The Nominal Game We Play

Intro

I have not heard one argument from the Inflationists that isn't tainted by concepts blinding them to the pragmatic reality of how inflation actually works.

(5400 words)

The Nominal Game We Play

The reason a wage price spiral is not a cause of runaway inflation is because wages are not a cause of rising prices; they are a price, and all prices are an effect of the money supply, which expands the balance sheets of consumers and businesses (depending on how it's distributed). This is not something that has to line up perfectly on a chart because there can be lags shaped by things like velocity and confidence, particularly when influenced by pre and post globalization effects, among other variables, but without a broad increase in the money supply, where does the money come from to pay for general rising prices? If you say “wages,” you are engaging in a self-referential loop that requires funding to fuel it. The flawed thinking goes like this: “prices go up, which pressures wages up, which pressures prices up in a self-fueling spiral....” But this assumes an infinite balance sheet when in reality rising prices cause consumer and business discretionary income to shrink because it’s not simultaneous and it's unevenly distributed. 

Let’s assume the money supply stays constant and the federal government forces a 10% increase in all wages so it happens simultaneously to all businesses. This would cause a 10% loss to all businesses via increased payroll, so let’s also assume every business decides to raise their prices by 10% to offset it. Let’s further assume everyone spends the 10% increase in wages proportionally across every business so they all initially lose 10% in higher expenses but it’s replaced with 10% of higher revenue. What is the result? Wages and prices go up but there’s no real economic gain. All that happens is the level of debt remains constant while the nominal wages and prices to repay it increases. This is the process of inflating away debt. 

There is not a self-fueling inflationary mechanism here unless the forced simultaneous wage increases happen consistently every year, and there’s a boatload of assumptions I made to illustrate how unfounded fearing a wage/price spiral actually is. In reality, the money doesn’t get spent evenly, so some businesses receive a disproportionate amount of the benefit while others receive less or none. Also, not every business can raise their prices without hurting their revenue in lost volume. A business would likely respond to forced higher wages by cutting hours and making the remaining employees work harder, which is another reason why a wage/price spiral cannot fuel itself without continual funding. The same reason high prices cure high prices, inflation cures inflation, except during hyperinflations which typically involve an ever increasing flow of money to broad consumers from a noneconomic actor like the government. Free market competition prevents runaway inflation. You will only find sustained inflation in sectors or countries where monopolies exist, or government intervention overrides free market mechanisms broadly.

Here’s another flawed concept: inflation expectations cause rising prices. There isn’t a single merchant on the planet who will take my inflation expectations as payment for their goods and services. They insist on money, which is a prerequisite for inflation expectations, so if the monetary expansion stops, inflation expectations will follow, and demand will weaken, ending the inflation as discretionary income and profit margins get squeezed and cause a slowdown or recession. A caveat to this is how idiosyncratic it can be. A growing business could see all of its input prices go up and yet its free cash flow still increases because its market share is growing. Likewise, an individual who gets a raise that exceeds their increases in expenses is not affected by inflation in real-time. Naturally, the percentage change in wage growth for those making less money doesn’t increase the absolute dollar amount of their discretionary income nearly as much as those making higher income, so the economic effect from the same percentage increase in wage growth varies dramatically across the income spectrum for the universal goods and services everyone consumes, which makes inflation a very regressive tax that hurts the poor the most. A statistic that would express this is showing the percent of disposable income consumed by each category of CPI across each of the income quintiles. If that statistic existed there would be far less conceptualizing about inflation.

If you think prices can sustainably rise without being fueled by the expansion of the money supply into the hands of broad consumers, prove it to me by drawing a flow chart of 5 consumers and 5 businesses as pyramids with the largest base layer as income, a smaller middle layer as expenses, and the smallest top layer as discretionary spending. What is causing prices to rise? Is it a supply side phenomenon or is the money supply increasing? If it’s a supply side problem, the middle expense layers of the pyramids expand (overall) but the bottom income layer doesn’t, so the top discretionary spending layer must shrink. This is what happens when energy costs, interest rates, or commodity prices, rise, which forces a reallocation of budgets away from discretionary items towards mandatory spending on staples and utilities. 

If there’s an increase in the money supply, the bottom income layer expands, which allows the top two layers to expand as well because there’s more money available to spend. You cannot expand the expense layer in the middle without shrinking the discretionary layer at the top unless the income layer rises, but the income layer can’t rise universally for everyone unless the money supply increases broadly through wide scale borrowing or redistribution stimulus programs. Increases in prices caused by the supply side induce recessions that self-correct the supply imbalance because consumers and businesses don’t have the money to pay the higher prices, so demand wanes. If the productive output of an economy increases while the money supply remains the same, prices go down. This is a welcome deflation and the natural mechanism of the free market because it reduces the middle layer of expenses and therefore increases the discretionary layer without requiring the income layer to increase.

A runaway wage price spiral is impossible, but a slow moving one is the basis of our economy. In fact, a system of fractional reserve banking and deficit spending requires a wage price spiral; it’s the lubricant that allows the engine to run, so it’s peculiar to hear people worry about a wage price spiral when it’s the desirable outcome. Without a wage price spiral the whole system implodes. How else are people going to pay for the higher prices? Prices don’t come down; wages go up. Our system requires a continual expansion of the money supply to fund a continual wage price spiral to prevent it from collapsing. It’s surprising how many people didn’t take the time to figure out the difference between a rate of change and a price level of inflation. There are still people who believe prices have to come down for inflation to subside when it’s wages going up over time that makes it work. What usually deflates following, or alongside, an inflation, is asset prices, not consumer goods, although sometimes asset price deflation is so dramatic it deflates consumer prices as well - until the money supply reinflates everything again, which is the pattern we’ve been in for a hundred years.

If we had sound banking, and sound money, wages and prices wouldn’t have changed much from 100 years ago. The median house would still be a multiple or two of around $6,000 and the median salary would still be a multiple or two of around $2,000. Prices don’t rise over time because the economy grows. In fact, the scale and efficiency of free market competition causes prices to fall over time. Prices rise from the money supply increasing, diluting purchasing power, which then requires more dollars to buy the same stuff, so it’s not prices that are rising, it’s the purchasing power of the dollar going down. Central bank critics blame this on the Fed when most of the money supply is created by banks. It does not matter that banks are funding what should be viable economic activity; what matters is the supply of money per capita vs the productivity. In theory, the money supply could expand and prices could still go down if the overall productivity was increasing faster. In comparison to a system of hard money like gold, the money created by banks could not exist. It is future economic activity brought forward into the present by a printing press. This is why demographics play such a huge economic role and why the Boomers distort everything they touch. 

