheap prices at the height of the panic. In order for this to work, the rich had to be conservatively invested or at least more conservatively financed than the people they were squeezing. 

Up until the mid-20th century, it was not even considered appropriate for trustee fiduciaries to invest in common stocks. It was only the inflationary post-war era that changed this, as limitations in trust instruments specifying fixed income investments became inconsistent with the always implicit goal of preserving the trust corpus in real terms.

That conservatism is long gone. Our elite - the politicians and the people who back them - have continually upped the financial risk they take as real interest rates have fallen. Now even the inner circle of central bankers with eight figure net worths are day trading to eke out more return on their capital. We just found out that the Dallas Fed president Robert Kaplan was trading in and out of $FLOT, the iShares floating rate ETF, during 2020. We know that Pelosi likes to get super long the market as well. 

It always felt like someone in the Trump admin (Jared & Ivanka?) was repeatedly leaking info, trading on it, walking it back, and repeating for all kinds of economically sensitive matters. And of course Trump spent his career comically over-leveraged in the most leveraged industry of all, real estate.

As I said once, "0% inflation feels like deflation for people who have made commitments that depend on gradual currency devaluation." Remember Trump carping about the Fed and interest rates? How much of that was his reelection prospects, and how much was his own personal balance sheet?

So it starts to seem that the people in this country who make the decisions are not even interested in playing the old deflationary squeeze game because, even if their precarious balance sheets could withstand it, their political Mandate of Heaven probably couldn't. Plus, baby boomer rich are very unlike the old school rich - they do not like seeing things marked down on their net worth spreadsheet. (Every baby boomer has a net worth spreadsheet.)

If a big devaluation is going to happen, it would be best to own attractively priced assets that will grow earnings at least as fast as the currency is devaluing.

Luckily for us, a major inflationary shock is brewing at the same time that people allocating capital are under the delusion that electric vehicles have "disrupted" oil.

Guest Post: @pdxsag on Episode 5 of The End Game by Grant Williams and Bill Fleckenstein

This is a new feature from our correspondent @pdxsag. He has volunteered to “sit through podcasts so we don't have to.” Although, he adds, you should still listen to them, because he is only going to review the podcasts which are excellent -- so excellent you don't want to risk missing-out on anything. The latest is Episode 5 of The End Game by Grant Williams and Bill Fleckenstein, with guest Russell Napier. PDXsag wrote up Episode 6 last month, which had Lacy Hunt as the guest. 

Episode #5 (iTunes) is the counter-point to last month's Episode 6. Lacy Hunt believes unless and until the Fed starts monetization via direct commercial lending, the disinflation cycle will remain operative, up to and ultimately including negative nominal interest rates.

Russell Napier was a fellow disinflation-ist with Lacy Hunt until the Covid crisis. He argues the PPP lending program and similar programs in other developed countries are the leading wave of monetary largess which will result in an inflation cycle among developed countries that nearly every active market participant has not experienced in their lifetime. Napier expects, and perhaps the litmus test of his prediction, a 4% consumer inflation rate by Q2 2021, likely sooner.

Like last time, below are summaries I made of various key-points. Emphasis are mine. Occasional opinions interspersed within square brackets are also mine.

3 min: Fleck asks Napier to go into his process that shifted his thinking to being an inflationist.

Napier always expected the “next recession” to lead to a change. He thought it would be MMT, but one afternoon realized bank credit guarantees are “it.” They didn't exist in February or March, but suddenly they did, and universally in all developed countries.

5 min: Williams suggests loan guarantees are a lot easier politically to get through than MMT, which is very controversial. Napier concurs. Loan guarantees are hard to argue against when they are loans to small businesses in need. And  as contingent liabilities it is easy to pretend they don't exist on the government balance sheet. There is no increase recorded in the national debt. And they can be rolled at 0% interest indefinitely. [A rolling loan gathers no loss.]

