Let's back up. Currently, policymakers are not targeting income and certainly not aggregate spending. We remain in inflation targeting regimes.
So how does fiscal policy affect inflation-targeting regimes?
Inflation is poorly understood. Let's review our current understanding.
The 4 causes of inflation
Inflation is poorly understood force. Let's back up and describe the 4 causes of inflation which come from the Keynesian framework.
- Cost Push inflation
This is inflation from the supply side that arrives when the cost of producing goods and services increases. This type of inflation tends to be the culprit when you see inflation across sectors. The commonality is the increasing cost of labor. Baumol effect dissects the phenomenon. If employees are able to capture an appreciable portion of an economy's productivity growth in their wages then industries whose productivity growth is cannot keep pace will be forced to pass the costs on to consumers. A classic example is education. If you are in the business of selling a credential a low teacher-to-student ratio is an input to the prestige of the credential. Therefore the teacher's higher wage cannot be scaled over more students.
In contrast, the geo-arbitrage of outsourcing has reduced the price of manufactured and durable goods. Simultaneously, service industries which are harder to boost productivity in, have experienced the highest inflation rate amongst consumption categories since WWII
- Demand-Pull inflation
This is the result of heated demand for goods and services. It most likely explains the difference of inflation rates with a category of goods and services.
- Structural inflation
This comes from self-fulfilling expectations that prices will continue to rise
The rejection of a currency as a store of value. It typically emerges out of a feedback loop between two mutually-reinforcing conditions: (a) Economic participants lose confidence in the future purchasing power of a currency and become unwilling to hold it, causing it to depreciate, and (b) The government issuing the currency has hard liabilities—e.g., inflation-linked debt, debt in a foreign currency, real resources that need to be purchased to fund vital causes, etc.—and is forced to issue ever-increasing amounts of the currency to fund those liabilities. The issuance deepens the loss of confidence and accelerates the depreciation, forcing additional issuance in a vicious cycle.
While we have listed the causes of inflation, we now turn to the actual mechanics.
In the context of expansionary fiscal policy, inflation can be driven by several of the typical causes but the primary mechanism will be demand-pull. The reason is that demand-pull is the state of excessive spending which is what the policy is trying to encourage by injecting financial wealth into the private sector.
Types of wealth
Before a definition let's define the 2 types of wealth.
- Financial wealth: this is wealth via money broadly defined which crucially includes credit. Financial wealth is relevant to inflation because it confers spending power
- Real Wealth: this is the wealth related to real goods and services including the real capacity to produce those good and services.
Real wealth is relevant to inflation because it's the means by which spending power is fulfilled. An example to demonstrate the distinction. If I borrow money to start a lemonade stand, I receive cash and pay it to my staff who runs the stand. The lender has swapped assets by giving cash in exchange for credit. I, the borrower have a liability in the form of a loan but an asset in the lemonade stand. There is no change to any of our financial wealth. However, the financial wealth of the staff has increased. If the lemonade stand is a productive enterprise that well-allocated financial wealth will represent real wealth fulfilled by the business. If the business is a failure, the financial wealth cannot be reclaimed from the staff but the loan and stand will be destroyed as they are no longer resting on a profitable stand's productive capacity.
We can now see what inflation really is. The condition of excess spending. This occurs when financial wealth is permitted to grow faster than the economy's capacity to fulfill spending.
How does inflation stay in check?(The invisible fist)
What Jesse, in a nod to Adam Smith's invisible hand, calls the "invisible fist". The requirement to return principal and interest to a lender constrains the expansion of credit and therefore spending power. Unproductive spending will lead to the destruction of financial wealth. If I borrowed money for a lemonade stand but then spent it on a vacation, my deficit spending will have created new financial wealth for the system, but it won't have created any new real wealth. I won’t receive future cash flows to repay the loan.
The actual mechanics are worth a look:
The first place where the invisible fist will destroy financial wealth will be on my personal balance sheet. I originally accounted for the business as a new financial asset that offset the new liability that I had taken on. If that new financial asset never comes into existence, or if it turns out to be worthless, then it's going to get written off. I'm going to end up with a new liability and nothing else—a negative cumulative hit to my net worth. The next place where the invisible fist will destroy financial wealth will be on the lender's balance sheet. The loan will get defaulted on. In a full default, the lender will suffer a hit to his financial wealth equivalent in size to the financial wealth that I added to the balance sheets of the people that I bought the vacations from. The lender will experience an associated decrease in his spending power, compensating for the increase in spending power that my unproductive vacation expenditures will have conferred onto those people. In the end, the total financial wealth and spending power in the system will be conserved. The invisible fist will not allow them to enjoy sustained increases, since the real wealth in the system—its capacity to fulfill spending—did not increase. In this way, the invisible fist will prevent an inflationary outcome in which the supply of financial wealth overwhelms the supply of real wealth.
