The Great Inflation Delusion

The Fed, the European Central Bank (ECB), and the Bank of Japan (BOJ) came up with lots of headline-grabbing shock-and-awe programs over the past 10 years in reaction to the Great Financial Crisis. Over time, they seemed to lose their effectiveness and ability to shock or awe.

Nevertheless, the US economy had improved sufficiently by 2014 that the Fed terminated Quantitative Easing (QE) in October 2014 and started very gradually to raise interest rates in late 2015. However, by the end of July 2019, the Fed was lowering the federal funds rate again. The ECB terminated its QE at the end of 2018 and was expecting to raise interest rates by mid-2019. However, by July 2019, the ECB signaled that it would most likely lower its deposit rate further into negative territory in September, and that more QE might be ahead. The BOJ has yet to even consider normalizing monetary policy, and continues to expand its balance sheet. By the summer of 2019, the major central banks seem to have run out of new tricks.

The central bankers have been fighting powerful forces of deflation. With all the liquidity they’ve provided, they have succeeded in averting outright deflation. However, the Fed, the ECB, and the BOJ haven’t succeeded in pushing inflation in their countries up to their 2.0% targets. Inflation remains awfully close to zero and too close to its border with deflation.

In my opinion, the central bankers are trying to fix problems that can’t be fixed with ultra-easy monetary policies. They are trying to fight the four forces of deflation: Détente, Disruption, Debt, and Demographics. I call them the deflationary “4Ds.” Let me explain:

Détente. Détente occurs after wars. Such periods of peacetime lead to globalization with freer trade, which means more global competition in markets for labor, capital, goods, and services. Wars, in effect, are trade barriers. The end of the Cold War marked the beginning of the current period of globalization.

Competition is inherently deflationary. No one can raise their price in a competitive market because it is capped by the intersection of aggregate supply and demand. However, anyone can lower their price if they can cut their costs by boosting productivity. The incentives to do so are great because that’s a sure way to increase market share and profits.

History shows that prices tend to rise rapidly during wartime and then to fall during peacetime. War is inflationary; peace is deflationary. The CPI for the US is available since 1800. It spiked sharply during the War of 1812, the Civil War, World War I, and World War II. During peacetimes, prices fell sharply for many years following all the wars listed above, except for the peace so far since the end of the Cold War in 1989. (Of course, there have been local wars since then, and all too many terrorist attacks, but none that has substantially disrupted commerce.) Prices still are rising in the United States, though at a significantly slower pace than when the Cold War was most intense.

During wartimes, global markets are fragmented. Countries don’t trade with their enemies. They face military obstacles to trading with their allies and friends. Commodity prices tend to soar as the combatants scramble to obtain the raw materials needed for the war effort. A significant portion of the labor force has been drafted and is in the trenches. The upward pressure on labor costs and prices often is met with government-imposed wage and price controls that rarely work. Entrepreneurs, engineers, and scientists are recruited by the government to win the war by designing more effective and lethal weapons.

Peacetimes tend to be deflationary because freer trade in an expanding global marketplace increases competition among producers. Domestic producers no longer are protected by wartime restrictions on both domestic and foreign competitors. There are fewer geographic limits to trade and no serious military impediments. Economists mostly agree that the fewer restrictions on trade and the bigger the market, the lower the prices paid by consumers and the better the quality of the goods and services offered by producers. These beneficial results occur thanks to the powerful forces unleashed by global competition during peacetimes.

As more consumers become accessible around the world, more producers around the world seek them out by offering them competitively priced goods and services of better and better quality. Entrepreneurs have a greater incentive to research and develop new technologies in big markets than in small ones. The engineers and scientists who were employed in the war industry are hired by companies scrambling to meet the demand of peacetime economies around the world. Big markets permit a greater division of labor and more specialization, which is conducive to technological innovation and productivity.

My war-and-peace model of inflation simply globalizes the model of perfect competition found in the microeconomic textbooks. The single most important characteristic of this microeconomic model is that there are no barriers to market entry. Anyone can start a business in any industry. In addition, there are no protections against failure. Unprofitable firms restructure their operations, get sold, or go out of business. There are no “zombies,” i.e., living-dead firms that continue to produce even though they are bleeding cash. They should go out of business and be buried. These firms can only survive if they are kept on life support by government subsidies, usually because of political cronyism.

