Right now, the outlook for inflation – or, conversely, for deflation – is one of the hottest topics of economic debate. Some observers contend that the sheer scale of financial intervention triggered by the coronavirus crisis has made soaring inflation inevitable. Others argue that, on the contrary, the weakness of the underlying economy makes deflation the greater risk.
The real threat, without a doubt, is inflation. This isn’t, though, going to be a re-run of the world’s last brush with hyperinflation in the 1970s and early 1980s.
Back then, soaring oil prices triggered sharp rises in consumer costs and an associated surge in wages. The problem now is that the financial system has out-grown the underlying economy to a dangerous extent. This means that hyperinflationary risk lies not in consumer prices, or in wages, but in the matrix of assets and liabilities created by an increasingly financialised economy.
What this also means is that conventional measures of inflation aren’t going to provide much, if any, forewarning of inflationary risk. This in turn is going to give policymakers every reason for not courting unpopularity by raising interest rates.
Rates will have to rise, of course, and the real prices of traded assets will fall, but it’s likely to be a case of slamming the policy door after the inflationary horse has bolted.
Two economies, one problem
This is an unusually complex issue, so we need to follow a clear analytical path to reach useful conclusions. The best way to start is by drawing a conceptual distinction between ‘two economies’ – a real economy of goods and services, and a financial economy of money and credit.
These ‘two economies’ have grown dangerously far apart. As we’ll see when we get into the numbers, the economy of goods and services had, even before 2020, been growing at barely 2% annually, whilst the financial aggregates of assets and liabilities had been expanding at rates in excess of 6%.
Prices act as an interface between these ‘two economies’, so it’s likely that inflation will mediate the restoration of equilibrium between the financial system and the underlying economy.
The fundamental issues are simply stated, and involve three essential principles.
First, nothing of any economic value or utility can be produced without the use of energy. This means that the economy is an energy system, and is not, as is so routinely and so mistakenly assumed, a financial one.
Second, whenever energy is accessed for our use, some of that energy is always consumed in the access process. This ‘consumed in access’ component is known here as the Energy Cost of Energy (ECoE). Because this fraction of accessed energy is required for energy supply itself, it is not available for any other economic purpose. This means that surplus (ex-ECoE) energy is the basis of economic prosperity.
Third, money has no intrinsic worth. It commands value only as a ‘claim’ on the material or ‘real’ economy of goods and services.
With these principles understood, we can examine the ‘real’ economy (of goods, services and energy) and the ‘financial’ or ‘claims’ economy (of money and credit) independently of each other.
If, through monetary expansion, we create present or future financial claims which exceed what the underlying economy of today or tomorrow can deliver, the result is an overhang of excess claims. Since these excess claims cannot be honoured, they must, by definition, be destroyed.
Of assets and liabilities
Before we can get into the mechanics of where we are now, we need to be clear about the meaning of ‘assets’ and ‘liabilities’.
Let’s start with the ‘real’ economy, comprising governments, households and businesses. From this point of view, assets can be divided into two categories.
Defined or ‘formal’ assets are monetary sums, such as cash holdings, and money owed by others.
Equities, bonds and property are undefined or notional assets. Their aggregate ‘valuations’ are meaningless – these asset classes cannot, in aggregate, be monetised, because the only people to whom they could ever be sold are the same people to whom they already belong.
In fact, the prices of traded assets of stocks, bonds and property are an inverse function of the cost of money, so rises in these prices are a wholly predictable consequence of pricing money at low nominal (and negative real) levels.
Unless the authorities are prepared to countenance the hyperinflationary destruction of the value of money, its price – meaning rates – will have to rise.
This, in turn, must cause asset prices to plunge.
It’s axiomatic, though scant comfort, that the bursting of bubbles doesn’t, of itself, destroy value. Rather, it exposes the destruction of value that has already taken place during the period of malinvestment in which the bubble was created.
Furthermore, if the value of a house slumps, or a company’s share price crashes, the house and the company retain their underlying value or utility. The real problems created by an asset price crash are problems of collateral.
This is why our focus needs to be on liabilities rather than assets.
The nomenclature here can be a little confusing. Debts and other financial commitments are the liabilities of the government, household and business sectors, but they are the assets of the financial system itself. This is why, during the 2008-09 global financial crisis, non-performing or at-risk debts were known as “toxic assets”.
The crisis in figures
With these basics clarified, we can analyse trends in the ‘real’ and ‘financial’ economies. For this purpose, we’ll be looking at a group of twenty-three countries for whom comprehensive information is available. Between them, this group of countries accounts for three-quarters of the global economy, so can be considered representative of the overall situation.
As you can see in fig. 1, energy used in these economies increased by 49% between 2002 and 2019. Over the same period, however, their trend ECoE rose from 4.5% to 8.3%. Accordingly, surplus energy increased by 43%.
This was mirrored in a 39% increase in these countries’ aggregate prosperity. Throughout this period, rising ECoEs steadily undercut the rate of increase in prosperity. Accordingly, annual rates of growth in aggregate prosperity have fallen below the rate at which population numbers have continued to increase. This, as the centre chart shows, has resulted in a cessation of growth in prosperity per capita.
This has happened despite the inclusion in this group of China, India and ten other EM countries. In more complex, more ECoE-sensitive Western economies, prosperity per person turned down a long time ago. The average American has been getting poorer since 2000, the inflexion-point in Britain occurred in 2004, and Japanese prosperity per capita stopped growing back in 1997.