This is the nominal game we play, and there’s no stopping it because in a debt-based system the value of the collateral supporting it can never deflate or it would destabilize the centralized creators of credit with contagious counterparty risk, which would force the Fed to bail them out. Some like to argue letting the system fail would be akin to the sharp quick depression of 1920, but in a globalized world we don’t have the base layer of manufacturing to lean on, so bailing out the system is not a choice, it's mandatory. Restructuring the debt is also not an option because it would be a massive deflation of the value of collateral. The only choice is the continual debasement of the currency through money supply expansion with the hope that increases in productivity from A.I. eventually outpaces it, or there will be a loss of faith in the currency, which is the ultimate expression and failure of the institutions comprising our system.

To illustrate the point, in 1913, an approximation of M2 was 29.7 billion, and the population was 97 million, which is $306 per capita. In 1959, the first year of officially tracked M2, we had 177 million people and an M2 of 298 billion, or $1,678 per person. In 2023, M2 was 21.1 trillion and the population was 339 million, which is $62,223 per capita, which is 203x the amount from 1913. M2 might be a flawed statistic but you get the point: if M2 was distributed evenly Jeff Bezos would have to sell the yacht. In a gold backed system, the money supply tends to naturally increase in proportion to population growth and improvements in technology as more people are available to mine the gold, and the equipment becomes more efficient. If the money supply per capita stayed relatively the same over the last century we would still have an imbalance of wealth but it wouldn’t be so extreme, and the evolution of technology would have been glacially slow, so there would have been pressure from foreign competitors who were increasing their money supply and reaping the benefits of faster technological improvements in the same way athletes got tempted into steroids to keep up with competition. The predicament we find ourselves in may have been the inevitable result no matter what choices were made along the way, but that doesn’t mean we can’t course correct voluntarily, or be forced to course correct by technology in the future.

One of the main benefits of an incrementally expanding money supply as the cause of incrementally rising prices and wages is best demonstrated with housing. When someone takes out a 30-year loan for $300k at 6%, they end up paying $347k in interest. If the house is $360k at the time of purchase and it appreciates at 4.59% (which is what Google just told me was the average from 1992-2023), after 30 years the house will gain $495k in value and be worth $855k. The average inflation rate was 2.48% during that time. The average annual wage growth since 1992 was 5.15% (according to Google citing SSA). So this Slowflation creates $150k in nominal purchasing power (not counting any refinancing at lower rates over time), which comes from the dilution of the currency causing house prices to rise more than the total interest cost, which is a transfer of wealth from those who hold the currency but don’t own a house, and it’s yet another contributor to the wealth imbalance as those who don’t own assets fall further and further behind. 

Slowflation benefits bankers in nominal terms (but since the money is created out of thin air, the interest received is a net gain even though the purchasing power of the principal they loaned gets diluted over time); it benefits homeowners in real terms (since their house and wages appreciate more than the interest and inflation (overall)); it benefits the government in nominal terms because the debt issued 30 years ago is diluted by rising tax revenue); and it benefits businesses in real terms as they raise prices and become more valuable as assets. The people it hurts are those who don’t own assets, savers in cash, and owners of debt (unless you create it out of thin air like a bank, or if the price of the debt rises like a treasury bond bull market for 40 years so the total return offsets the loss in purchasing power when the principal is repaid). 

One of the more misleading charts is the 99% loss of purchasing power of the dollar over the last 100 years because it doesn’t show the rise in wages that offset it. Chat GPT says inflation since 1913 has averaged 3.1% but real wage growth was still 2% until 1979 and then just below 1% ever since. While money sitting under a mattress decays over time, money earned to pay living expenses has outpaced inflation, so the question is: why haven’t real wages for the lower half kept up with the upper half as seen here, and the answer is globalization. If you owned assets AND got real wage growth during this time you’ve done quite well as “number go up.” This outperformance of higher wage earners in real terms is more evidence of the insidious effects of globalization and the wealth imbalance it causes.

One of the better arguments for a trend change from structural disinflation to structural inflation is the shift from monetary to fiscal dominance. And while I agree this shift is happening and will continue to happen, I don’t agree that it has to cause consumer prices to accelerate any faster than they have in the previous century of Slowflation. Fiscal dominance does not necessarily mean a runaway train of inflation - it means the effect of the responses to deflationary collapses will be more dominated by fiscal policies than monetary policies, but that doesn’t change the order of operations requiring a deflationary collapse first, which then causes an inflationary response that will now likely be dominated by fiscal effects, but typical deficit spending doesn’t cause “general rising prices” in the same way it causes rising prices in specific sectors. 

If we follow the money, government spending flows to the military, transfer payments, healthcare, retirees, infrastructure, etc., which creates artificial demand for the businesses in those sectors and ends up on the balance sheet of banks, but banks aren’t short on capital, so this increase in lending capacity still requires creditworthy borrowers with collateral and viable loans. Neither the Fed nor the Treasury can print creditworthy borrows. To use the pyramid analogy, deficit spending is not a broad based increase in the income layer of the overall population because it’s narrowly distributed to select recipients and businesses. If the government passed a UBI policy, or the Fed started pinning the curve, then I would agree it would be a structural change (which is likely coming if AI takes too long), but that is a really high bar to pass Congress and would only happen as a response to a deflationary collapse. 

If you believe deficit spending causes broad consumer prices to rise, prove it to me with a flow chart showing where the money comes from, and who receives it, then explain how the price of milk and beef and cars will rise if 80% (?) of the population doesn’t receive the money to increase the demand for those products. Prices can only rise if there is an imbalance of supply and demand, so if supply remains constant then where does the sudden increase in demand come from? Some of the inflationists have the right understanding; they’re just saying it wrong. Deflation is the problem; inflation is what they do to prevent the problem from occurring. Some of the deflationists have the order of operations right but they underestimate the response: the only certainty in life is the Fed will be diluting the purchasing power of existing bond principal to pay for future government obligations.