The sensitivity of the "fist"
The sensitivity of the "fist" comes from interest rates
Higher real interest rates strengthen the fist
This is desirable when there are many opportunities to add value to an economy through investment, and where those opportunities are crowding on each other, driving aggressive competition for a tight underlying resource pool, higher real interest rates will lead to better supply-side outcomes. They will strengthen the grip of the invisible fist, pushing out the less productive, less profitable opportunities that can't afford the higher rates. Use lower real interest rates to weaken the fist. When do you want to do this?
In economic situations where opportunities to add value to an economy through investment are limited, and where significant portions of the underlying resource pool are sitting idle, lower real interest rates will lead to better supply-side outcomes, since they will weaken the threat of the invisible fist and help draw out any value-additive investment opportunities that are there.
The precondition to inflation
A precondition to inflation is bypassing the "fist"
If the real rate of interest is too low, investors and consumers may be encouraged to to take excessive loans which leads to unproductive investments. The financial wealth creation can spur inflation by creating nominal wealth while reducing the real value of the debts it is based on. This unproductive deficit spending applies to govts as much as it does to the private sector and is effectively equivalent whether it is done via debt issuance or money printing. A govt that issues its own currency is in fact unique in its ability to bypass the invisible fist since it experience a short squeeze on its collateral. It can simply print more money. This is an important observation since a govt that can set the financial wealth of the private sector to any desired value is holding a loaded inflation gun.
By now we understand what inflation is, how it can be caused, and the risk of bypassing the fist that would typically keep it in check.
But now we must ask, what is required to actually drive inflation?
Preconditions for inflation
Stimulus does not necessarily cause inflation
Just because a govt can inject financial wealth (aka claims on an economy's real output) into a system does not mean it must cause inflation.
The vast majority of the potential claims that exist as financial wealth in the system are not going to be exercised in a given period, but will instead be held idle, as savings. Of course, some of the claims will be exercised, but as long as the economy has the capacity to fulfill those claims by delivering the wanted goods and services that people are seeking to purchase, then the rest of the claims can peacefully coexist together without depreciating each other.
In other words, if all the credit and money isn't spent all at once, the existing stock of productive capacity will be able to meet demand.
Spending is a flow phenomenon, whereas wealth is a stock phenomenon. The addition of stock (wealth) to the private sector via government deficits can lead to an increase in flow (spending), but it doesn't have to lead to such an increase.
If the govt hands you $1,000 you might not spend it. If you do it will multiply by some factor. But if the next recipient of your spending in the chain chooses to withhold the money rather than spend it, the cumulative multiplier effect might be quite small remaining well below the economy's capacity to fulfill the desired spend. To put numbers to it...the total stock of wealth in the US economy is $100T. The annual flow or GNP is $21T. If even a fraction of the wealth was spent in addition to a typical year's GNP then that can be enough to spur inflation.
What to be on guard for
So what do we look for to handicap the possibility of inflation if not the total wealth in the system?
The key variable is:
the demand to withhold (ie saving without spending)
The critical variable that determines the extent of the multiplication that occurs in the process is the economy's withholding demand, the number of times the wealth has to get tossed around as income and spending before it falls into the hands of someone who wants to hold it rather than spend it.
The scary thing about "withholding demand" is that it is not static. It fluctuates over time.
So a wealth injection that originally occurred without any sign of inflation could end up provoking inflation at a later time, possibly years later, when conditions supporting multiplier effects have improved.
Consider our current situation in 2020:
The fears and constraints that are currently keeping inflation down are not permanent fixtures of the economy. They're temporary consequences of the virus. In the future, when the problem of the virus is resolved, they will go away. But the previously injected wealth will not. It will remain in the system, free to multiply in an inflationary process.
Our experience in the aftermath shows that this concern is not just theoretical
WWII is the only other large debt expansion that the US govt has ever taken on. It was the largest 4-year increase in private sector wealth in U.S. history.
