Inflation And Broken Windows

The pandemic is clearly accelerating some pre-existing trends. Globalization was already starting to slow and possibly reverse for technological reasons. President Trump’s trade war gave more impetus to “Buy American” and “Buy Local” policies, and Biden seems intent on continuing them. And now COVID-19 gives national governments everywhere reason to be as self-sufficient as possible. Businesses feel the same pressure.

But what really matters is how the Federal Reserve responds if price inflation pushes interest rates higher. Louis believes the Fed will enact some kind of “yield curve control” to keep long-term Treasury yields near 2%. This will tank the dollar, raising inflation but sending “real” interest rates even more negative than they are now, thereby helping finance fast-growing government debt (TLT).

This scenario would be good for gold and terrible for bonds. But it’s not the only scenario, so let’s turn next to my favorite bond bull.

Broken Window Fallacy

Lacy Hunt of Hoisington Investment Management has been steadfastly bullish on Treasury bonds for 39 years. He saw what Paul Volcker was doing and became a monster bond bull. He has been exactly right. His argument is really just simple math. To summarize:

  • Growing public and private debt suppresses economic growth as the additional debt has a smaller and smaller effect.
  • The low growth reduces velocity of money, without which sustained general inflation is impossible (though there can be inflation in some segments).
  • Inflation being the major determinant of Treasury yields, those yields will move lower.

In his latest report, Lacy takes on the idea that fiscal stimulus plus recovery from the pandemic will spark inflation. He notes that any GDP growth from here won’t reflect the pandemic’s vast wealth destruction. He compares it to the famous Frederic Bastiat/Henry Hazlitt story of the broken bakery window. Fixing the damage boosts GDP, but you don’t see the other costs incurred or opportunities missed. Just as we can’t grow the economy by breaking each other’s windows, we can’t expect pandemics or other disasters to be beneficial.

He also points out (and Louis Gave does, too) that most fiscal stimulus has a small and maybe negative multiplier effect. Governments aren’t “investing” in new productive capacity or building anything new. They are simply transferring money between taxpayers, bondholders, and benefit recipients. This may be necessary in the short term, but it also misallocates resources and reduces future growth.

Lacy saves his real fire for our overuse of debt. This isn’t new but the pandemic has accelerated it.

When debt capital, like any other factor of production, is overused its marginal revenue product declines. This serves as a persistent drag on economic activity that restrains growth despite the best efforts of monetary and fiscal policy. The decline in the marginal revenue productivity of debt, due to the pandemic, must now operate with even weaker demographics around the world. The pandemic resulted in considerably lower marriage and birth rates which will have negative long-term consequences for domestic and global growth. Based upon the universally applicable production function, the capability of achieving historical rates of economic growth will be even more difficult in the years ahead.

Source: Hoisington Investment Management

The Federal Reserve is trying to stimulate an economy that already had too much debt with yet more debt. No surprise, it’s not working, though it is boosting stock/asset/housing prices. Most of their stimulus simply stays on the sidelines. This is very clear in the velocity of money, which was already trending lower but fell sharply in 2020.

Source: Hoisington Investment Management

At the most basic level, this is just plumbing. Water flows downhill. Inflation is hard to imagine unless that velocity line turns higher. But water can still splash for short periods. Velocity rose sharply in the post-WW2 years when, not coincidentally, the Fed was engaged in the kind of yield curve control Louis Gave expects.

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Disclaimer:The Mauldin Economics website, Yield Shark, Thoughts from the Frontline, Patrick Cox’s Tech Digest, Outside the Box, Over My Shoulder, World Money Analyst, Street Freak, Just One ...

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