To think inflation is the problem is like saying alcohol is the problem for the alcoholic when it’s the underlying condition of pain causing them to drink. This is not just semantics. If inflation was the problem you’d want to be long the dollar and short everything else because the Fed would be forced to keep increasing overnight rates ever higher attempting to contain it. Since deflation is the problem, you want to be long assets that benefit from Slowflation as nominal prices continually increase over time from monetary and fiscal policies forced to prevent a deflationary collapse, which occurs at times along the volatile way. 

The 1970s inflation was largely caused by simultaneous demand for credit by a freak demographic boom all hitting their peak borrowing years at once over an entire decade (amplified by oil, of course). The 1940s inflation had elements of a locked down economy, and a simultaneous release of consumers when soldiers returned, all hitting a restrained supply chain since so many manufacturers switched to producing munitions, so a sudden increase in demand hit a reduced supply. (Among other factors in both decades, of course.) To whatever weak extent companies are reshoring due to subsidies, that is a supply side force because it’s not increasing the money supply. And Treasury deficit spending financed by the private market isn’t inflation; it’s just redistributing money and crowding out private investment that could have happened elsewhere. Foreign buying of treasuries is outside money like the Fed, which is additive, but you’d have to follow the money to determine who is receiving it to figure out which consumer prices are likely to sustainably rise from it, not to mention where it came from, which is our trade deficits. In other words, unless there’s a fiscal program that broadly distributes the money, it’s not possible for demand to outpace supply and cause a general rising of consumer prices, so there is no chance of a resurgence in inflation like we saw during Covid. When the Fed inevitably starts cutting rates it is very unlikely to cause enough borrowing to spur inflation like the 70s’ freak demographic boom - largely due to the loss of secure incomes in the lower half caused by globalization. There is a huge difference between general rising prices and the rising prices of specific sectors caused by government interference in the free market. And there is a huge difference between rising prices caused by the supply side vs rising prices caused by an increase in the money supply. The former causes a temporary economic boom while the latter causes a recession, so a new word should be coined to express the difference because the effect on assets prices is dramatically different. 

My experience of the Covid inflation will force the “supply shock only” theorists to soften their views. When I bought my business in 2018, if I call the numbers I bought into 1x, I expected the changes I implemented to increase both the top and bottom lines by 50% in 2019, which is exactly what happened. I thought maybe another 25% increase would happen in 2020, but that would max out this business without getting into a world of headaches I had no intention of getting into. But then Covid hit in 2020 and both the top and bottom lines increased 3.5x and stayed there for two years. I was not affected by a supply problem at all, not even a little bit. My suppliers all raised their prices by 50-100%, which forced me to raise my prices the same, but that was in response to the insane demand, not a supply shortage. In July 2022, when everyone started the summer of endless vacations, my numbers reverted all the way back down to 2019 (a 70% drop). I am neither that good nor that bad at running this business, and while there is some degree of consumer preference changes for sure, nearly all of what happened was caused by the one-off stimulus money. I agree a supply shock was the cause of some degree of the price hikes for a lot of global companies, but if the inflation wasn’t driven by money, then how did the top and bottom lines for so many companies increase so much?  I would argue 75% of the CPI increases were caused by the distributed money and 25% was a supply shock. This is a better explanation why it’s taking so long for the last mile as the money works its way through the system, which has been extended by the Inflation Amplification Act. 

To put inflation in the most concrete terms possible, put yourself at a sales counter of our newly established business. In front of you is our cash drawer, a credit card terminal, and a computer with financing options. On the other side of the counter are 5 customers representing each of the 5 income quintiles. The person in the lowest 20% income bracket is not a factor in determining our cash flow. In fact, in the business of their life they are losing money since their income is being subsidized by transfer payments from us. Most of the people in the 20-40% bracket feel like they’re in the bottom bracket and don’t have much discretionary income. The top 80-100% bracket also doesn’t matter because there’s not enough of them to move the needle broadly and they don’t have to change their consumption even as the world ends in an apocalypse. It’s the 40-80% and most specifically the 60-80% bracket that will move the needle on economic numbers the most. This is the group with the highest number of people with the most discretionary income to spend. 

Now a genuine inflationary impulse happens like the Covid stimulus. First of all, businesses don’t control their prices; they are set by demand relative to the supply in context of the competition. A functioning business does not want to raise its prices; in fact, it’s scared to raise its prices because it could lose customers and hurt its top and bottom lines from less volume. When inflation causes all its expenses to go up, a business is forced to raise its prices and look for efficiencies anyway it can. The idea of pricing power is also exaggerated because it too has limitations. If Coke and Pepsi raise their prices too much they will discover their loyal customers will choose to get their diabetes from the local generic brand. 

Once the intensity of the inflationary demand subsidies, the hangover begins. The business has higher expenses, the employees have higher expenses, the customers have higher expenses, and wages haven’t kept up for enough of the population because they’re unevenly distributed. So the business has to get lean, eliminate unnecessary spending, and figure out how to reduce payroll by giving the most critical employees a raise, but also more duties so hours can be cut overall to keep the expense the same (if necessary). This is why a wage/price spiral is so impossible. It’s not how it works at all. The thought process of a business owner morphs into: how can I maintain (or even increase) productivity with the same payroll? 

If you apply this dynamic to every business on the planet, some businesses (like mega cap tech) are growing their markets because they have products and services continually in need and expanding throughout the globe, so they aren’t as impacted, but the vast majority of small businesses feel an economic contraction much more intensely, so their ability to raise prices to offset their expenses is limited, which is why it’s not a self-fueling phenomenon unless the flow of money to the broad consumer base that is causing the supply/demand imbalance is perpetual. Imagine being behind the sales counter of every business in existence. Follow the money of deficit spending. How many dollars are reaching the customers standing before you and which income quintile do they belong to, and what sector is the business in?  Imagine an extended oil price shock, or a weaker dollar causing commodity prices to rise, or any supply side shock like higher interest rates or higher prices from “deglobalization.” Our prices are going to rise but the consumer's discretionary income is shrinking, so they have less to spend. Now compare the supply side causes with stimulus checks sent directly into the hands of our customers, bidding up our prices. The supply side causes a contraction; the demand side causes an expansion, then a contraction. This is at the crux of the difference between cyclical and structural forces. 