7 min: Spain, Germany, Britain all have debt guarantee programs analogous to the US PPP. As an example of loan programs just being extended, Spain's emergency lending started as a 100 day program, then one day by edict it was a 150 day program. Napier concedes if these are a one-and-done pulse then his argument fails, but so far that doesn't appear to be how any of these programs are trending.

Even the Germans[!] are in on the game. They have the fastest growing banking system in Europe.

Britain has the “Bounce Back” program. Loans are up to 50k pounds, ie. to small biz, and 23 billion was disbursed in the first 6 weeks. The loan quality of the “Bounce Back” loans was such that 50% are expected to fail. Under traditional QE none of these loans would have been made. This is a fundamental difference. QE money sits on banks' balance sheets because the credit risk is still the banks' problem. Loan guarantees remove the credit risk, so the loans happen and lead to new money getting into the real economy. The loans are 3.6% for 6 years. Everyone who could, took a loan whether they actually needed one or not. Proof is the gang-busters business boats and sports car dealerships are doing.

Bank credit growth in Japan is shooting up as well. It's everywhere you look.

10 min: Williams says pieces for inflation are everywhere, and yet no one believes inflation can happen. Napier thinks it is entirely a timing question. Pros are paid to leave the party one minute to mid-night. So they are still in the no inflation camp because they think it's still 2-3 years away.

11 min: When every country has double digit money growth it's time to pay attention. 6 months ago OECD released a money growth number that was lowest since 2009. Four months later the rate has more than doubled. [He doesn't state the exact numbers though.]

12 min: If we had a blended inflation rate that took into account asset prices instead of just consumer prices we would be measuring inflation and no one would be arguing otherwise. Napier says he can argue there's a big difference between central bank balance sheet growth and broad money supply growth and their respective effect on asset prices and consumer prices. However, no one wants to argue that point. They justify the last 10 years of CB balance sheet growth only effecting asset prices like it's a good thing [which it's not, unless you're one of the Boomers that already own all the assets you ever are going to need], and use it to act like broad money supply growth won't affect consumer prices either.

17 min: Fleck highlights the distinction Napier made between asset inflation and consumer price inflation and asks why people act like one is good and the other is bad. Napier responds it's because of the amount of debt in the system. The pros realized that asset inflation is a one-way bet in our highly geared system. Even a slight amount of asset price correction would cause the whole system to crash. So pros are able to call policy-setters' bluff by loading up on debt and knowing central banks will act.

20 min: Williams mentions the only time in the last 35-40 years where top 10% incomes have fallen more than bottom 90% was during the S&L crisis. S&L was when asset prices deflated and were allowed to deflate. And it's not talked about much anywhere. The crisis came and went and everyone remembers Charles Keating [ahem, and John McCain], but the game of inflating asset prices since then has become crucial. Napier agrees – recounts he used to see Paul Volcker once a year or so. Napier finally asked him where did it all go wrong. Volcker was adamant that it was LTCM. LTCM was the bail-out where it all went wrong. [Proud to say I've been saying this for 20 f*cking 2 years.] Since then everyone who could gear-up money has bought assets on the belief that they won't be allowed to lose money. Napier continues that there are good reasons we have inequality today – for instance, not everyone is a Steve Jobs – but there are some really bad ones. And a select class being able to gear-up debt to buy assets and get all the tax advantages of that, which equity doesn't get, and know they'll be bailed out if anything goes wrong is one of the bad ones. This isn't an argument against assets or capitalism, it's an argument against one kind of overly favored class. [ahem, more equal] Napier calls it financial engineering vs. capitalism. He laments financial engineering may well prove to be bad for capitalism. [We've all seen enough Millennials cheering on AOC to know he's right about that.]

22 min: Fleck concurs LTCM was the Fed's Rubicon.

23 min: Napier reminds us of the Time cover with Greenspan, Summers, and Rubin, “Committee to Save the World”. It wasn't just Greenspan.