At first, this was not inflationary as we mentioned earlier. Uncertainty restrained demand. However, since the wealth was not used to finance capacity that is used to serve peacetime needs, the financial wealth had grown much faster than the economy's ability to fulfill it. When optimism returned, this wealth started being spent and overwhelmed the supply of goods and services. What ensued is sobering.
In the case of World War II, political considerations prevented the Federal Reserve from appropriately responding to the inflation pressure that emerged in the aftermath of the war. At the insistence of the Treasury, the Fed kept rates near zero and allowed the inflation pressure to proceed unchecked. As a consequence, inflation accelerated into the double digits, and anyone who was unfortunate enough to be holding money in a savings bond or in a bank went on to suffer a dramatic loss of real wealth—more than 25% over the three-year period that followed the war—without receiving any remuneration in the form of interest. It was a permanent loss of capital, fully unrecoverable, inflicted on bondholders and bank depositors that were never exposed to the prospect of gains.
How do we fight inflation?
Inflation is hard to fight
If the economy rests on a large stock of financial wealth, it only takes an increased tendency to spend to start having that wealth apply inflationary pressure.
What are the options for removing financial wealth?
- tax increases
- spending cuts
- raising interest rates
In broad strokes you can say that tax increases are progressive while spending cuts are regressive. Raising interest rates, the least political channel since it does not involve congress, is the path of least resistance and therefore the most likely way to reclaim financial wealth. (a quick and interesting aside to that: interest itself is a form of income. If the stock of debt in the economy is large then raising interest rates can actually be counterproductive in that the immediate drawdown in capital wealth would be offset by increased interest income by the private sector which owns the debt which can actually increase its spending power...Jesse shows that this effect is also dangerously non-linear depending how much debt is in the system. I suspect that the immediate reduction in financial wealth depends on the willingness and ability for borrowers to roll fixed-rate debt over as it matures could be the larger factor but who knows)
An inherently political problem
The main point is that the way the govt chooses to claw back the financial wealth is deeply political and is a question of fairness.
Inflation destroys the wealth of people who are holding their savings in the form of money and debt. To earn whatever financial surplus they are currently holding, those people did work and added value to the system. Inflation prevents them from getting that value back. It effectively confiscates the value and arbitrarily redistributes it to those who are holding real assets, to include real labor assets. Principles of fairness would suggest that if earned wealth is going to be permanently taken from people in order to fund important government spending, it should be taken broadly from everyone, based on progressive considerations such as how much wealth a person already has. But inflationary fiscal policies don't operate in this way.
However, besides the progressive and regressive nature of various reclamations Jesse makes a sympathetic point.
Instead, they target people who lack the financial cleverness to foresee the inflation and shelter their wealth from it. Those people end up paying the entirety of a bill that is owed by everyone. [me: sophisticated investors look for ways to hedge inflation]
To the unfortunate people who lost large chunks of their wealth in the post-World-War-II inflation, we can certainly put the blame back on them—"It was your fault for being stupid, you should have foreseen the inflation and sheltered your wealth from it in stocks or in real estate." But someone had to hold the paper assets that the government created to fund the war, and therefore someone had to be the eventual bag-holder in the inflationary outcome that ensued. If it hadn't been them, it would have been whoever they bought stocks and real estate from. Their decision to hold the assets may have been stupid in hindsight, but the point is, it's wrong to single out the stupid and have them pay for government spending. We all should pay for that spending, based not on our investing guile, but on our ability to pay.
[me: This is a diabolical coordination problem. It's a scary reminder that community cohesion can rest on govt policy that may be allocated in total disproportion to its cost.]
What are the scenarios for fighting inflationary pressures when and if they mount?Regime 1: Fed abandons inflation target and lets it runRegime 2: The Fed maintains inflation targets
How do we handicap these possibilities?
Reasoning through the tree
1. Start with the prevailing Fed mindset
Understanding the prevailing mindset before handicapping possible outcomes
Why the Fed would be inclined to fight inflation
- With respect to letting inflation running hot it's important to note that Deeply negative real interest rates are not a comfortable settling place for an economy. Fed may have bias towards removing stimulus if fiscal environment is supportive of growth
- Fed prefers action over inaction. Fed will have trouble "sitting on its hands" and leave rates at zero in the face of inflation/exuberance
Why they may let inflation run
- Right now, an inflation-fighting monetary policy mindset is not needed and hasn't been needed for a very long time... The Fed has been very clear that it's going to maintain a dovish bias, with a preference for keeping interest rates near zero, until inflation proves itself by exceeding the 2% target. The question is whether inflation will actually prove itself in that way.