A structural force is grounded in the incentives of the participants, making it perpetually self-sustaining unless something changes to alter the incentives. Structural disinflationary forces are caused by: downward pressure of free market competition eroding profit margins; improvements in output from the efficiency of technology; cost savings from CEOs seeking the lowest cost labor and expenses in the world; the saturation of debt devouring consumer discretionary income; and the demographics of the baby boomers entering their non productive years.

The argument that we entered a new inflationary regime rests on forces like remote work, higher energy costs, fiscal dominance, and deglobalization, but remote work is likely disinflationary, if not deflationary because it will cause serious write-downs of commercial office real estate debt on bank balance sheets with unknown consequences. Remote work is like globalization for digital services, and, really, it’s just changing office locations - it doesn’t add or subtract economic activity. When workers don’t want to come to the office, it opens the potential workforce to the entire world. I recently needed some web work done, so I put an ad on Upwork and received so many replies I had to shut it down. My choices were Dan from Denver for $150/hr, or Monika from Mumbai for $35/hr. One thing you discover about the Monikas from Mumbai is they don’t always represent their fluency in English accurately. And I’m sure some US jobs require a cultural knowledge that can only be acquired through decades of living here, but there is an enormous amount of work the Monikas from Mumbai can do if our workforce doesn’t want it. She did a fantastic job. The point is there’s no economic gain or inflationary impulse if you relocate workers from a downtown office to their houses.

I won’t spend much time on energy because it would be a supply side issue, not an inflation problem, so by definition that’s cyclical as the market will seek a high enough price to self-correct the imbalance, which will drive up prices without an increase in money to pay for it, so it will cause a recession. I agree with Doomberg that Peak Oil is a myth. According to Worldometers the globe has 47 years of proven reserves at current consumption. And if a supply shortage one day becomes an issue, we already have existing technology to solve the problem, even if all the budding new approaches fail: we can convert to natural gas; we can build modern nuclear plants and make our own hydrogen or ammonia; and/or upgrade the grid to power sodium/lithium or lithium/iron batteries, among dozens of other possibilities. The necessity of data centers incentivizes the creation of cheap, efficient energy. I won’t be surprised if A.I. solves fusion or aliens come out of the closet with advanced energy technology. 

Why we don’t incentivize EV hybrids as an interim solution to slow down oil use and grant more time to develop the tech is beyond me. This does not mean we won’t cause our own energy crisis from political incompetence, but that is a political argument, not an energy scarcity one. The abundance and efficiency of energy will go UP over time, dramatically. I expect the next 150 years will have an even greater, cleaner, and cheaper energy impact than the last 150 years, but humans do all the wrong things first until they finally get it right. (Again, I’m not talking about the price of oil spiking if we sabotage ourselves. I’m talking about energy scarcity or abundance and whether we need to worry about the future existence of our civilization.) We already discussed fiscal dominance as a reactionary function and limited in scope unless the money is broadly distributed. We’ll explore the illusion of deglobalization next week. 

The Fallacy of Real Yields and Universal Inflation 

There’s a huge difference between a universal system of standardized measurement like the Metric System, or the US Customary System, and a relative system seeking an average statistic to calculate things like CPI, which varies immensely per individual. Since there is no universal measurement of inflation, there is no universal real yield. It’s a meaningless number akin to the weather channel saying the global temperature is 48 degrees (Farenheit). It depends entirely on where an individual lives, and in the case of CPI, what they spend their money on, what they own, how much income they earn, and their net worth. 

The way to calculate a meaningful real yield would be a spreadsheet where an individual can enter their income and how much they spend per CPI category to derive an individualized CPI, which would have to be compared to their local prices over time. Unlike a house, rising auto prices have a much different effect since they lose value for everyone, but the percentage loss against incomes and its psychological effect vary immensely. Increases in services depend how much you spend on them. Once you input your income, assets, and spending in the proper CPI categories, you can calculate an exact inflation rate against any rise in your income. If you own a house it’s likely keeping up with overall shelter percentage increases but it will of course vary by region and locality and the value of your home. If your wage increase is higher than your personal inflation rate then you’re not being affected by the real-time inflation, even as the purchasing power of the dollar is going down. Technically, the real yield on your excess savings can’t be determined until the money is spent. In the future, when every dollar can be embedded with the ability to track CPI and asset returns across time, it will be possible to calculate the real yield of each dollar from the time it was acquired until the time it was spent, which is the only accurate way to do it. 

If you have money in treasuries collecting 5% in an investment account that you’ll never spend in your lifetime, it’s more appropriate to measure the real yield in terms of alternative investments. Even though it’s apples to oranges, that money could be invested in the S&P, or if you think a market cap weighted stock index to bonds is an unfair comparison, you could use low beta dividend etfs, or more duration, or credit risk, or asset diversification strategies etc... When making a real yield calculation across long periods of time, comparing the yield against alternative investments is just as relevant as CPI to determine the loss of purchasing power. But the final real yield isn’t complete until it’s compared with the price increases in the categories of how the money is spent. Otherwise, it’s just an average global temperature, which may be all we have, but it’s wildly inaccurate.

SUMMARY

Rising prices caused by an increase in the money supply into the hands of broad consumers creates a temporary economic boom that lifts the top and bottom lines of businesses and their equity prices, but much like a drug, it is not self-sustaining and only lasts as long as the money is flowing. Rising prices caused by any other reason shrinks margins and disposable income, which results in the lower equity prices of a recession to reflect the self-correction of the supply imbalance through demand destruction. Sustained inflation can’t exist unless a monopoly like the government overrides free market competition, but even then it’s important to follow the money to determine if it’s a general rise in prices or it’s contained to narrow industries and therefore a relative rise in specific prices like education or health care. The Fed inflates asset bubbles; the Treasury inflates consumer prices wherever the money flows. These two forces, combined with fractional reserve banking, inflated an Everything Bubble via a 203x increase in M2 per capita over the last century. Since the Fed and Treasury have chosen to prevent the deflationary pressure of globalization upon our economy with liquidity (as seen in their balance sheets), but most of our treasuries are privately owned, inevitably there comes a point when the interest to service the debt consumes the entire budget so the Fed will have to outright monetize the debt and pin the curve. A productivity miracle from artificial intelligence can save the day, but will it arrive in time? The mystery and suspense is like living in a movie. 