The microeconomic model of perfect competition predicts that the market price will equal the marginal cost of production. An increase in demand might temporarily increase profits, but that would stimulate more production among current competitors and attract new market entrants. If demand drops such that losses are incurred, competitors will cut production, with some possibly shutting down if the decline in demand is permanent. New entrants certainly won’t be attracted.

So no one firm or group of firms can set the price. Both producers and consumers are “price-takers.” No one has enough clout in the market to dictate the price that everyone must receive or pay. The price is set by the “invisible auctioneer,” who equates total market demand to total supply at the market’s equilibrium price, which is determined by the marginal cost of production.

Profits are reduced to the lowest level that provides just enough incentive for enough suppliers to stay in business to satisfy demand at the going market price. Consumer welfare is maximized. Obviously, there can’t be excessive returns to producers in a competitive market. If there are, those returns will be eliminated as new firms flood into the excessively profitable market. Firms that try to increase their profits by raising prices simply will lose market share to firms that adhere to the market price. That’s a good way to go out of business.

This microeconomic textbook model of perfect competition seems to be much more relevant in explaining deflation and disinflation during periods of globalization than any macro model. Globally, there have been fewer barriers to market entry because of the end of the Cold War. This is certainly true geographically. It is also true in other ways. For example, a potential barrier to entry in some industries is the availability of financing. Technology is especially dependent on venture capital. Low interest rates and booming stock markets around the world since the early 1990s provided plenty of cheap capital—too much, in some cases.

Disruption. Competitive markets facing worker shortages will tend to stimulate productivity via technological innovation. Technology is inherently disruptive across a wide range of businesses. That’s all very deflationary. Clearly, there is a tremendous incentive to innovate and use technology to lower costs. Firms that do so gain a competitive advantage that allows them to have a higher profit margin for a while. That’s especially true if their advantage is sufficiently significant to put competitors out of business. However, some of their competitors undoubtedly will innovate as well, and there is always the possibility of new entrants arriving on the scene with innovations that pose unexpected challenges to the established players.

Debt. The forces of deflation that had been mounting since the end of the Cold War were held back by rapid credit expansion around the world. Central banks were lulled by the decline in inflation and the proliferation of prosperity following the end of the Cold War into believing that they had moderated the business cycle. Indeed, they attributed this achievement to their policies rather than to globalization, and they dubbed it the “Great Moderation”—which presumably started during the mid-1980s but ended abruptly with the “Great Recession” in 2008. So they provided lots of cheap credit and enabled lots of borrowing by households, businesses, and governments.

The central bankers simply ignored the implications of soaring debt. Their macroeconomic models didn’t give much, if any, weight to measures of debt. Perversely, their easy monetary policies reduced the burden of servicing previous debts, which could be refinanced at lower rates, allowing borrowers to borrow more. By declaring that they had moderated the business cycle, the central bankers encouraged debtors to be less cautious about the potential dangers of too much leverage.

Around the world, governments borrowed like there was no tomorrow. In the United States, buyers bought homes with no money down and “liars’ loans,” where credit was granted without a formal credit check. In the Eurozone, banks lent to borrowers in Portugal, Ireland, Italy, Greece, and Spain (the “PIIGS”) as though they had the same credit ratings as German borrowers. That turned out to be a very bad assumption. Emerging market economies likewise could borrow on favorable terms despite their often spotty credit histories.

These credit excesses all hit the fan in 2008, and the consequences were clearly deflationary. The Great Moderation turned into the Great Recession. To avert another Great Depression, the central banks of the major industrial economies scrambled to flood the financial markets with credit. So far, their ultra-easy monetary policies have succeeded in offsetting the natural, peacetime forces of deflation. Of course, central bankers existed in the past when deflation prevailed but monetary theory and operating procedures were primitive. Today’s central bankers claim that this all proves they are better than ever at managing the economy with monetary policy. I hope they’re right, but I’m not convinced.