- The Fed is aware that the increase in spending power has been greatly overstated. The increase in M2 that is popular to point on on charts does not represent an increase in the economy's financial wealth.
When the Fed purchases fixed income assets from private investors through bank dealer intermediaries, it takes those assets, which don't count as part of the broad money supply, and converts them into cash, which does count as part of the broad money supply.
The money supply increases but the matched reduction in assets on private sector assets is not captured by M2. If you want a measure of money that correlates with spending power you need to include all the liquid liabilities of the banking system that are used to save money. So a proper definition of financial wealth is money and credit. M2 only tells half the story. From 1970 until the Great Financial Crisis increases in the money supply were mostly driven by credit. It's only in the years since the dawn of QE that the expansion has come from M2. In fact the growth in total liabilities which is the sum of credit and money supply has actually been muted in the past decade, a story that stands in defiance of those Zerohedgey M2 charts which neglect the credit aspect.
- Monetary policy seems to have reached its useful limit. Reserve ratios are at 0. Rates are already below the threshold of creditworthiness considerations so the credit channel is unaffected by further rate easing. Demonstrating that the market knows monetary policy is out of ammo: The market found some support during the March Covid sell-off from the Fed's effort to backstop corporate credit but it took news of a strong fiscal response to catalyze recovery in asset prices.
When did the sustained market rally finally begin? On the evening of March 23rd, when it became clear that Congress was set to pass the biggest fiscal spending package in the country's history, a package that was several times larger than initially expected.
2. Identify the constraints
First what is the constraint on fiscal policy
- Let's start with the traditional argument argument: The govt invisible fist argument: Govt borrowing should be subject to the same tests of productivity as private borrowing so as not to confuse financial wealth with real wealth.
By conceptualizing the government as if it were constrained in this way, unable to lean on a captured central bank or a printing press, we allow the invisible fist to enforce proper discipline on it, preventing inflationary outcomes.
This is the theoretical constraint
- The practical constraint differs from this theoretical constraint Since a sovereign gov't can print its own currency, financing is not a constraint. The true constraint is:
the amount of financial wealth (aka spending power) that the private sector is willing to passively absorb in that currency. How much spending power can the government inject into the private sector before it pushes actual spending above the level that the economy's productive capacity can support?
How much spending power can it inject before it is forced to battle runaway inflation via harmful policies like higher interest rates, taxes, and price controls?
The consequences of stimulus are not going to be distributed fairly or evenly across the society, and so it makes sense for people—particularly, those who have worked to accumulate savings that can be taken away through inflation—to be less-than-enthusiastic about what we're doing.
Unfortunately, we cannot run a controlled experiment to estimate the possible outcomes. We can't just inject a bunch of stimulus and measure inflationary pressures over different time frames, tinker with tax and interest rates to keep those pressures in check, and compute if we would be better off having bondholders and bank depositors bear the brunt of the wealth erosion.
3. Estimate the impact of the stimulus
Start with estimating the impact of the wealth injection on spending
The projected injection is $7.5T over 2 years. This is about 3.2% of household net worth per year (about 18% of GNP per year). These numbers are eye-popping only until you put them in context.
- Consider a rolling 10 year average of change in household net worth. In the past 50 years household net worth that moving average has ranged from 3 to 10%. This stimulus would merely replace the lowest amount of growth households have seen since 1960 and that includes periods like the stagflation of the 1970s and the GFC.
- Furthermore consider WWII. The govt stimulus as a fraction of GNP was 7x the size of the Covid stimulus albeit over 4 yrs not 2.
So the eye-popping numbers are actually much more reasonable in context. In fact the WWII stimulus makes the Covid response seem underpowered. But this underpowered look is actually an illusion. The basis for that illusion is a very strong hint for what can truly trigger inflation. So what's the difference between WWII times and today that makes the fiscal policy stronger than its lower relative number might suggest? Wealth inequality.
Today's stimulus targets the low and middle class which own a much smaller proportion of the total wealth than they did post WWII. Today, the bottom 50% own 1.5% of the wealth. So when we inject 6.4% of household net worth into the economy we are quadrupling the bottom half's net worth over 2 years. This is the segment which will spend the stimulus maximizing the multiplier effect.
If spending power is an injection times a multiplier we must examine wealth inequality (rich people save marginal income while lower classes will tend spend it) to handicap how sensitive the multiplier will be.