Next week in The Surprising Superiority of Modern Monetary Theory, we’ll find out if a long-term sound money advocate has changed his mind. 

The Governing Dynamics

Intro

These articles explore key economic ideas that all financial professionals know, but in my quest to "question everything," I hope to convey a pragmatic, divergent viewpoint that challenges your beliefs and illuminates potential ramifications of how various asset classes would be affected.

The Governing Dynamics 

(5035 words)

The entire world is a giant free market with varying degrees of distortion, and the building block of a free market is business. Someone combines physical or digital raw materials into a product or service and charges more than it costs to produce, which is the profit margin that pays for everything in life from wages to taxes to expenses - for everyone. Creating a viable business from scratch is challenging, and rare, but once a business hits escape velocity by generating enough revenue to pay for its own expansion, it can choose to pursue its potential by attracting investment capital, or slowly expand on its own. A viable business model that generates a high return on capital invested over a long period of time is the holy grail of investing, and its potential cash flow is the basis for determining its value. 

Ultimately, if the core product or service remains in demand and has a large enough market, competition emerges, which creates downward pressure on prices as profit margins get squeezed. Over time, successful businesses in free market capitalism tend to consolidate and form oligopolies of grand size and efficiency. With rules enforced by the government to ensure no collusion in price setting, the natural competition between large players with efficiencies of scale produces the lowest possible price for the consumer as the businesses integrate within our daily life, penetrating the borders of a purely domestic economy to improve the lives of the entire world.

The government does not exist as an independent entity. It's just a group of people we elect and grant the power to fund communal operations by extracting taxes from the profits of viable businesses (meaning, all personal taxes actually come from the profits of the business). No new economic rules emerge from this process; the economy remains nothing but a collection of viable businesses in different stages of maturation, and the resources they use. The government has expenses, income, and debt with interest just like a business that must be paid or rolled forward. Businesses, however, are embedded with an ownership stake that ensures efficiency and price discovery because the operators are incentivized to produce the most profit possible since the excess is retained by the owners and/or distributed to shareholders. The government lacks this accountability since its services don’t have ownership, so its spending is often indiscriminate and wasteful at best, or unnecessary and corrupt at worst, especially when there isn’t a hard restraint on its ability to issue debt and/or create money. When you compound the problem in a (indirect) democracy by requiring politicians to appease voters to get elected, and further compound the problem with a central bank able to (indirectly) fund the deficits, the misaligned incentives guarantee an ever increasing amount of government debt that continually debases the currency and inevitably leads to collapse. In order to change this output, you have to change the misaligned incentives of the inputs, or hope the productivity of technology outpaces the growth of the debt so the increased taxes can pay for it.

A healthy domestic economy has sound money, sound banking, and a natural balance of goods and services. The reason manufacturing is the engine of an economy is because it produces the base level physical goods of survival. The human body needs food, shelter, clothes, (and an iphone 🙂) to survive. The next add-on layer of goods consists of furniture, appliances, cars, TVs, etc.. Wherever a modern civilization exists, the physical goods of survival are created first. Services are the multiplier jobs that layer on top. A culture can certainly exist by satisfying only its survival needs, but it cannot exist by only having add-on services. The need for a car to get to a job creates the need for a mechanic etc., not the other way around. When you export the base layer of manufacturing it creates an imbalance in the economy that will show up in GDP and trade deficits as the economy slows and/or stops growing organically. 

It makes no sense why government deficits count in GDP because it’s not a viable business model producing sustainable growth. Once you remove the distortion, we haven’t had much growth since the turn of the century, but it’s actually worse because government spending has a multiplier effect until it reaches the point of diminishing returns, which some people estimate around 90% debt/GDP. Until then, one dollar of deficit spending produces more than one dollar of growth, but after that point it takes ever higher amounts of spending to generate the same dollar of growth, which is a doom loop if the problem causing the deficits is structural like globalization because you’d have to keep shoveling more and more money into the furnace to get less and less heat. Therefore, in order to get a more accurate gauge of our true GDP, you’d have to subtract the deficits and the “pre-diminishing return” multiplier, which would reveal the developed world has been broken and flirting with depression for twenty plus years. 

Ideally, when someone makes an assertion like that you’d want to see evidence in other data, so if what I’m describing is true you would expect to see a decrease in the labor participation rate since around the turn of the century when the WTO policies put globalization into high gear. You would also expect to see a long era of decreasing interest rates that ultimately end up pushing the zero bound because the free market is a self-correcting mechanism, so when economic growth slows, interest rates fall to stimulate demand for the borrowing to restart it. But if the problem causing the slowdown is the manufacturing base of the developed world domestic economies relocating to the developing world to capitalize on cheap labor, inexpensive land, lack of regulations, etc, then the self-correcting mechanism of the free market won’t be able to restart the engine to regain the previous trend line of growth even at zero rates, so it forces the government to keep pouring gas into the car with deficit spending but the engine is missing to restart it. I have no idea why people say “raising the debt ceiling is paying for bills we already incurred” when bills are paid with income, not debt, so raising the debt ceiling is the definition of NOT paying the bills. 

Advocates of globalization (who tend to be heavily invested in its beneficiary businesses and therefore have a conflict of interest preventing them from seeing the truth because they’re being paid to not see it) (if this is you I don't mean this personally) argue that digital services have replaced our manufacturing base, but this is demonstrably untrue. All you have to do is look at the trade deficit, which is the middle class standard of living being exported overseas. If digital services were an equivalent replacement there wouldn’t be such a drop in the trend of GDP, or the labor participation rate, or interest rates, and there wouldn’t be such a wealth imbalance, or populism, or the pervasive feeling that Main Street is being left behind, which are symptoms of a systemic problem. Even digital services that can be exported and improve the trade deficit are not equivalent because they tend to be higher skilled jobs with a much smaller employee-to-executive ratio per revenue produced; whereas, manufacturing creates more secure jobs for a greater number of workers that requires less formal education and naturally has a more balanced distribution of the wealth produced, particularly because private sector unions help balance the power (and unintentionally caused their own demise). If anything, based on the percentages of the population’s formal education, it could be argued there should be more manufacturing jobs than services. 