Demography. Demographic profiles are turning increasingly geriatric around the world. People are living longer. They are having fewer children. As a result of widespread urbanization, children no longer provide the benefit of labor in rural economies. Instead, they are a significant cost in urban settings. Economies with aging demographic trends are likely to grow more slowly and have less inflation.

Governments with aging populations are bound to borrow more. Governments challenged by rising dependence ratios—with the number of retiring seniors outpacing the number of young adult workers—don’t have much choice but to borrow money to meet their funding gaps. Debt accumulated for this purpose is likely to weigh on economic growth rather than to stimulate it.

The 4Ds combined tend to weigh on economic growth and are inherently deflationary. This explains why unconventional ultra-easy monetary policies have become conventional over the past 10 years. The central bankers are doing more of the same and getting the same disappointing result. Like Sisyphus of ancient Greek mythology, every time they push the boulder up the hill, it comes rolling back down.

Central bankers tend to be macroeconomists who were taught in graduate school that inflation is a monetary phenomenon. They were also taught to hate deflation as much as inflation. That’s why the major central banks have all pegged 2.0% as their Goldilocks inflation target, not too hotly inflationary or frigidly deflationary.

But surely, they must have learned over the past 10 years that inflation isn’t a monetary phenomenon after all. They must realize that the four powerful forces of deflation are microeconomic in nature.

In a speech in July 16 speech in Paris, Fed Chair Jerome Powell acknowledged in passing that inflation may not be solely a monetary phenomenon: “Many factors are contributing to these changes—well-anchored inflation expectations in the context of improved monetary policy, demographics, globalization, slower productivity growth, greater demand for safe assets, and weaker links between unemployment and inflation. And these factors seem likely to persist.”

He also acknowledged that these factors collectively may continue to keep the “neutral rate of interest low,” i.e., too close to zero, which is the dreaded “effective lower bound.” He concluded: “This proximity to the lower bound poses new complications for central banks and calls for new ideas.”

The problem is that the central bankers have run out of new ideas (and policy tools), so they keep trying the same old ones. Their delusion is that doing more of the same (i.e., ultra-easy monetary policy) should boost inflation to 2.0%. Maybe they should just give up on the notion that deflation is a bad outcome of the 4Ds and admit that they are trying to fix a problem that monetary policy cannot fix.

If they persist in their delusion and their ultra-easy monetary policies, the outcome will continue to be asset price inflation, especially in global equity markets. That’s fine, until it isn’t.

Embezzelcoin

In late 2017, when bitcoin was soaring toward a record-high price of $18,961 on 12/18/17, a distant relative asked me what I thought about the cryptocurrency. He had bought one bitcoin when it was around $4,000 in mid-2017. I said it reminds me of digital tulips. “What do you mean?,” he responded. He is a Millennial who had never heard of the Dutch Tulip Bubble from 1634-38. I explained what happened back then and noted that the bubble was mostly confined to Amsterdam, whereas the bitcoin bubble is global.

Of course, some bitcoin fans believe that bitcoin has a legitimate role in a portfolio as a hedge against the madness of central banks. I concede that point. However, as we saw last year, it can crash, which is what it did on its way back down by gut-wrenching 83% from the high of $18,961 on 12/18/17 to a low of $3,224 on 12/14/18. But now it’s back up to $11,171. It certainly is volatile and hardly a stable store of value, which makes it a very poor candidate to replace more stable forms of money.

Some of this volatility may be attributable to the illegitimate uses of bitcoin. I’ve noticed more news stories this year about hackers planting ransomware on the computer systems of small city governments in the US. They successfully extort tens of thousands of dollars in exchange for the software key to unlock the frozen computer systems. Payment has to be made in bitcoin.

In June, Riviera Beach, a city in Florida, paid hackers $600,000 in bitcoin with the hope of having its systems restored. Also during the month, Lake City, Florida facing a ransomware demand, authorized the payment of $490,000 in bitcoin to a hacker in order to regain access to its phone and email systems. At the end of the month, the village of Key Biscayne confirmed it had been hit by a cyberattack, though it wasn't clear if it was related to ransomware.

Cities and small businesses are becoming more popular targets for hackers, who recognize frequently unsophisticated systems. According to FBI estimates, there were 1,493 ransomware attacks in 2018, with victims paying a total of $3.6 million.