24 min: Williams asks what may happen from here. The return of inflation creates a whole new set of problems, some of which from the point of view of bankers and law makers are pretty dramatic.

Napier: Correct, 1) you have to create inflation and 2) you have to keep interest rates from rising. Not just short term, but long term too. We've done this before. Read “The Deficit Myth.” Yield Curve Control was done from 1941 to 1952, which the author uses as an example of a success, without mentioning during that time the US had rationing, price controls, credit controls, and capital controls including forced purchases of government debt. There was massive inflation in the black and grey market, and of course shortages in the regular market. Next, they forced (institutional) savers to buy government bonds.

What you're really doing is wiping out savers through forced taxation. If we do that, the richest people in the world will get around it. They have the tax advisors and attorneys to get around it. What you're really doing is wiping out the middle class. They can't afford to avoid it. Societies that wipe-out their middle class pay a really high price for it. Yield Curve Control sounds so innocuous and rather technocratic and very boring, but actually it changes the nature of what a society is.

28 min: Napier comments on how they could enforce YCC – They won't force individual savers to buy government bonds. However, life insurance, pension, mutual funds are all regulated entities. Being regulated, the government can say to them, you must buy X% of government bonds. They'll call it Macro Prudential Regulation. Who is going to come out against that? You'd be mad to be against prudential regulation. It's like mom and apple pie. [And universal healthcare coverage.]

29 min: Williams: the pernicious effects of this change from deflation to inflation is going to do more harm to more people than ever before. Napier corrects that it's savers that are harmed, not all people. It moves money from savers to debtors and it strikes at a schism in society. It's a redistributive tax without legislative accountability.

31 min: Napier: Soft money regimes are a product of democracy. We shouldn't forget that. The gold standard ends as soon as women get the vote. [Based!] Now a lot of people support the gold standard, but I don't. I prefer democracy. [Sad trombone] But I would think hard currencies and democracies are incompatible.

32 min: Fleck: what do you say to the people that are in the camp that there's too much debt.

Napier: There's not too much debt, there's not enough money. [lol wut] For the last 20 years we've tried to let Central Bankers create more money and they've failed to achieve it. So finally they've found a way around that with these lending programs. There are several ways to bring down a debt to GDP ratio and inflation is the least painful, and that's why it's preferred over defaults and preferred over austerity. The post-WWII gives us the model. Policy makers point to the 1945 to 1980 period as a triumph. But to put into context for listeners, what was it like to be a saver in that time period? If you owned British gov bonds you lost 85% of your purchasing power. There are modern policy makers that believe that to be one of the greatest success stories in history.

35 min: Napier: It's a supreme irony that every one I talk to believes Central Bankers are all-powerful, just as they've lost all their power to government policy makers. Government usurped Central Bank control by dictating the commercial banks' balance sheet growth and contraction. If banks are mandated to increase lending, they will have to make the loans and that money will enter the system. Admittedly people push back and say these lending programs are temporary, and if they are temporary I will be proven wrong. But, I'm not, that's how government can overwhelm Central Banks. It's capitalism with Chinese characteristics.

38 min: Napier brings up Euro and how this model with 19 member nations doesn't bode well. There will come a time when Germany wants to stop and countries like France or Italy are still very keen on keeping the money growing, and that's where the schism comes into the Euro, which raises questions about a single currency.

39 min: Fleck asks about End Game in Japan.

Napier: Start from the premise that Central Banks will never shrink their balance sheets. Is it really debt then? It is a perpetual non-interest bearing transfer. Where I come from a perpetual non-interest bearing transfer is a gift. [lol] Even Goldman couldn't sell a perpetual non-interest bearing transfer.

Japan's broad money growth is 5.9%, a 30 year high! People may ask why didn't they do this to begin with. Because they didn't create debt they created Reserves. Historically, if you created too many reserves in the system you got massive bank loan growth and inflation, but this time around those reserves just sat there: no loan growth, no new money, ergo no inflation.