The free market response to the competition of cheap overseas labor would have been a dramatic drop in our wages to compete with them, but the problem is twofold: no one would work for that rate; and it would be devastatingly deflationary because no one would earn enough to pay their developed world expenses. If our domestic companies all bandied together and agreed to stay onshore for the sake of our country, the strength of our currency would have made their exports too expensive for developing countries to afford, so it was inevitable that they would expand overseas to increase their markets, but an interesting alternate history to consider is what would have happened if a law was created stating any final goods sold to a retail customer must be (predominantly) manufactured within the same country (yes, it’s complicated). Our companies could have added facilities in Mexico and China to expand their markets, but if their final products had to be sold within the same country, their profits would be dramatically less because the prices they could charge would be proportional to the low wages the local foreign workers could afford. A policy like that would have put Main Street equal to Wall Street and resulted in much smaller market caps for our global companies, and a reduced imbalance of wealth. But a policy of global cooperation in an era of competition was not meant to be, particularly when the lobbyists of our global companies had so much influence over policy and so much incentive to sell out our middle class for their own benefit. 

If I argue in favor of globalization, the international penetration of US companies and their products and services increases the exposure, and potential adoption, of our culture and values (even if only internally) like a philosophical Trojan Horse, which, in theory, could improve our security as a nation in the long-term if more of the world adopted the broad ideas and policies of a free market democracy (the faults of which we will explore in future articles). However, our overseas military bases that come along with the deal certainly cause a perceived threat to the cultures who don’t follow our lead, which creates disdain and blowback, so influencing the creation of Bollywood in the wake of Hollywood doesn’t come without the price of critics and haters protecting their own culture and values. The Trojan Horse of our exported culture certainly amplified the spread of our life improving, efficiency enhancing technologies throughout the developing world, and it happened much faster without any restrictions or laws protecting our middle class, so if you look at it from the perspective of humanity as a whole, it’s a sacrifice the developed world middle class is making to lead the competition for who owns the technology taking over the world. Is that a trade-off worth making? Will global markets inevitably self-correct, or is there a higher design unfolding through the global penetration of technology and its interconnected network? 

If you follow the money of our trade deficit, it isn’t quite as bad as it seems because only a portion of it goes to the local foreign workers for their labor and/or the parts they manufacture to assemble into final products like an iphone. Much of our trade deficit ends up in the coffers of US companies overseas, which boosts their revenues and their stock prices for shareholders. This network of technology expanded their total addressable markets to the entire world and created eggerious wealth  for founders, early investors, boards of directors, higher paid employees, and shareholders, all at the cost of our lower skilled, less educated, domestic middle class, especially the people who don’t own assets and can’t keep up with the debasement of the currency this arrangement forces to mask the economic hole it creates. People like to blame the Fed for our wealth imbalance when it’s actually the fault of globalization. The policies of the Fed and Treasury are an effect of globalization, not a cause of the problems it creates. Many people get this backwards. The world has divided, and will continue to divide, between those who do, or don’t, share in the ownership of global companies.

The Federal Reserve does not control interest rates; the economy controls interest rates. Does the Fed control innovation and technology? Do they control demographics? Do they control China? Do they control pandemics? Does the Fed control globalization? Do they control geopolitical tensions, or OPEC, or the invention of shale oil technologies? Do they control the creditworthiness and optimism of consumers and businesses that borrow? These are the forces that control interest rates; the Fed and Treasury react to them.

To think the Fed controls interest rates is to focus only on the supply side of the equation, but in a fractional reserve system the banks have a near infinite supply of money because in practice their ability to create money never gets exhausted. Has there ever been breaking news about JP Morgan unable to make a loan because they ran out of balance sheet capacity? The Fed can create whatever level of reserves that are needed to support whatever level of viable borrowing is demanded.

If you ask most people who are not financial professionals to describe how fractional reserve banking works, they’d say something like: “the bank keeps a fraction of a customer’s deposit and loans out the rest,” but if that were true the money supply wouldn't expand. What actually happens is banks treat their deposit base as the reserve requirement and lever it up by creating money out of thin air just like the Fed. Since this easily gets lost in abstraction, the best way to express it is to imagine if the homebuilders were allowed to act like a bank. A family comes in and wants to build a home, so D.R. Horton runs a credit and income check, displays their options, and the family chooses a $500k house, so the sales guy goes into the back room, clicks a couple buttons, and literally prints $500k in hundred dollar bills (we’ll use cash for clarity when really it's credit), which he uses to pay all the contractors to build the house. This is where the majority of our money supply comes from. This is why the dollar has lost 99% of its purchasing power over the last century. This is economic activity that wouldn’t exist in a hard money system (which I’m not advocating) due to the limited supply of gold available to lend, making it difficult to get credit, so only the best business ideas, and the people with the highest creditworthiness would qualify. As the price of money goes up it incentivizes more production and mining, utilizing the self-correcting mechanism of the free market, which tends to naturally keep the money supply in proportion to the number of people and efficiency of the technology to produce it. 

Interest rates are determined by the borrower. Mortgage rates are influenced by the 10-year risk free rate, but that responds to inflation, growth, term premia, and supply with a touch of rate differentials, currency strength, sentiment, and carry costs thrown in. In fact, the ten-year yield is so independent from the Fed that it disagrees vehemently with their outlook during inversions. The Fed is reactionary, not causative, which is why there’s decades of quotes from Fed governors who are surprised, even confused, by the reaction of the economy to their policies. People act like the Fed is a grand conductor of the ebbs and flows of the ocean when really they’re on a tiny raft getting tossed around like a ragdoll as they react to the chaotic, uncontrollable ebbs and flows of economic forces beyond their control. This is what happens: banks create margin and cause a stock bubble that bursts and the deflationary effects force the Fed to react; World War happens and the Fed reacts; a Baby Boom, geopolitical tensions, shale oil, globalization, a pandemic, technology etc etc... happens, and the Fed reacts. Their policies are an effect of economic events, not a cause of them. 

The reason so many people find this heretical is because the prices of financial assets are extremely sensitive to overnight borrowing rates, so it’s easy to conflate the wild fluctuations of Wall Street with a illusion of control on Main Street, but it’s the forces of demographics, technology, globalization, the cost of energy, and the creditworthiness (balance sheet) of the borrower that sets long term interest rates for Main Street. 

