Paul Brodsky

An Adult Approach – II (Defining Relative Real Value)

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Regardless of how well it is measured, all inflation is not created equal. There is a big difference between the driver of consumer inflation and asset inflation. Changes in goods and service prices are ultimately determined over time by the growth or contraction of physical currency in float plus unreserved bank deposits (what Austrians call “checkbook money”). Changes in asset prices are ultimately determined in an over-levered monetary system by changes in the availability of credit. (After all, that’s why they call them financial markets.)

Asset holders benefitted at the time of the 2008 base money inflation because the Fed deposited newly created reserves into the creditor banking system, re-funding banks and by extension their investors, and allowing investment asset prices to rebound. In fact, the growth of the permanent money stock and where it flowed since 2008 explains much about recent returns. The table immediately below shows how markets have performed in nominal terms since the Fed began substantially increasing US base money:

Table depicting market performance

And the table below shows real returns — the nominal performance in the table above deflated for the SGS 1980 CPI, a more accurate measure of goods and service inflation:

Table depicting market performance - real returns

According to the BLS, cumulative CPI has risen 3.6% since August 2008. However, the table above succinctly portrays what we believe American investors know intuitively — since 2008 their asset values have not kept pace with accurately calculated goods and service inflation. In other words, US wealth and income has declined materially since 2008 in real terms regardless of popularly-accepted data to the contrary. (We are reminded of the Texas cad who indignantly demanded of his wife when she caught him in flagrante; “are you going to believe me or your lyin’ eyes!”) In short, asset holdings today are broadly perceived as a “savings pool” that will be exchangeable at current relative valuations for consumables tomorrow. This seems a faulty assumption.

US output has been shrinking in real terms too. Since September 2008, cumulative GDP growth deflated for the cumulative SGS 1980 CPI has been -29.86%. This implies the US economy shrunk in real terms by almost 30% since the Lehman bankruptcy. Does such a startling figure resonate with you or do you find it hard to believe? Before you answer, please consider the current value of your consumption and investments in 2008 dollars. The BEA suggests real GDP since then has been +1.8%. This figure does not comport with our sense of output and pricing.

It should not be considered acceptable to be in a profession – as a political economist, policy maker or investor – in which self-delusion has become a necessary requirement for success and perpetuating that delusion is harmful to the broad economy over time. Yes, but the “public good” you say? Ah, but for how long?

Inflation Perspectives

As implied, expectations of future inflation in the general economy that drive consumption patterns, (should I consume now or later?), as portrayed by the CPI and PCE deflator, should theoretically correlate most tightly with physical currency in circulation; while expectations for the Dow Jones Industrial Average, home prices, college education costs, etc. (i.e. items sponsored with explicit or implicit leverage), should theoretically correlate most tightly with bank credit dynamics.

Further, we think the common notion that prices of goods, services and assets are solely determined by a rise or fall in aggregate demand should be summarily dismissed in today’s environment. While it is true that increasing demand for goods, services and assets correlated with steady price increases from 1945 to 1971, it seems more accurate to attribute that dependable glide path to the forces behind it. Production and consumption shifted from the public sector to the private sector after World War II and there was very little private sector leverage at the onset of the peace in 1945. Monetary and credit policy makers after the War could afford to show restraint every now and then while still allowing the economy to grow and eventually recover with new credit accommodation.

It also must be acknowledged that government spending and Fed money creation was hindered by the natural discipline of the gold-exchange standard under Bretton Woods, which greatly curtailed systemic leverage.

Then, as we know, from 1981 to 2006 asset prices rose far more than goods and service prices. A decade after the demise of Bretton Woods in 1973, balance sheets remained comparatively unlevered. Additionally, the baby-boomer bulge in Western populations had incentive to begin saving for retirement. As interest rates began their long descent in 1981, savers gradually moved out on the risk spectrum, investing directly in equity markets, indirectly in derivatives and structured financial products, and finally in levered real estate. Their more speculative actions were further validated along the way in the real economy. Productivity soared, domestically and globally, as new technologies and innovation provided greater efficiencies.

Finally, the fall of communism in the East provided a new, cheap global labor pool almost overnight. Throughout this golden age of investing from 1981 to 2006 there was also a great counter-factual at work: despite enormous productivity gains that would have otherwise greatly reduced prices of goods and services, easy monetary policies in developed economies led to ballooning balance sheets that stabilized the general price level (GPL). Global central banks led by the Fed did not stabilize goods and service prices by restricting credit, which would have tamped down price increases, but by promoting credit to levitate the price level.

For the last thirty years economic policy makers have been in the business of promoting asset prices higher through easy credit. (It seems “stable prices” being the primary objective of all central banks demands they spike the punchbowl rather than take it away?) Within this environment, price increases for goods and services badly lagged price increases of assets bought with unreserved deposits or unreserved bank credit. As asset prices rose, collateral values backing potential consumer credit rose too — a virtuous credit cycle.

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