For eight years I have been saying this is how it would end. They just mandate commercial bank balance sheet growth. I didn't see them doing it through bank credit guarantees, but here we are.

We've done bank balance sheet limiting to fight inflation. Nixon did it. The revolution of the 1980's was using interest rates to regulate money growth, not government regulation. Now we've come full circle. We're using government regulation to induce inflation, not fight it.

45 min: Napier: under the new model, fire everybody and hire Brazilians. If somebody can grow capital in Brazil that person deserves respect and admiration. You should have Brazilians on the End Game program. Developed world investors have learned everything they know under 40 years of disinflation. Emerging markets have a different skill set. By way of example, the skill set you needed from 1945 to 1979 is a different skill set than you've needed from 1980 to the present. [CBS - investor genotypes in an investing ecosystem]

47 min: Fleck asks Napier to give investors of today a short-hand for what financial repression means and how it operates.

Napier: Yeah, so I have a 90 minute presentation on this, so in other words we're really going to have to really, really, really get going. 1.) Prepare for capital controls. 2.) Inflation above interest rates – the firms that are prepared for that are minuscule in market cap. If you've had a 40 year trend in inflation and the winners are all those that benefited from disinflation, when you turn that around, those are not going to be the ones suited to the new environment. 3.) Look at Japan. They've not benefited from high fixed costs in a world of disinflation, so higher inflation should benefit them now. [Very interesting that Buffett made news this week with a $5 Billion investment in Japan] 4.) Read about the 1945-1979 period 5.) Gold is the stand-out asset. I'm not a gold-bug. It's not a productive asset, but it is the stand-out asset when we are dealing with financial repression.

50 min: Williams: with the caveat you're absolutely not a gold bug, could you talk a little bit about gold.

Napier: I'll set aside the inflation bit. That's the part everybody “gets.” The other bit is the interest rates, mandating they be below inflation. In response people go for that thing that isn't a paper asset that can be interfered with. If government wants to interfere with return on equity it's easy, they can double the corporate tax rate. If government wants to interfere with return on bonds they can do that by creating inflation and forcing you to buy bonds. The only way government can interfere with returns on gold is to take it off you. That's not impossible, but it is unlikely. [CBS - Actually very likely since it already happened during the 20th Century.]

If you look at gold now it's taking off while inflation hasn't. That's a reflection of government interfering and creating a premium for that which cannot be interfered with, because if it's inflation driving it, gold is way above where it should be.

53 min: Williams: where are inflation expectations?

Napier: They are still at incredibly low levels. Indicated inflation rates are 0.5% for whole of Europe. Italy is below 0.2%. US is higher. South Africa and Brazil are higher. But they are still incredibly low. France is below where it was in 2009.

Put another way, except for Japan most of the break-even inflation rates are at levels of inflation over the next five years that none of these countries has ever achieved. [It's Stag Mark's world and we're all just livin' in it. :)] Even Germany. Germany has never achieved the level of inflation they are expected to achieve over the next 5 years. So yes, inflation expectations are higher, but they are no where near what might be considered break-out levels. It's just not happening yet. So it's interesting about gold. Whatever is moving it is not inflation.

55 min: Fleck responds: Bond markets have been anesthetized. They've been an administered market for so long no one knows what to do. Conversely gold it still a “free market” where participants think for themselves and know how to act. So they are ready to respond to inflation expectations faster than the bond markets.

58 min: Interesting take on China military action potentially driving gold too. The medium range missile treaty Trump got US out of wasn't done because of Russia. It was done because of China. So now the US needs a country in Asia to stage medium range (3000 mile) missiles.

1 hr: Williams: What do you think of all the V-shape recovery talk.

Napier: Using SARS in Hong Kong as something of a guide, it all reverted to normal within 18 months. I have this incredible faith – and dismay – [lol] in human beings' ability to revert to form. Think of what human being have been though... the Blitz, SARS, etc. But they want to go back to what they had before. And on whole the achieve it, and they achieve it far more quickly than you'd think. So that's not a V-shaped recovery, but if in 18 months if consumption relative to savings is back to what it was in January; if we have the same GDP as before and broad money growth stabilizes at 15% a year from now, 4% inflation doesn't sound so unrealistic.

