How do we get out of this mess: inflation and the gravitational pull of debt
Farming in the vortex of change
What a time to be alive!
I have had a lot of questions about fiscal and monetary policy and how it is effecting commodity markets in the short and long run. So I thought I would mix it up and write about the current macroeconomic atmosphere we are currently operating in. To summarize, this is some of the most interesting economic landscape that I have ever witnessed in my 30 years of following markets, and why you as commodity producers are sitting in the catbirds seat!
As some of you know my background and fascination is centered around financial markets and the economic realities generated from the both fiscal and monetary policy.
I will caveat this with my belief that politics are down stream of economics and therefore in my opinion have very little to do with economic outcomes. Save the hate mail cuz I throw both sides in the same bucket, or as Charles Koch said…..”the only difference between current conservative and a liberal policy is that one is doing 60 mph into a tree and the other is doing 70mph”. My view is that man is led by the “invisible hand theory”….aka he will do what is in his own best interest….google Adam Smith if you want to learn more. The invisible hand theory can have positive impacts for society as a whole as well as the individual. Keep this thought in mind as we discuss current realities in the commodity and financial markets.
To frame the current market I think you have to recognize the financial markets as we knew them changed with the GFC(great financial crisis). From that point forward monetary policy took the lead. Although it is influenced by political and fiscal tomfoolery, it in of itself has been the driving factor of our markets for the past 13 years. QE has put a floor under all markets and assets. Low interests rates(free money) has moved money from bonds to risk assets like no other time in history as the risk/reward relationship is now skewed in favor of all out “risk on”. Only accelerating with COVID after the initial dip in March of 2020.
In March 2020 the markets sold off hard. Almost immediately fiscal and monetary stimulus stepped in to assure people they could continue their life without working, paying rent, paying student loans or any financial hardship. All would be curtailed by stimulus, subsidies, no recourse loans, PPP, or any other name you want to put on FREE MONEY from dear old Uncle Sam. I mean the president of the Federal Reserve went on 60 minutes and said, “We are just printing it”!!!. No further explanation needed!
Where are we now and how do we get out from under it?
If we can agree that fiscal spending and monetary stimulus will continue to increase….how will we ever get the national debt back to “manageable” levels? Currently the debt stands at about 30 trillion+-. Gross Domestic Product(GDP)stands at 20 trillion. So a debt to GDP ratio of 150%. The only other times in modern history that we reached this level was during WWII. How did we manage to pay it down back then? Well, we had and now have three options in my opinion…..but really only one that is realistic.
Discover a productivity game changer! (industrial revolution, internet…etc…)….where we can grow GDP at a rate that reduces the debt levels to manageable levels. The gain in productivity from the internet boom in the 90’s managed to put us in a slight surplus for about 3 years.( see government surplus1998-2001).
“hard default” on government debt. Tell all US treasury holders that the paper they hold is now worth half of what it was yesterday. This will lead to the largest bank run in history and likely a banking system freeze up….there will be blood in the streets if this were to happen.
“Soft default” on government debt. In my opinion this is the most likely and is what we did to pay for WWII.
What is a “Soft Default” on government debt?
This is the exact play the USA made post WWII. Let me explain. DEBT to GDP ratio reached nearly 130% as the war ended and by the early 60s we had reduced the ratio down to 30% or so. HOW DID THEY DO IT??? Three main themes emerge here…
taxation in the late 40s early 50s was extreme….highest “marginal rates” were above 80%.(see below)This option is very unlikely today.
Productivity increases were some of the best recorded(near vertical line at end of war).
FINANCIAL REPRESSION…..Interest rates were held artificially low while inflation was allowed to run “hot”(green line higher than blue lines)
Financial repression has the greatest effect when combined with #1 and #2. Financial repression by itself is not nearly as effective as when combined with productivity gains and tax increases. Tax increases are very unlikely in todays polarized world. What financial repression effectively does is allow cost of debt(interest)to be capped(also called yield curve control) and the GDP to expand as well as allows revenue from higher taxes applied to an ever increasing asset price structure(inflation).
Is it TRANSITORY?
NO. Inflation is and was the desired net effect of fiscal and monetary policy over the past 2 years and will be the policy going forward for the foreseeable future. Financial repression with inflation will be the only way we “mitigate” the national debt. Notice I say mitigate and not pay back the national debt.
The goal of current monetary and fiscal policy is to reduce the ratio of DEBT to GDP not necessarily to reduce the actual debt. If and when they achieve this, then and only then, will they be in position to actually move interest rates back to more normal levels. Normalizing interest rates should be the goal of long term monetary and fiscal policy because it is the first step to organizing markets back to productive risk/reward relationships.
How long will this take?
The duration of this move will depend on the ability of the market to digest inflation and taxation without breaking down. If we do a quick back of the napkin math it may look like this: real inflation at 10% and repressed interest rates at 1.5%. The difference is a real negative 8.5% interest rate on the debt……if we continue at this rate we can expect DEBT to GDP to be back under 50% in about 11.76 years. 150-50=100 / 8.5 = 11.76. Simple math here and it surely has more nuance but the point is made.
What can farmers do to protect themselves?