In my book, Predicting the Markets (2018), I wrote:

I’m particularly intrigued by the impact of bitcoin and other cryptocurrencies on our monetary system. Blockchain, the software that runs these digital currencies, is allowing banks to eliminate clearinghouse intermediaries in their transactions and to clear them much more rapidly. Smartphone apps allow consumers to use these digital devices to deposit checks and make payments. These innovations could reduce employment and bank branches in the financial sector, much as Amazon is doing in the retail space. Central bankers are scrambling to understand the implications of bitcoin and blockchain. In time, central banks likely will incorporate these technologies into their operations, perhaps spawning bitdollars, biteuros, bityen, etc.

I concluded:

Libertarians might long for a day when central banks are replaced by a monetary system based on a digitized currency that is unregulated by governments. I doubt that the central monetary planners will allow that to happen. But who knows? Technology has disrupted major industries. Maybe it will disrupt central banking!

The International Monetary Fund (IMF) is studying cryptocurrencies. The 6/27 IMFBlog is titled “Five Facts on Fintech.” It reviews the findings of a report titled, "Fintech: The Experience So Far." Based on its research, countries generally foresee the emergence of crypto assets backed by central banks. The study surveyed central banks, finance ministries, and other government agencies in 189 countries. More specifically:

The survey reveals wide-ranging views of countries on central bank digital currencies. About 20 percent of respondents said they are exploring the possibility of issuing such currencies. But even then, work is in early stages; only four pilots were reported. The main reasons cited in favor of issuing digital currencies are lowering costs, increasing efficiency of monetary policy implementation, countering competition from cryptocurrencies, ensuring contestability of the payment market, and offering a risk-free payment instrument to the public.

Increasingly, at the top of the list for the central bankers is the need to improve cybersecurity in the payments system. Banning cryptocurrencies that are not officially backed by central banks undoubtedly will be considered. Whether this is even feasible is a matter for future discussion.

Running Out of Workers?

I am not convinced that the demand for labor was hard hit by Trump’s escalating trade war during May. Granted, payroll employment was weak last month, rising just 75,000 (Fig. 1). That compares poorly to the average gains of 186,250 per month during the first four months of this year and 223,250 per month during 2018.

The problem may be that all the anecdotal evidence of labor shortages is actually constraining the growth of payrolls. Perhaps we really are finally running out of workers, or at least those with the appropriate skills and geographic proximity to fill job openings. Consider the following:

(1) Openings. There certainly are plenty of job openings. They totaled 7.45 million during April, exceeding the number of unemployed workers by a record 1.6 million (Fig. 2).

(2) The most. Here were the industries with the most job openings during April: professional and business services (1.241 million), health care and social assistance (1.244 million), and leisure & hospitality (1.004 million) (Fig. 3). Those are roughly the same levels of openings as a year ago, when the job market was also widely deemed to be tight.

(3) The biggest. The biggest increases in job openings compared to a year ago have been in some of the most cyclical industries: construction (404,000, up from 258,000), durable goods manufacturing (322,000 up from 288,000), state & local government excluding education (359,000, up from 339,000), transportation, warehousing & utilities (373,000, up from 348,000), and financial services (365,000, up from 328,000) (Fig. 4).

(4) The least and the one big loser. Interestingly, neither mining & logging (33,000) nor information technology (131,000) is looking for very many workers. Job openings in retail trade fell from 1.032 million a year ago to 837,000 during April (Fig. 5).

(5) Labor force. Last year, the labor force increased 217,000 per month on average (Fig. 6). During the first five months of this year, it is down 119,000 per month on average. This must be exacerbating labor shortages.

(6) NILFs. The problem is that senior Baby Boomers (65 years old and older) are retiring and dropping out of the labor market faster than 25- to 64-year-olds are entering the labor market, while most members of the 16-24 cohort are still in school (Fig. 7).

Over the 12 months through May, the total number of people not in the labor force (NILFs) increased 428,000, with senior NILFs up 1.1 million, younger adult NILFs down 137,000, and student NILFs down 440,000.