Floating rate debt like credit cards based on a spread over SOFR or the prime rate are certainly influenced directly by the Fed, but the Fed isn’t in control of their own policy; the economy is. People who overweight the effect of the Fed are conflating overnight rates with interest rates of all durations. Truthfully, the Fed doesn’t even control overnight rates. They do what the market tells them to do. When there’s disagreement between the market’s projections and the Fed’s, and the market is wrong, commentators like to say: “the market is coming around to the Fed,” but what’s really happening is both are acquiescing to the data from the economy, which is often volatile, highly unpredictable, and prone to long delays from policy initiations. 

The only power the Fed has is in the direction of tightening because they have the power to end inflation at will by inverting the curve and creating a floor for maturing debt to be rolled over at higher rates, which squeezes margins and disposable income and induces a recession, but the illusion of their control gets exposed in the other direction when they can’t stimulate growth or CPI no matter how low overnight rates go, or how much money they print because there’s no widespread transmission mechanism into consumer pockets on Main Street except a weak psychological wealth effect from creating asset bubbles that stimulate some additional spending, and the even weaker effect of putting minor downward pressure on long-term rates through quantitative easing. If no one has the balance sheet capacity, the optimistic willingness to borrow or creditworthiness, then nothing the Fed does will move the needle. Eventually, balance sheets get repaired through deleveraging over time, which is the essence of the business cycle as the Fed gets pulled along in the caboose.

The other power the Fed has is lifting toxic assets off the balance sheets of the private sector. This is the real purpose of QE. It’s like an immune system detoxifying the body to prevent systemic collapse. The flaw is that the natural process of getting sick from consuming toxic substances is how we learn what to avoid to be healthy. 

In terms of globalization, if the government wasn’t allowed to run deficits, and the Fed didn’t exist, once our global companies moved offshore, our financial system would have collapsed, which is how market forces would have behaved to retain balance as the drop in our prices and wages made them competitive with overseas labor. Obviously, that couldn’t happen, so the Fed and Treasury have been forced to continually debase the currency through ultra easy policies that stimulate asset prices. This is the crux of the problem. While our global companies with ever increasing markets as their technology penetrates the world can justify expensive valuations, if you gut the stable, secure manufacturing jobs from the lower half of the income spectrum and force them to either drop out of the labor force or accept a lower paying, less secure alternative, eventually the wealth imbalance this creates will break the system either through populism arising to impose policies like unilateral tariffs or through the ever expanding government debt required to prevent collapse reaching the point of no return when the interest expense consumes all the tax revenues collected, which then forces the Fed to directly fund the deficits and ultimately lead to currency collapse (again, unless AI saves us - we’ll return to this in later articles). In other words, globalization, fueled organically by the innate incentives of Capitalism via businesses seeking the lowest expenses creates a built-in mechanism that results in a race between the forces of technology restoring balance through a productivity miracle and the destruction of the currency.

The other reason people overweight the effect of the Fed is because they want someone to blame, so if you put them at the center of the financial universe like the Wizard of Oz, they’re an easy scapegoat to criticize when things go wrong, even though all they do is react to economic data, usually with a giant lag, which is why they’re always late. 

The Fed did not repress interest rates for a decade; globalization did. As evidence, I’d like to direct your attention to the 2-year yield, which is enough duration to be independent, but not too long that other forces affect it as well, therefore ,I agree with Jeff Gundlach's view that the Fed ultimately just follows the 2-year. When actual inflationary pricing pressures began in earnest from the one-off Covid fiscal stimulus hitting a constrained supply chain during a geopolitical oil shock as an unleashed consumer was released from lock down, the completely independent 2-year yield skyrocketed higher months before the Fed even thought about thinking about raising rates. Yields did not rise in anticipation of Fed policy; they rose in reaction to incoming and projected economic data, which is always the case, even though it often appears like the reaction is to the Fed.

If the Fed was repressing interest rates for a decade, where was the commensurate move higher in the independent 2-year yield during that time? Where were the higher consumer prices such a regime of repression would cause? Don't say it was a decade of lag effects when there’s a reasonable explanation like globalization (and shale oil) to explain the downward pressure on interest rates during that time. When the Fed represses interest rates they will be pinning the curve on purpose as a policy like the BOJ, which is exactly what they will do to prevent bonds from collapsing when interest rates consume the budget yet they still have to print money to avoid a deflationary collapse. If they pin the long end at 2%, the short end at 0%, and the Treasury sends out smaller, consistent checks to everyone in the lower half, they can hope to cause a more manageable widespread rise in general prices to inflate the debt back to a manageable size through an increase in nominal tax revenues from broad consumer prices and wages going up as they buy time for the productivity miracle from technology to catch up and then outgrow the pace of government spending, which would literally be a miracle because our projected entitlement obligations goes straight up. Or the Treasury can devalue the currency by remonetizing and revaluing gold 5-10x higher. The most interesting potential game changer is the revolution in energy being incentivized by Big Tech’s need to power data centers leading to disinflation in energy costs for both the consumer and businesses.  Like any great movie, the story is rife with potential to go horribly wrong, but a happy Hollywood ending is still possible.

In lieu of writing about the mechanics of QE and why it doesn’t cause broad consumer prices to rise, here’s a ten page article about it from Harvard: Banks Can't Lend Out Reserves. However, it’s inaccurate to take the accounting identity too far and say none of the QE money makes its way into the economy or affects asset prices. If the Fed buys from the public or a non bank like a pension or insurance fund, or the primary dealers do, it’s transforming their duration into an investable deposit. The Fed prints money. People who think all of it sits as reserves at the Fed are assuming the dealers are only buying from the Treasury. The reason it doesn’t cause broad consumer prices to rise is because almost none of that money reaches broad consumers to spend, which requires the Treasury to distribute it according to an Act passed by Congress in enough size to create an imbalance of demand over available supply for general goods and services. Without a distribution into consumer pockets, the effect of QE is limited to asset price inflation from both the added liquidity and the duration transformation of balance sheets.

Here’s how ChatGPT puts it: 

The Federal Reserve typically conducts its open market operations, including the purchase of Treasuries, through primary dealers. Here’s how the process works:

1. The Fed buys and sells Treasuries primarily through primary dealers. These are large financial institutions that participate in the open market operations (OMOs) and serve as the main intermediaries between the Fed and the broader market.

