There is an important debate currently raging between experts within the financial industry. Since it involves a question I’ve been receiving increasingly as of late I am going to address here.
The debate is whether we get significant inflation / falling U.S. Dollar or deflation / rising USD. It should be noted that there are very smart, successful investors, advisors, hedge fund managers and economists on both sides of the debate.
The recent year-over-year Consumer Price Inflation (CPI) prints have been quite high at 4.16%, 4.99%, 5.39%, and 5.37%. However, the bigger question we’re exploring here is if high inflation will be sustained for the foreseeable future or if the inflation is truly “transitory” as some policymakers are suggesting.
A long time ago, “inflation” actually referred to the money supply itself. If you think about the word “inflation” it is more synonymous with the word “expansion” as opposed to “increase. Inflation, classically referred to an expansion of the money supply itself, which can lead to increase in prices (what we refer to as inflation today).
For purposes of this commentary, and to be consistent with the modern lexicon, we’re defining inflation as an increase in the AGGREGATE price level of goods and services in the U.S. economy.
Inflation can be caused by either (1) increasing money supply, and/or (2) declining availability of economic goods.
Interestingly, both those factors have been at play the last 18 months due to an increasing money supply combined with supply chain disruptions as a result of global policies enacted in response to the pandemic. In other words, more money is chasing fewer goods.
Below you’ll find a chart of the U.S. money supply (M2) from 12/31/2019 showing it has increased over 33%.
Specifically, the total money supply has grown over $5 trillion to $20.4 trillion from $15.3 trillion!
Over the same period the U.S. federal debt has also grown over $5 trillion to about $28.5 trillion where it stands now as the government has implemented an array of stimulus programs and transfer payments to businesses and households.
Deficit spending that adds to the national debt is not necessarily inflationary nor does it necessarily increase the money supply. After all, if individuals and institutions are lending their savings to the government then there is no increase in the money supply as a result. There is simply a shift in how the money is allocated and spent in the economy (which has it’s own issues…not a topic for this commentary though).
However, the federal deficit over this period was not entirely financed from the existing pool of savings. Instead, the Federal Reserve monetized much of it by buying government debt with money it created out of thin air for that purpose.
Below is a chart showing the growth in Federal Reserve assets of over $4 trillion to over $8 trillion. That’s a 100% increase in just 18 months!
Hopefully by now we’re getting the idea: Trillions of U.S. dollars were created out of thin air to fund various stimulus programs employed throughout the pandemic. This resulted in more money chasing fewer goods and, hence, the inflation we’re now experiencing.
However, the question is whether we will continue to see prices rise at this pace (or higher) for a long time. I’m not yet convinced we will.
A Case for Deflation
After supply chains are back online, backlogs eliminated and inventories have been replenished (3-9 months depending on the industry), I believe it’s possible we could experience deflation for a time because there is already an extreme amount of debt / leverage in the U.S. economy.
To understand why this extreme leverage could potentially be deflationary we need to first understand how money is created (and extinguished) in a fractional-reserve banking system like the United States’.
I’ve already discussed one way in which money is created (via the Federal Reserve exchanging securities for money/bank deposits created out of thin air). However, traditionally, the majority of money supply is created by banks via their lending activities.
When you deposit money into your checking account you receive interest (or at least used to). The bank is able to pay you interest because the bank is lending that money out at a higher rate. They keep the spread between the two rates.
What’s interesting is that when we’re talking about checking/savings deposits you have full access to those funds whenever you want in addition to the loans the bank funds with those deposits. How does that work?
Only a fraction of your checking deposit is actually kept in reserve (let’s call it 10% of the balance) while they lend out the rest, hence why the U.S. banking system is called fractional-reserve banking. Yet, simultaneously, you (and others) have access to 100% of your account balance whenever you want even though 90% has been loaned out. How does that work if the money isn’t actually there? Well, 100% of all customers’ deposits are not actually at the bank and available for withdrawal…not even close.
This is why if a relatively small portion of banking clients withdrew all their money from a bank the bank is essentially insolvent. The bank could never honor all those withdrawal requests. When this happens it’s called a “bank run.” A fractional-reserve system relies on the assumption that depositors won’t demand their funds all at once so the 10% reserve tends to be sufficient the vast majority of the time.
However, when customers lose confidence in their bank’s ability to honor and redeem their balances those customers don’t want to be the last one’s out as they know nothing would be left so there’s a rush to be the first ones to cash out. This results in a vicious cycle as more and more people rush to get their money out.
This occurred during the Great Depression, which is why FDIC was created in 1933 as part of President Roosevelt’s Banking Act.