(7) Small business owners. The report reviewing May’s NFIB small business survey showed that the demand for labor by small business owners remains strong. Last month, 38.0% said that they have job openings, which continues the readings in record-high territory (Fig. 8). The net percentage increasing hiring over the next three months was 21.0%, near previous cyclical highs. However, the percentage complaining of few or no qualified applicants for their job openings was 54.0%.

Twenty-five percent of all owners cited the difficulty of finding qualified workers as their Single Most Important Business Problem, equaling the record high. Fourteen percent of all firms reported using temporary workers. In construction, 59% had openings, and 93% of those openings were for skilled workers. No wonder that construction payrolls rose only 4,000 during May.

The NFIB survey’s job-openings series is highly inversely correlated with both the national unemployment rate (at just 3.6% in May) and the percentage of respondents who say that jobs are hard to get in the Consumer Confidence survey (at only 10.9% in May) (Fig. 9 and Fig. 10). All these indicators portray a labor market that’s been very tight through May, when payrolls rose much less than expected.

(8) Productivity to the rescue? Does it really matter whether payroll employment growth slows because we’ve run out of workers or because demand for workers is weakening? Either way, wages and salaries growth will slow and depress consumer spending and GDP growth. In our opinion, better productivity growth may have started to offset the supply constraints that are slowing payroll gains. Businesses will still have demand for their goods and services and will do what they can to produce more by boosting productivity.

Income Stagnation Is a Progressive Myth

The Progressives claim that—despite the (Old) New Deal, the Great Society, and Obamacare—the incomes of the vast majority of Americans have stagnated for three decades and that income distribution remains disturbingly unequal and must be fixed with more progressive taxes. Who would know better than Joseph Stiglitz? After all, he is a Nobel laureate in economics. In 1972, I took Stiglitz’s course on microeconomics in Yale’s PhD program. He gave me a good grade, so I like him.

In a 4/19 NYT article titled “Progressive Capitalism Is Not an Oxymoron,” he lamented: “Despite the lowest unemployment rates since the late 1960s, the American economy is failing its citizens. Some 90 percent have seen their incomes stagnate or decline in the past 30 years. This is not surprising, given that the United States has the highest level of inequality among the advanced countries and one of the lowest levels of opportunity—with the fortunes of young Americans more dependent on the income and education of their parents than elsewhere.”

Freshman Rep. Alexandria Ocasio-Cortez (D-NY) must have read Stiglitz’s article. She recently tweeted that “working Americans haven’t gotten a raise in 30 years despite unprecedented growth & living costs have exploded.”

That’s certainly a problem that needs to be fixed! But hold on: There would surely be a revolution in America if 90% of our citizens have suffered income stagnation or worse, as Stiglitz claims has happened for the past 30 freaking years—i.e., since 1989! Real GDP is up 110% since then, yet only 10% of Americans have benefitted, he claims. Is it possible that the great silent majority has enjoyed no improvement in standards of living since 1989? No freaking way, Professor!

I have taken deep dives into the data on standards of living and income inequality. Nowhere can I find a credible series that confirms a 30-year drought in standards of living for almost all Americans. Instead, the data show that Americans have never been better off. I’m not making a political statement, just a statement of facts (which, I acknowledge, do have political implications). Consider the following:

(1) The worst data series ever! Stiglitz must be relying on annual data compiled by the Census Bureau on real median household income (Fig. 1). I hate this series with a passion because it is an extremely flawed measure of income; yet it is widely used by Progressives to prove their claim of widespread and prolonged income stagnation. It is up only 13% since 1989 through 2017. The flakiness of this measure is confirmed by the modest 27% increase in real mean household income (which gives more weight to the rich) since 1989 despite a 52% increase in real GDP per household over this period.

In Chapter 7 of my book, Predicting the Markets, I discuss all the problems with the Census income measure in the last section, titled “Income stagnation myth.” It is woefully misleading, because it grossly underestimates Americans’ standards of living. It is based only on surveys that focus just on money income. On its website, the Census Bureau warns: “[U]sers should be aware that for many different reasons there is a tendency in household surveys for respondents to underreport their income.”