To do this we need to connect wealth to actual spending or spending per unit of wealth. The focus on money multipliers is incomplete just as a focus on M2 is incomplete. Money is not the ultimate source of spending power. Wealth is because it represents the direct ability to spend as well as the ability to borrow to spend. Wealth is held in many forms besides just money.
Since so much our wealth is concentrated in few households we need to understand not a single homogenous money multiplier but how wealth is spent across the range of wealth from poor to rich.
We are actually interested in wealth velocity. It's PCE (personal consumption expenditure) as a percent of household net worth. This velocity is very different across the range of classes. Jeff Bezos' marginal dollar does not get spent. His wealth velocity is extremely low as his spending as a percentage of his net worth must be tiny. Since 1960, the national wealth velocity has hovered between 13 and 18%. Let's say you are worth $1mm, you might spend $150k per year to be in range. But if you are worth $1B you likely spend far less than $150mm per year. So aggregate wealth velocity will overstate the actual wealth velocity when most of the wealth is held by a few people. The aggregate number is a conservative estimate of the multiplier produced by wealth injections.
Current aggregate wealth velocity is estimated to be about 13%. since the stimulus is $7.5T we expect about $950B increase in actual spending. That represents about a 3.2% increase in spending per year, similar to the increase in household wealth we estimated earlier, but this is likely overstated since it presumes pre-covid levels of wealth velocity.
4. Consider the counterforces
Is the spending increase associated with Covid stimulus going to be inflationary?
Of course it depends. what are the counter-inflationary forces.
- Are we still going to enjoy cost-push deflation? For 25 years, durable goods inflation has fallen 2% per year, non-durable goods have flatlined, and the service sector has driven trend inflation. Will globalization and technology remain a headwind to goods inflation?
- High private sector debt crowds out inflation as debt service increases demand to withhold. The US private sector debt is 141% of GDP. Down from its 2008 peak of 155% but much higher than any other point in history. With such a debt load, we do not need a large rate increase to stem inflation.
- Aging demographics in the the US are a headwind to wealth velocity. (Immigration policy can tilt to exacerbate or alleviate this particular headwind)
- Finally, the point that I find the most compelling is the income inequality effect. I refer to Jesse's explanation as the "inflation heat sink" and explains why all the increased wealth doesn't seem to be having an appreicable impact on inflation (outside of financial assets which represent the supply of savings). The explanation is as follows. Wealth is a stock not flow variable. Annual income is the flow variable. Not only is our wealth distribution top-heavy but our income-distribution is as well. The top 50% own 98.5% of the wealth. The top 40% own 75% of the income! This second point is critical because it reinforces the first. Every dollar that makes it's way thru the economy eventually ends up in the hands of the upper classes. The more top-heavy the income distribution is the the quicker the spending multiplier peters out as the dollars find their way into a savings account even faster. In Jesse's words:
any new wealth that gets injected into the system is going to get re-filtered through that distribution. The wealth might start out in the hands of low-earners, but it's not going to stay in those hands. Low-earners are going to spend it. When they spend it, they're going to get less than 3% of it back as income. The stimulative exercise will then be over for them. The majority of the spending will turn into income for high-earners and for corporations, segments of the economy that have much lower marginal propensities to spend. Their withholding of the new wealth will attenuate the multiplicative process, muting the inflationary impact of the injection...If they can't sufficiently extract income gains from the economy's spending gains, then inflationary chains of growth in income and spending are going to be significantly harder to sustainably induce. It's what allows us to run aggressive fiscal interventions during crises without introducing longer-term inflationary pressures.
So what does Jesse present as possible paths?
- If the stimulus turns out to be just a 3% boost to spending he does not expect inflation
My sense is that in the aftermath of the pandemic, the economy will be able to absorb the additional spending introduced by the wealth injection without experiencing significant inflationary pressure, especially if the injection turns out to be a one-time, pandemic-related event rather than a recurring feature of future fiscal policy.
- However if the stimulus reached double-digits, it's possible that a stronger inflationary outcome could ensue, necessitating a monetary response that turns markets upside-down. Recall, in contrast to the inflation + stocks have a field day scenario, this would be the bearish inflation scenario characterized by
- Competition from higher real interest rates
- Corporate profits impaired by higher borrowing costs
- Increased labor costs
- Higher corporate taxes required to offset gov't severe debt service burden