1 hr 5 min: Fleck: on the subject of inflation, CPI has been bastardized in the US. So when you say 4% do you mean CPI at 4? I think we'd need inflation at 10 or 12 because it's such a bad measure.

Napier: No I think the reported number can reach 4. [record-scratch] 4 isn't so outrageous. We were close to 4 in 2007, 2011, 2000, 1996. I have a long presentation on why 4 is important.

Those were all periods of China producing and periods of massive technological breakthrough. And those were periods of money supply growth closer to 10 than 4, and even then you got to 4 on the measured number. I think it's a fairly straight-forward forecast. Where it gets difficult is what happens after that, because above 4 it can spiral out of control very quickly. That's what's significant about 4.

There's been four times in the US where it's gotten to 4 and stopped. [Um, by crashing the equity markets.] I don't think it will this time. But it's hard enough to convince people it will even get to 4.

That's an interesting part of history. I don't think there's been a fiat currency that's stopped at 4. That's an achievement of sorts. It's come at a very high price if you ask me.

Fleck: we've had two bubble bursts to achieve that.

Napier: that's what I mean by it's come at a high price. But if the market believes we can cap it at 4. And through that time period we've just added more and more debt, meaning we really have to inflate it away. Maybe that's why people think it can't go above 4 – “because it's never been above 4 in my lifetime,” – which means that you're very young. [Ok, wow! Good points.]

1 hr 8 min: Williams: Can you tell people how they can follow you more?

Napier: Well there's kind of bad news. I write at my website, but you're only allowed into my website if you're a regulated financial institution. That's just how it is under British law. The good news is that lots of people steal it and appears all over the place. Using [Bing] and the year 2020 it's amazing where it will crop up. Some day we will pursue those vagabonds, but for now you can get it if you are resourceful. [lol]

1 hr 10 min: Closing comments.

Fleck to Williams: Wow. That's gonna blow some people's minds. [Guilty] I mean, I believe everything he's said. He's articulated it better than I ever could. I thought about the point Michael Green made, that the game you're playing might not be the game that's being played. Napier said it differently, but maybe the game is changing to something you'd have to have a lot of grey hair to have seen before.

Williams: That's what this series is all about. You have to stay alert to changes in the game. They will change the rules and when they do it's going to be really fast, before anyone can react to the rules having changed, or what's the point of changing the rules? [Indeed. Lots of quotes about lying central banks and lying politicians come to mind here.]

Stagflationary Mark on Inflation

We've been able to bring Stagflationary Mark (proprietor of the Illusion of Prosperity blog) out of retirement and he's commenting on recent posts. He made a good point last night that everyone should see:

In February 2011, Jeremy Siegel said, "As economic growth recovers and real rates rise, the price of Tips will fall leaving Tips investors with large losses in the face of accelerating inflation."

This is my favorite quote of his. It’s been a recurring theme on my blog.

30-year TIPS real yield then: 2.10%
30-year TIPS real yield now: -0.19%

Thankfully, was never a believer in the economic growth will drive real rates higher theory. Never experienced the large losses. Far from it. That theory only makes sense if the prosperity isn’t illusionary and the economy can therefore tolerate higher real yields without imploding.

Was also never a believer in the Treasury Inflation Protected Securities (TIPS) would leave me with large losses in the face of accelerating inflation theory, either. Maybe it’s because those bonds would be inflation protected in the face of accelerating inflation. Go figure. Fortunately, never really had to test that theory. Inflation never really did accelerate.

2.10% was a gift for risk-averse long-term investors, and I wish to thank Jeremy Siegel and his mindset for helping to make it possible. Locking in an acceptable real yield with intent to hold to maturity never caused me to lose much sleep. Unfortunately, those days are over. Now we can all lose sleep together. Those of us paying attention, anyway.