Critically, though, aggregates of financial claims have grown much more rapidly than the pedestrian expansion in aggregate prosperity. Between 2002 and 2019, when prosperity increased by 39%, debt grew by 136%, and non-debt financial assets by 234%.
The result, as shown in the right-hand chart, has been the insertion of an enormous wedge between financial claims and the underlying economy. If you wanted to find hyperinflationary risk on a map, this chart gives you the co-ordinates.
At constant values, the increase in prosperity during this period was $19 trillion. Debt expanded by $116tn, and total financial assets by $262n. In effect, then, each dollar of incremental prosperity was accompanied by $6 of net new debt and $7.60 of additional other financial assets.
This is a good point at which to remind ourselves that these ballooning financial “assets” are the liabilities of the ‘real’ economy of governments, households and businesses.
The following charts amplify the picture by showing rates of change, in the real economy metric of prosperity, and in the debt and assets components of the financial economy. Annual growth in prosperity averaged just under 2% between 2002 and 2019, and has been on a declining trend. Financial assets, on the other hand, expanded at an annual average rate of 6.2%.
To be sure, we haven’t – yet – seen a replication of the dramatic rates of expansion in financial commitments witnessed during the GFC. Now, though, the response to the coronavirus crisis is likely to have accelerated the pace at which we’re taking on financial obligations at the same time that prosperity has taken a beating.
The financial support provided by governments is only one part of the crisis picture. At the same time that governments have incurred enormous deficits to support the incomes of households and businesses, the granting of interest and rent ‘holidays’ has created enormous deferred financial obligations, which in our terms are ‘excess claims’.
Back in 2002, financial assets equated to 298% of prosperity. By the end of 2019, this ratio had expanded to 598%. Taking together both the pandemic hit to prosperity and the rapid expansion in financial commitments, it would be by no means surprising, pending final data, if this ratio was now in excess of 700%.
Ultimately, what we’ve been witnessing is a dramatic escalation in financial claims on what is now a contracting economy. This, rather than consumer price or wage pressure, is the source of the inflationary pressure that jeopardises the system.
How will we know?
As we’ve seen, then, inflation risk isn’t going to be flagged in advance by conventional measures such as CPI and RPI. These measures are sometimes criticised on the grounds that innovations such as hedonic adjustment, substitution and geometric weighting result in the understatement of changes in the cost of living. The big problem with these indices, though, is that they exclude both changes in asset prices and the effects of asset price changes.
The conventional broad-basis measure, the GDP deflator, is really no better than these consumer prices indices. In theory, system-wide inflation is meant to be captured by comparing a volumetric with a financial calibration of economic output. Like GDP itself, though, this deflator is subject to the cosmetic inflation of apparent ‘activity’ by the expansion of financial claims.
In an effort to measure comprehensive inflation, a system is under development, based on the SEEDS economic model and known as RRCI.
Preliminary indications are that RRCI averaged 4.1% through the period between 1999 and 2019, markedly exceeding a GDP deflator of just under 2%. This differential (of 220 bps) may not sound huge, but its application to a global economy said to have expanded at 3.4% through this period leaves precious little “growth”. Last year, estimated RRCI inflation worldwide was 5.5%, markedly higher than the GDP deflator (1.2%).
Preliminary data for 2020 indicates that RRCIs moved up dramatically in a small number of countries, such as Britain and Ireland, which also happen to be ultra-high-risk in terms of the relationships between their financial exposure and their underlying economies.
More broadly, RRCI suggests that systemic inflation has been rising markedly, both in the sixteen advanced economies (AE-16) and the fourteen EM countries (EM-14) covered by SEEDS.
What and how?
Even RRCI, though, isn’t likely to give us a clear warning about the true magnitude of hyperinflationary risk. To get a handle on the scale and possible timing of this risk, we need to think about two issues. One of these is spill-over, and the other is futurity.
Where spill-over is concerned, the risk is that rises in the prices of traded assets may induce consumers to increase their recourse to credit in order to boost their spending to levels commensurate with their perception of increased wealth.
If someone’s home has increased in theoretical value from, say, $400,000 to $600,000, is there any reason why he or she shouldn’t ‘cash in’ part of that gain’ using secured or unsecured credit, which, in any case, remains cheap?
Likewise, is there any reason why a company whose stock price has soared shouldn’t go on an acquisition spree, preferably buying lower-rated companies to enhance ‘growth’ perceptions, and boost earnings per share?
These spill-over risks are additional to the basic risk of supply and demand imbalances in the market for everything from stocks and houses to classic cars and works of art.
The more fundamental issue, though, is futurity, which for our purposes means our collective or ‘consensus’ picture of the economic future. This is far too big a topic for detailed examination here. What it means, though, is that investors might favour seemingly costly stocks if they anticipate brisk growth in earnings; house-buyers may be prepared to bid up prices if they anticipate perpetual expansion in property markets; and lenders might be relaxed about extending loans to borrowers whose incomes, they assume, are going to grow markedly.
Despite the coronavirus crisis, faith in a ‘future of more’ seems unshaken, and there are assumed to be ‘fixes’ for all issues. The consensus assumption remains that everything from vehicle numbers and passenger flights to corporate earnings and automation are poised to go on growing indefinitely, and that there are technological solutions even for environmental risk and energy constraint.
Looking ahead, it isn’t difficult to see asset price inflation carrying over, first into consumer prices and then into wage demands. This is the point at which policymakers realise, belatedly, that policies of ultra-cheap money are, by their nature, inflationary.
The real risk, then, isn’t just that reactive (rather than anticipatory) rate rises cause asset prices to slump, but that these blows to confidence simultaneously expose the delusions of false futurity.