#192. The Great Dilemma

MAPPING THE STAGFLATION TRAP

Governments in general – and finance ministries in particular – face a tricky dilemma.

Simply stated, the dilemma runs like this. If governments don’t keep pouring liquidity into the economy, activity will slump, numerous businesses will collapse and voters will face extreme hardship.

But if they do carry on with gargantuan financial largesse they risk, not just a surge in inflation but, quite possibly, an associated rise in interest rates.

The only practicable line for finance ministers (and central bankers) to try to walk is a “Goldilocks” one, avoiding the extremes both of an overheating financial system and of an excessive cooling of the economy.

The theory is that, if they can tread this course adroitly, economies will enjoy the benefits of a return to growth, with inflation in due course falling back into a preferred range somewhere between 1% and 2%. If achieved, this would amount to a return to what was, in the 1990s, sometimes called “the great moderation”, describing a combination of solid growth and subdued inflation.

If conventional, ‘money-only’ economic interpretations were valid, it might just about be possible for them to walk this line – in reality more like a tightrope – and find solid ground on the other side of the crevasse opened up by the coronavirus crisis.

But energy-based interpretation reveals that no such solid ground exists. Rather, something not unlike stagflation has long been hard-wired into the system. Whilst global GDP expanded at a trend rate of 3.4% between 1999 and 2019, growth in underlying prosperity trended at only 1.25%, and has now ceased to grow at all. This disparity of itself suggests that broad inflation has long been far higher than reported levels. 

None of this should really come as too much of a surprise. After all, pouring cheap credit and cheaper money into the system has been going on for more than twenty-five years, and energy-referenced analysis, as provided by the SEEDS model, reveals that this has done no more than disguise the reality that relentless rises in ECoEs (the Energy Costs of Energy) have put prior growth in material prosperity into reverse.

The aim here is to start by explaining the fiscal and monetary dilemma as it appears on the surface before moving on to use SEEDS analysis to explain why the problems are in fact both structural and insurmountable. In doing so, we need to refer to market expectations, which makes it appropriate to remind readers that this site does not provide investment advice, and must not be used for this purpose     

Loaded for inflation

We should be clear that the balance right now is heavily tilted towards inflation. Throughout the coronavirus crisis, governments have been able to replace the incomes but not the output of idled workers and businesses.

This amounts to supporting demand at a time of extreme contraction in supply.

This is why we’re already seeing inflation spiking in a number of categories, affecting anything that might be in short supply during a vaccine-driven economic rebound. We can infer that official expectations are that this is a transitional effect, likely to ease as capacity is restored, and demand-side stimulus fades. Be that as it may, significant inflationary pressures are showing up across the board.

This perception may have influenced asset market participants, who have bought in to the “Goldilocks” plan but with a distinct bias towards the inflationary side of the equation.

If investors were to factor higher inflation into their calculations, we would expect them to favour those asset classes (such as equities and property) which could be counted on to – at the least – ride the rising inflationary tide. They would steer clear of cash, and be wary of bonds, because, in an inflationary climate, interest rates might rise enough to drive bond yields upwards (though not by enough to make cash a viable preference). They might look favourably on assets such as cryptocurrencies and precious metals which could be perceived as hedges against inflation.  

This, by and large, is what has been happening. Markets, it seems, are expecting policymakers to ‘talk hard and act soft’, combining hawkish homilies about debt and inflation with a continuation of generous support for households and businesses.

This stance echoes the prayer of St. Augustine, who called on the deity to make him virtuous – “but not yet”.

Furthermore, investors, no less than the authorities, must be aware of the delayed price-tags attached to some of governments’ covid response initiatives. For instance, granting interest and rent “holidays” has inflicted substantial losses on counterparties such as lenders and landlords, and these costs must in due course be made good, unless we’re prepared to accept failures in counterparty sectors.

We should, then, anticipate some virtue-signalling tax rises which, in sum, amount to little more than small down-payments on the enormous costs of combating the pandemic.  Not for nothing has inflation been called “the hard drug of the capitalist system” – it offers a beguiling short-term alternative to painful and unpopular adjustment to economic stresses.

The energy point meets the expectation bubble

Guided by conventional interpretation – whose faith in ‘perpetual growth’ is, as yet, unshaken by events or anomalies – governments and investors alike believe that there exists a ‘promised land’ which, if we can once reach it, combines real growth of at least 3% with inflation of less than 2%.

The fatal error on which this supposed nirvana is based is the belief that economics is nothing more than ‘the study of money’, such that energy and broader resource limits to material prosperity do not exist.

The reality, of course, is that everything (including other natural resources) which constitutes economic output is a product of the use of energy, whilst money is nothing more than a medium for the exchange of energy-enabled economic goods and services. The fly in this ointment isn’t that we might ‘run out of’ any form of primary energy, but that energy supply costs (measured as ECoEs) might undermine the dynamic by which energy is translated into economic value. 

As regular readers know, the undermining of this energy dynamic is exactly what we’ve been experiencing over a protracted period. Global trend ECoE has risen from 2.6% in 1990 to 9.2% now. Along the way, this pushed prior prosperity growth in the advanced economies of the West into reverse from 2006 (at an ECoE of 5.7%), and is now doing the same to less complex, less ECoE-sensitive EM countries. There’s a whole raft of flaws in the thesis that we can transition, seamlessly and painlessly, from increasingly costly (and climate-harming) fossil fuels to renewable sources of energy.   

The weakening energy dynamic is precisely why, globally, we’ve spent two decades borrowing $3 in order to deliver $1 of “growth”, and why the ratio of borrowing to GDP has averaged 9.6% to support “growth” of just over 3%.

We’re at the point now where, if they wish to sustain a simulacrum of ‘growth as usual’, the authorities will find it necessary to pour ever-increasing amounts of liquidity into the system. In so doing, they will be creating financial ‘claims’ on economic output that the economy of the future will be unable to meet at value.

At the point at which the ‘real’ economy of energy can no longer support even the illusory sustainability of the ‘financial’ economy of money and credit, the value supposedly contained in these financial “excess claims” will have to be destroyed. Whilst “hard” defaults cannot be ruled out, the balance of probability favours the “soft” default of rampant inflation.

Optimistic investors might, if they were aware of this, think that ‘real’ assets, like equities and property, can still maintain their real value by rising by at least as rapidly as inflation destroys the purchasing power of money.

This, though, is to ignore the effects of the involuntary de-growth induced by the decay of the energy dynamic. As prosperity recedes, consumers will be forced to choose between sinking into a quagmire of debt or adapting to the rising real cost of necessities by cutting back on discretionary purchases.

Whole sectors will suffer utilization rate erosion as prior gains from economies of scale go into reverse. De-complexification of the system will strip some sectors of critical mass, whilst simplification of products and processes will de-layer entire sub-sectors out of existence. Even the Fed cannot sustain the stock prices of businesses whose profitability has ebbed away. 

It was once famously said that inflation is “always and everywhere a monetary phenomenon”. In our current situation, inflation is likelier to be a ‘denial phenomenon’, if we insist on trying, financially, to engineer “growth” when the critical energy equation is heading in the opposite direction.