Just before writing this, I purchased I-Bonds and EE-Bonds for the year. Wanted to get the purchases in before rates reset on May 1st. The former are tied to the inflation rate but cannot deflate. The latter double in value if held a full 20 years (effective 3.53% annual interest rate). No greater fool ever needed.

The Federal Reserve has to maintain a delicate balance. I say that they will err on the side of sliding into Japan’s situation instead of Zimbabwe’s situation. Japan has clearly shown that as dire as it always looks, it has still been manageable. At least so far, they never really lost control. Zimbabwe’s situation is the immediate end of America as we know it. Lesser evil thinking. Delay and postpone. That’s the only end game there is now.

The Fed cannot risk any resemblance to the 1970s repeating from here on out, because the next time we will probably never pull out if it. It was so hard the first time.

The Fed can risk ZIRP and Japan level deflation though. They will stay in control. I’m thinking best case for them, given current conditions, is 0% inflation with 0% interest rates. Gives the Fed temporary infinite power to protect the banking system. There’s no way out of the trap. It will obviously fail someday. But perhaps after I’m dead.

Real yields too low and toilet paper won’t be the only thing people are hoarding. Too high and the economy implodes. That’s why I’m betting on 0%. Is it a coincidence that Japan ended there for both inflation and interest rates? Maybe not! Lesser of all evils I’m thinking.

And lastly, remember that long-term fed funds rate chart I did? It was an exponential decay chart that ends at 0%. Well, it’s happening again. We’re right back on trend. There may come a time, like Japan, when a quarter point increase in the fed funds rate is thought of as draconian. And back down to zero we will go.

Just theories. If I knew everything, then I wouldn’t have called myself Stagflationary Mark, lol.

Glad I backed up the truck on long-term TIPS quite a few years ago, back when I was told there was a bond bubble. The ones that mature in 2040 and 2041 are still paying me 2.13% over inflation. I should probably sell them to those now settling for negative yields, but I already cashed out the one TIPS bond filling my retirement account. That’s all cash now and it’s patiently waiting for fairly low risk long-term opportunity. I’m reasonably content.

If the Fed intended to shock and awe me into taking serious risk, they have failed miserably. I have never been this content in cash. I saw two different predictions for oil this week. One was negative $100 (short-term);and the other was positive $100 (longer-term). Feels like a casino and far too obvious, like nice round numbers are just being pulled out of a hat for many retail investors to choke on.

The Fed could easily get us to hyperinflation if the banking system truly wanted that. All they would need to do is announce a $180+ trillion program to protect America’s $180+ trillion pre-crisis net worth. The Fed most certainly does not want that though. Instead, they offer a much, much smaller program with intent to shock and awe us into believing they will toss unlimited amounts of money from helicopters.

Today, the National Review wrote that "it really doesn’t matter which economic theory you subscribe to, they all arrive at the same destination — more inflation."

Speaking of Japan, we have an update on the Japanese consumer price index. It's up about 2% - total - over the past 20 years. Meanwhile their central bank balance sheet has expanded 6x. Japanese stocks are flat over that time period. Their 10 year bond has occasional positive yields now, but hovers around zero. What I said in 2014 about Japan:

On a long term view, Japanese CPI increases seem to have stopped right around the time that serious yen printing started. The "increased monetary base causes increased CPI" thesis has sprung a leak, and the inflationists are out of buckets. Clearly there is a different, lurking variable. In fact, an increase in monetary base and a fall in the inflation rate both look like dependent variables of population!

The expansion of the Federal Reserve balance sheet (money printing) is not exactly a secret, and seems to be more than priced in, at least in the assets and commodities that rich people buy because they think they will protect them from inflation. Lumber is cheap, but timber land is not.

The Federal Reserve balance sheet expansion is easy to measure, and people obsess about it. Deflationary forces are real, but harder to measure.