However, this is not the case for something like a CD to which the owner does not have access whenever they want. Instead, it has a stated maturity when the funds will become available. In the case of a CD, savings are just being borrowed from a saver and lent out to someone else. The money is shifted from one to another while the CD owner (saver) is compensated for giving up access to those funds for a while. So there is no increase in the money supply as a result. Same principle applies with corporate bonds purchased by an individual investor, mutual fund, etc… An individual or institution is simply lending existing savings to another entity until the loan is paid back so no new money is created as a result of this activity. The lender cannot simultaneously spend that money they’ve lent as they can with a checking deposit.
Therefore, almost every time a bank makes a loan they are creating money and increasing the money supply. You deposit $1,000, the bank must maintain $100 in reserve (assuming 10% reserve requirement) and lends out $900. All the while you still maintain full access to your $1,000 in addition to the borrower having access to $900 so that the money supply has increased by $900 to $1,900 from the original $1,000 deposit.
This goes in reverse as well. When a borrower pays off a loan the money supply decreases by that much. In our hypothetical from above, that $900 loan payoff essentially extinguishes $900 out of economy and reduces the money supply back down to $1,000 until the bank makes a new loan.
So, you can see if the economy experiences widespread defaults and/or lending activity simply slows down and/or loan payoffs increase it can put downward pressure on money supply, or at least on the growth rate of the money supply, which can have an impact on the value of the USD and aggregate price level (inflation / deflation).
For example, we’ve been experiencing a decline in the growth rate of the money supply the last few months (see below).
So, what does this have to do with my first point about debt being so large that it could be deflationary? Well, if a sponge is already fully saturated with water it cannot physically take on any more water. It must first lose some water before it can take on more.
Same thing with the debt. There’s got to be a point where the economy is so saturated with debt that it simply cannot take on much more without first shedding some of the old debt. Unfortunately, there is no hard and fast predetermined amount of debt an economy can take on relative to its underlying income and asset base.
Today, the TOTAL debt in the U.S. (including both public AND private sectors) is over $83 trillion. In and of itself that doesn’t tell us a whole lot until we compare it to the GDP of the U.S. economy, which is about $23 trillion. In other words, the total debt is about 400% of GDP. Even that doesn’t tell us a whole lot until we understand that particular figure in the context of history (see chart below).
The Federal debt today at over $28 trillion is about 120% of GDP, which is the same level it was at the previous peak in the 1940s when we were fighting World War II. The difference, however, is that the private sector had very little debt back then while we have a ton of leverage today. In fact, the total debt back then was only about 160% of GDP (not pictured on the chart) as opposed to 400% where we stand today!
My (and others’) theory is that this massive debt overhang gives our nation less capacity to borrow and invest in productive activities thereby dragging on economic growth (which we’ve already been experiencing for quite some time), slows the growth in money supply (or may even lead to contraction in money supply) and makes the economy more fragile and susceptible to economic and geopolitical shocks.
It’s also important to understand what the borrowed funds are being used for. If they are being used to invest in expanding production than the debt is self-funding, but if it’s being used largely for consumption then we’re simply pulling demand forward, and the debt is not self-funding.
To bring it back to the original discussion, this massive debt overhang could imply that a deflationary debt deleveraging cycle is in our future as the economy tries to get out from under the burden of this massive debt load.
A deflationary deleveraging cycle is what set off the 2007-2009 Great Financial Crisis, but the Federal Reserve and federal government managed to halt that corrective process and push it off to another day.
If I’m right about this we would likely see the U.S. Dollar increase in value as USD’s would actually become scarce in that scenario and folks around the world would be scrambling for them.
Remember, there is a lot of debt worldwide priced in U.S. dollars given the Dollar’s status as the world’s reserve currency. All those debt payments require dollars as well so there is an inherent stable global demand for US Dollars.
Prices of “risk” assets would likely fall along with even “investment-grade” corporate bonds.
I know it seems strange to talk about the potential for deflation in the midst of a period that includes massive stimulus, deficit spending and money printing from the Federal Reserve combined with goods shortages and supply chain disruptions. However, I believe deflation is a scenario that few are expecting but must at least be incorporated into potential outcomes. There are a lot of factors and unknown variables at play so it’s important to be prepared for either outcome.
One thing is sure to me, however, IF we do get a deflationary deleveraging cycle, the Federal Reserve will likely respond with an unprecedented amount of money printing (many trillions more than they did the last 18 months) to try and combat the deflation with inflationary monetary policy. This is why I still maintain precious metals for both clients and me personally.
Regardless, combining the most extreme levels of debt in history with the most overvalued stock market in history, one starts to understand why it’s prudent to be a patient, cautious and disciplined investor in today’s world as tempting as it might be to throw caution to the wind and chase performance.
I have very little doubt that patience and relying on time-tested economic principles will be rewarded while gambling and chasing low-quality assets at extreme valuations will be severely punished.