The short answer……you are doing it. In a time where inflation runs hot and the cost of debt is capped you have the advantage of borrowing at a fixed rate and paying back that debt with ever cheaper dollars(inflation causes money to lose value over time). Only in America right?!! OK so if we win by using debt…who loses? Short answer….anyone who’s income does not pace inflation or anyone who is sitting on mounds of cash or fixed rate bonds as a high percentage of net worth…..You as farmers do a great job of turning money. You have fixed financing for long term land assets and you borrow/invest annually into a crop and then get revenue by selling the single most inflation sensitive commodity there is…..FOOD.
What can go wrong with a heavy debt load?
The short answer……a massive deflationary event(market crash, bank run, the real estate bubble pops). If you have huge debt and the dollar regains its strength(deflates) it makes paying that debt back harder and harder over time. See 1982-88.
How do we get a strong dollar?
To achieve a strong dollar is not just a mechanical function of the market…..it is both a mechanical and psychological function. What may be counterintuitive to most is that as you increase debt(inflation) in the system there is also deflationary aspect which is poorly understood. For example….as the system creates debt(loans being made=inflationary)it also, true to the laws of physics, creates the opposite impulse as the debtors seeks to earn dollars to pay back the debt(deflationary) per the loan schedule. So in theory the lending of money is inflationary and the need to pay it back is deflationary. Private sector loans are usually offsetting. (H/T to Brent Johnson for explaining the Dollar Milkshake theory that opened my eyes to what 4 years of economics could not get to stick!)
So why is government Debt different?
Hmmmm??……offsetting inflation/deflation is very true in private sector debt but when fiscal policy creates debt(helicopter money, PPP loans, farm subsidies, social security, medicare….….etc etc.) and that debt is repaid with printed dollars from the FED. Those dollars are not productively earned so it does not offset the inflationary pulse of the money creation…… hence you are left with only the “inflation” side of the equation. Government debt can be productively spent like it was on the US interstate highway system or hydro production ventures of the past but when just handed out for routine expenses it really becomes inflationary right out of the box in my opinion.
Why dollar strength if we are printing like crazy?
Fortunately the US Dollar is the slowest sinking ship in the harbor. To steal an analogy from Lyn Alden. Picture yourself on a boat called SS DOLLAR. Around you are the SS YEN, SS EURO, and the SS YUAN. All 4 boats have holes in them(inflation), so they are all sinking(some faster than others). As you stand on the deck of the SS DOLLAR it appears that you are rising(strength)compared to the other boats, when in fact, the boats around you are just sinking faster than you. So dollar strength is relative to the currencies it is compared to. If the rates of change stay the same then the dollar will appear strong compared to others but it is still losing purchasing power. Which is why you are now paying 8 dollars for the same Happy Meal that cost 4 just 10 years ago!
See chart below….since 2008 dollar trend is up (again…WHEN COMPARED TO OTHER CURRENCIES)…..does not mean inflation is not happening. It is just at a slower rate than everyone else.
What happened in the 70’s and 80’s?
So the older fellas remember that the 80’s brought in high interest rates and bankrupted a lot of good farm boys who were in a pinch to deep. Correct…..the question is why the high interest rates worked then and not an option now?
In 1971 we came off the gold standard(foreign countries could no longer redeem dollars for gold). Nixon did this to allow money to be printed to pay for war in SE Asia and to cover other fiscal spending pressures. Inflation was unbridled and ran hot! To counter that and bring inflation to bay the federal reserve raised rates aggressively and caused dollar strength(refer back to dollar strength being bad if you are in debt). This is not an option today because the size of the debt is different.
“This time it is different”??? Well actually, it is quite different….in the 80’s DEBT to GDP was under 30% so the cost of raising interest rates on government funding was not restricted…today we are at 150%!!! That is a big difference! So to put it bluntly…..the government can’t afford to raise rates as it will drive the cost of its own debt thru the roof! Why don’t or won’t they just print it all you say? Well they could but they will then lose the “psychological” aspect of dollar strength and the privilege of maintaining world reserve currency status….or in other words the rest of the world will lose confidence in our dollar. So when we want to buy something from overseas…you get a couple four letter words for an invoice.
Are we totally up a creek?
No. I would not bet against America. We have been here before and will eventually do what is right after we have exhausted all other measures. The playbook is clear and explained well by my favorite quote from Twitter….. “the Federal reserve is trying to ride two horses with one ass”-Luke Gromen. On one horse the federal reserve wants to keep interest rates(cost of debt) low thus signaling to the bond market that inflation is not a problem but on the other horse they need inflation to run high so they can reduce the national debt as a percentage of GDP! It is a confidence game like no other….and so far Jerome Powell has managed to wiggle thru some tricky spots. Time will tell if he can maintain course or if the bond vigilantes return like they did in the 80’s and drive interest rates up……at which point the FED will have to step in with Yield Curve Control (YCC) and put a cap on interest rates.
This is my first public posting…and wish to tip my hat to all the great thinkers and posts that are put out on FinTwitter. It is a great place to learn and explore ideas from some of the brightest minds in the world.
We live in the exponential age and I am excited and optimistic about our future in the agricultural industry.
My advice to farmers….keep your debt respectable and keep some powder dry. Remember you are sitting in the catbirds seat….the normal course and structure of your business inherently protects you from inflation. CARRY ON!!
John R. Ezinga