Deflation and Modern Monetary Theory
As an investment advisor I worry about inflation a lot. Besides political revolution, no other force turns rich people into poor people as quickly and as surely as inflation. If your income is fixed by a pension or annuity formula which doesn’t escalate along with the cost of living, or if most of your money is tied up in long-term bonds with low yields, then your means will shrink at the pace of inflation. A few consecutive years of double-digit inflation can turn a comfortable retirement into a marginal one if your portfolio does not own enough real assets to defend against it.
Happily, inflation has been predictable and tame for almost 40 years. Consumer Price Index (CPI) inflation has not advanced at a double-digit annual pace since 1981. It has not even been as high as 5% since 1990. Many analysts believe that the CPI’s methodology understates the “true” rate at which prices rise. I agree, but the magnitude of the understatement is probably no more than 1% per year. Buttering another 1% onto the price level annually certainly adds up over time, but it does not change the fact that we have recently enjoyed an era of extraordinarily stable fiat money.
There are some reasons to worry that inflation could accelerate, helicopter-money stimulus and the impending entitlements crisis being two big ones, but I want to talk about the opposite possibility because it feels more likely that we see deflation rather than inflation over the next 12-24 months as we slowly climb out of this COVID-induced recession.
I never thought I would find myself worried about deflation in a world where the Federal Reserve works hand-in-glove with the Federal government to sustain unlimited amounts of credit. When I studied economics twenty years ago I learned that prices are determined by the quantity of money chasing the supply of goods. The supply of goods tends to be more stable than the quantity of money, which depends on banks’ ability to extend credit. In turn, the Federal Reserve controls how much credit banks are allowed to extend. Fluctuations in credit levels determine the price level, at least the way I learned it. The famed free-market economist Milton Friedman famously opined that “Inflation is always and everywhere a monetary phenomenon.”
I think I want a refund on my economics degree. Friedman’s “Quantity Theory” simply cannot be right in light of recent experience. Look at how much money has been created since the last financial crisis. From 2008 through 2015, the Federal Reserve’s balance sheet swelled from a starting point of approximately $1 trillion to $4.5 trillion, going from 8% of GDP to 25%. Total Federal debt went from 68% of GDP to 99%. Despite all that extra credit sloshing around in the financial system, CPI inflation averaged just 2% annually during those eight years.
More recently, since the Federal Reserve and the Federal government started implementing emergency measures in March, the Fed’s balance sheet has swelled to $7 trillion, and Federal debt has increased to approximately 140% of GDP. How can this flood of money fail to produce runaway inflation unless the Quantity Theory is lacking?
An apologist for the Quantity Theory might quibble that “money” is not defined exactly the way I’m implying. I would respond that however you define it, the monetary base has expanded at a breakneck pace. Quantity Theorists would claim that an offsetting slowdown in “velocity” has largely neutralized the impact. “Velocity” measures the turnover of the money supply. It is imputed rather than observed. Whenever the theory doesn’t work, just blame something else called velocity.
The most prominent alternative explanation I’m aware of is Modern Monetary Theory (MMT). MMT argues that bank lending is almost irrelevant in setting prices because private credit expansion always comes with an associated, offsetting liability. When a business borrows money from the bank, new money is created along with new debt. As the loan is retired, the debt and the money both disappear together. MMT proponents describe these kinds of transactions as “horizontal” because they do not change the overall (vertical) level of prices.
Under the MMT framework, inflation is a fiscal phenomenon, not a monetary one. It is determined mainly by consumer and business confidence. Rather than being modulated by Federal Reserve policy, its mechanical levers are the Federal government’s deficit spending and tax collection. MMT harkens back to a much older concept called Ricardian Equivalence, which I learned in school as a kind of quaint historical novelty. Very roughly, Ricardian Equivalence says that handing out money is only inflationary if recipients never expect to pay it back through higher taxes.
Rather than get too deep into various theories, let’s steer back to the question of what comes next, inflation or deflation? If we can get past the intuitive but, seemingly, wrong assumption that more money sloshing around has to cause higher prices, then it is not hard to see why deflation looks likely in the near term.
To start, consider the world businesses operated in leading up to the recent crisis. Cheap access to credit prompted low-return investments. A building project expected to earn a modest 6% return on investment looks like a winner when your cost of capital is only 4%. This is the world we have lived in since at least 2008 when the Federal Reserve embarked on various “quantitative easing” programs to keep yields low and banking liquidity high. Corporations responded to the low-rate environment rationally by taking on debt. Some of this debt simply went to buying back shares, but much of it went toward real investments such as building projects or research and development initiatives.
COVID-19 then descended onto a corporate landscape that was already overbuilt. Unless the recovery is much faster than most businesses and economists believe, a number of industries will be plagued by overcapacity for years to come. Overcapacity is poisonous to investment returns and should tend to produce deflationary pressures as sellers compete for scarce buyers. It will take time to grow back into the physical infrastructure we have overbuilt.
Technology is another powerful deflationary force, although its full effect is hard to measure. We can measure the rate at which flat screen TV’s or CPUs get cheaper, but we cannot measure the rate at which computing makes other things cheaper. A modern business might produce the same output with half the staff, half the inventory, half the logistics infrastructure, and half the waste required forty years ago, all thanks to various new technologies. If anything, this deflationary force seems primed to accelerate in the coming years.
Early in the lockdown, Microsoft’s CEO Satya Nadella commented that the adoption curve for remote work technologies such as Skype and Microsoft Teams had been pulled forward by about two years. Remote workers are suddenly living in mid-2022 “thanks” to COVID-19. This rapid, forced adoption will have follow-on implications that are deflationary as well. New technologies will emerge on top of new technologies.
What this means for your portfolio is that despite helicopter stimulus and runaway deficits, your cash savings should retain its purchasing power for at least a year or two. This is not a guarantee, but it seems likely. I worry about inflation returning once the economy rebounds because both the Quantity Theory and MMT seem to agree that conditions look ripe. It’s just not quite time yet. Tick tock.
Miles Putnam, CFA