Furthermore, the Census measure of money income, which is used to calculate official poverty rates, is missing key noncash government-provided benefits that boost the standards of living of many Americans, including Medicare, Medicaid, the Supplemental Nutrition Assistance Program, and public housing. The Census series is a pre-tax measure of income. So it doesn’t reflect the Earned Income Tax Credit and the Additional Child Tax Credit that many low-income households receive from the government.

That’s insane: The government’s bean counters are excluding many of the beans provided by government programs designed to reduce income inequality. So the Census series will never show the progress made by Progressives’ pet programs, seemingly calling for more such programs to fix a “problem” that might have been mostly fixed by the existing programs already! (Software programmers call this phenomenon a “Do Loop,” which is to be caught in a series of actions that repeat endlessly.) Enough will never be enough. No wonder the Progressives love this series, while I hate it.

(2) Price deflator makes a big difference. The Census series uses the Consumer Price Index (CPI), which is based on an indexing formula that gives it an upward bias over time. That’s simple to fix by dividing the nominal version of the Census measures of median household income by the personal consumption expenditures deflator (PCED). Since 1989 through 2017, it is up only 7.4% using the CPI but up 21.5% using the PCED (Fig. 2). That blows away the income stagnation myth without much effort.

(3) Smaller households distorting income stagnation and inequality measures. Another problem with any income series on a per-household basis is that growth of the singles population (aged 16 and older) continues to outpace that of the married population. It’s been doing so since the start of the data in 1976 (Fig. 3).

What’s changed in recent years is that the former cohort exceeds the latter, as singles are getting married later in life and unattached seniors are living longer (Fig. 4). That means more single-person households, which tend to have lower incomes than married-couple households. That trend will weigh down both median and mean per-household incomes, exaggerating income stagnation and inequality.

(4) The true story is a happier one. While the political agendas of Joe Stiglitz and other Progressives rest on a flawed measure of income, plenty of other indicators tell a different story. Over the past 30 years, from March 1989 through March 2019, inflation-adjusted average hourly earnings of production and nonsupervisory workers is up 32%, using the PCED and a measure of wages that covers more than 80% of payroll employment (Fig. 5 and Fig. 6). That’s NOT stagnation!

Median measures of income are hard to find. However, the Bureau of Labor Statistics (BLS) has a quarterly series on pre-tax “median usual weekly earnings of full-time wage and salary workers” that starts in 1979 and is based on survey data. Dividing this series by the PCED shows that it is up 25% since the start of 1989 (Fig. 7). Clearly, American workers haven’t been reporting stagnant paychecks over the past 30 years to the BLS survey takers.

Finally, I believe that the best measures of standards of living are the disposable income and consumption series compiled monthly by the Bureau of Economic Statistics on a per-household basis. Deflated by the PCED, the former is up 61%, while the latter is up 67% from March 1989 through March 2019 (Fig. 8). Real GDP per household is up 54% over this period.

Admittedly, these alternative measures of standards of living are means rather than medians, but the rich don’t eat much more than the rest of us. There aren’t enough of them to make a significant difference to average measures of income and spending. IRS data for 2016 show that the so-called “1%” of taxpayers earning more than $500,000 in adjusted gross income included 1.3 million of the total 150.3 million returns filed that year. Furthermore, as noted above, there are fewer mouths to feed per household as the population of adult singles continues to grow faster than married couples.

(5) Bottom line. American households are enjoying record standards of living. Income stagnation is a myth. Income inequality isn’t a myth but an inherent characteristic of free-market capitalism, an economic system that awards the biggest prizes to those entrepreneurs who benefit the most consumers with their goods and services. Perversely, inequality tends to be greatest during periods of widespread prosperity. Rather than bemoaning that development, we should celebrate that so many households are prospering, even if a few are doing so more than the rest of us.

S&P 500 Run, Forrest, Run!

Forrest Gump’s fans cheered him on during his remarkable roundtrip cross-country marathon by exhorting him to “Run, Forrest, run!” Similarly, bullish investors are cheering for the bull market in stocks with their gleeful chant, “Run, bull, run.” In this video podcast, I discuss why I believe that the bull market still has legs with revenues and earnings likely to keep it moving higher.