2. When the Fed decides to purchase Treasuries, it announces the operations, and primary dealers submit offers to sell Treasuries to the Fed. The Fed selects offers based on price and other criteria, effectively buying from the primary dealers.

3. While the Fed does not typically buy directly from pension funds, the pension funds can sell their Treasuries to primary dealers, who in turn can sell them to the Fed. Thus, pension funds and other investors can still indirectly participate in the Fed's Treasury purchase programs through their transactions with primary dealers.

4. The Fed controls the volume and timing of its Treasury purchases based on its monetary policy objectives. It determines the amount of Treasuries to buy and when to buy them to influence interest rates, manage liquidity, and achieve its macroeconomic goals.

Hey ChatGPT, when the Federal Reserve buys Treasuries from a pension fund, does the money it creates in this transaction end up as a bank deposit?

Yes, here’s how the process works:

1. The Federal Reserve decides to buy Treasuries from a pension fund to increase the money supply and stimulate the economy.

2. The Fed credits the account of the bank where the pension fund holds its deposit with the purchase amount. This credit increases the reserves of that bank held at the Federal Reserve.

3. The bank, in turn, credits the deposit account of the pension fund with the amount received from the Federal Reserve. This increases the deposit liabilities of the bank (i.e., the bank deposit of the pension fund).

4. The reserves of the bank at the Federal Reserve increase because of the Fed’s payment. The deposit balance of the pension fund at the bank increases, as the pension fund now has more money in its bank account. In essence, the money created by the Fed in this operation becomes a bank deposit held by the pension fund. Simultaneously, the reserves of the pension fund’s bank at the Federal Reserve increase, reflecting the bank's receipt of funds from the Fed.

Hey ChatGPT, can pension funds use the money they receive from selling Treasuries to buy stocks or other financial assets. 

Yes.

End ChatGPT

Certainly, there are degrees of easiness, and tightness, of credit based on whether banks perceive the overall economic risk of lending as higher or lower, but that is determined by borrower side influences (the economy). The only power the Fed has is one of distortion. Markets are in control, the economy is in control. The Fed can only ignore them for so long before they end up breaking the economy unnecessarily, so they speak a lot of words and inevitably follow the market. Since they can only do harm, there’s really no need for the Fed to exist. Markets don’t have egos, or memories, or worries about repeating past mistakes; they don’t need to get reappointed before turning hawkish; they don’t indirectly collude with the Treasury or other central banks; and they’re driven by the collective intelligence of the crowd with skin in the game, so when they’re wrong, they adapt fast, in real-time. With that said, I do wonder if the birth of the coming revolution of technology would have been possible without the long period of liquidity added by central banks to avoid the deflationary pressure of globalization, mask the depression, and repress the political backlash from an angry public that would have stopped or reversed it. 

I do think there’s a case to be made for a lender of last resort in a fractional reserve banking system, but that should require hard rules about repayment and personal consequences tied to receiving a bailout, so there’s no rolling accumulation of debts or moral hazard. In other words, the damage caused by letting the market purge itself would be arguably worse than providing necessary liquidity to prevent it, but if a bank got itself into such a situation, what should be wiped out is the equity of the CEO and board of directors (or another law with personal consequences). Watch how carefully they manage their balance sheets if the consequences affect them personally. In other words, it’s possible to be both a critic of the central bank, Treasury, and banking system, understand the solutions to those flaws, and still see the entire mess as prerequisite conditions for the emergence of a future that will transcend it.

(I won’t even wade into reasons of how the influences of the global Eurodollar system can supersede Fed policies, which is Jeff Snider’s domain.)

Here’s a few quotes from recent articles to illustrate the difference between people operating on a level of concepts vs the pragmatic point of view grounded in physical limitations and the incentives of economic participants I am trying to express (my comments in parentheses): 

• “By suppressing the cost of debt, Quantitative Easing (no, globalization) encouraged the federal government to take on a much greater amount than would have been possible otherwise.” 

•  “This fiscal profligacy enabled by monetary accommodation (no, globalization) is now one of the forces behind persistent (no, cyclical) inflation pressures in the economy (a deflationary collapse is coming, which will cause the next reflationary impulse).

• “But massive asset purchases by the Fed (as a reaction to structural stagnation caused by globalization) have also exacerbated inequality, with the wealthy actually benefiting from the current economic environment…while the rest struggle with a slowing labor market amid persistent cost pressures (which is caused by Treasury and Fed reaction to the economic hole of globalization).”

• “This bifurcation only exacerbates the trend toward growing social unrest (which is the self-correcting mechanism of the market that the Fed and Treasury are interrupting, necessarily).”

• “The pressure on unions to force wages up only exacerbates a wage/price spiral of inflation (no, it doesn’t - wages are just another price going up with the rest of them; it’s not self-fueling, and it’s the desirable outcome that’s been happening for 100 years).”

• “We’ve entered a new era of higher interest rates and higher R star (no, we haven’t, it’s trillions of stimulus creating transitory economic activity still working through the economy; it’s not a sustainable new source of growth or inflation (unless UBI and YCC happens)).”

SUMMARY

I grew up in Rochester, NY, where Kodak employed most of my mom’s side of the family. Kodak was not a victim of globalization because it fell on its own sword, but the result was the same: they all lost their jobs - along with many people in other manufacturing facilities in the area that moved overseas. A successful global manufacturing plant is an engine of money production that offers lower skilled, less educated people more job security, more money, and more benefits, which changes the psychology of their spending and creates discretionary income to invest and grow wealth in a way that is not available with other jobs. The wealth imbalance that has occurred in the wake of globalization is not sustainable. One of the governing dynamics of life is how living organizations move from balance to imbalance back to balance in perpetual adaptation to change. I believe technology will be the catalyzing force that restores balance as the entire world is transformed into a new way of co-existing with each other, and with technology, as a unified global system emerges, which we will explore in The Spirituality of Technology in a few weeks. 

Next week we'll explore inflation in The Nominal Game We Play and The Fallacy of Real Yields & Universal Inflation.

BONUS SONG: The mood of Johnny Cash's cover of NIN's "Hurt" perfectly expresses the personification of the force of globalization and the victims in its wake: Hurt