3-Card Macro

Here’s a rarity for this letter. Let’s play macroeconomics.

I don’t usually write about “macro” because it feels like astrology. You can look at any bit of data (the “current thing” as they say on the internet is inflation) and see it molded to be the cause or result of whatever axe a speaker is trying to grind. People who just learned what inflation was on Tuesday have incorporated it into their pre-existing worldview so seamlessly that by Friday their updated narrative is more coherent than ever.

Macro is the raw material for story-telling. For marketing. It’s a political battering ram for both sides. But macro is a ball of yarn. The discourse that’s consumable is reduced so much to aid absorption that the logic, by necessity, ends up sounding unassailable. It must. The logic is solving for convenience. Not understanding.

So I don’t write about it because I don’t think it’s especially useful. It’s more likely to give you brainworms by beefing up your priors. It will calcify hunches into commandments when the evidence only merits “things to learn more about”.

“Buy Potatoes”

While I don’t write about macro, I’m hardly immune to the animal urge to read about it and pretend I understand how the world works. My mind’s sentry just keeps me from taking it too seriously. [I suspect the sentry has saved me many times and cost me many times and I can’t tell if it’s worth the free rent it gets in my head. The question is moot, since I can’t evict it anyway. It’s like SF up in there.]

My first macro boner happened (was searching for the right verb here and “happens” is the most fitting action word to apply to boners) while reading Michael Lewis’ Liar’s Poker when I was 21. When Michael was a junior salesperson on the Salomon trading desk, he was taken under the wing of a senior trader named Alexander:

The second pattern to Alexander’s thought was that in the event of a major dislocation, such as a stock market crash, a natural disaster, the breakdown of OPEC’s production agreements, he would look away from the initial focus of investor interest and seek secondary and tertiary effects.

Remember Chernobyl? When news broke that the Soviet nuclear reactor had exploded, Alexander called. Only minutes before, confir mation of the disaster had blipped across our Quotron machines, yet Alexander had already bought the equivalent of two supertankers of crude oil. The focus of investor attention was on the New York Stock Exchange, he said. In particular it was on any company involved in nuclear power. The stocks of those companies were plummeting. Never mind that, he said. He had just purchased, on behalf of his clients, oil futures. Instantly in his mind less supply of nuclear power equaled more demand for oil, and he was right. His investors made a large killing. Mine made a small killing. Minutes after I had persuaded a few clients to buy some oil, Alexander called back.

“Buy potatoes,” he said. “Gotta hop.” Then he hung up. Of course. A cloud of fallout would threaten European food and water supplies, including the potato crop, placing a premium on uncon taminated American substitutes. Perhaps a few folks other than potato farmers think of the price of potatoes in America minutes after the explosion of a nuclear reactor in Russian, but I have never met them.

But Chernobyl and oil are a comparatively straightforward example. There was a game we played called What if? All sorts of complications can be introduced into What if? Imagine, for example, you are an institutional investor managing several billion dollars. What if there is a massive earthquake in Tokyo? Tokyo is reduced to rubble. Investors in Japan panic. They are selling yen and trying to get their money out of the Japanese stock market. What do you do?

Well, along the lines of pattern number one, what Alexander would do is put money into Japan on the assumption that since everyone was trying to get out, there must be some bargains. He would buy precisely those securities in Japan that appeared the least desirable to others. First, the stocks of Japanese insurance companies. The world would probably assume that ordinary insurance companies had a great deal of exposure…

If you are 21 years old today, how can you not hear “buy potatoes” and not think of trading as Settlers of Catan? Trading is the ultimate boardgame. It’s just that now, an algo sweeps all the call offers on Brent futures before Alexander finishes reading the headline. [Actually, the market-makers’ streaming call offers have a “panic” setting that gets triggered if they get hit on more than couple related strikes at a time and pull their co-located quotes before they get picked off by the news-reading algo. So prices can gap to something closer to fair value on very little trading volume. The graveyard of backtesting signals that don’t appreciate this would occupy every blade of grass on the planet if it were a physical place].

The blessing and curse of our frontal lobes is a desire to understand how the complex world works. Macro brings the romance of chess to investing. It lures mandate-dodging pros and tourists alike with scalable p/l if you can:

a) make accurate predictions

and

b) identify mispriced lines with respect to those predictions.

In reality, it’s more like 3-card Monte where you have no chance of guessing where the card is and if you get lucky the reward is the false confidence to wager more next time. [I highly recommend the Wikipedia for 3-card Monte. The analogy of “marks” and “shills” to the finance marketing machine writes itself].

My personal relationship with macro is as follows:

1. I’ve got some mental model of how things work
2. Stuff happens — none of it was predicted by that model
3. Backfit new models to explain the strange stuff
4. Repeat

Seriously, the meme never stops giving.

With that, in this week’s Money Angle, I’m going to go full-Tobias [narrator: you never go full Tobias] and share some macro takes I found resonant in explaining the past several decades.

Money Angle

Since this is macro story-telling I’d consider this entertainment. I’m just picking a story that feels right. These are the re-factored views of Lyn Alden and Cem Karsan.

In Lyn’s March newsletter, we start by rewinding the clock.

1. The globalized labor arbitrage begins
   
   Starting in the early 1980s, China began to open its economy to the rest of the world. And then starting in the early 1990s, the Soviet Union collapsed and its various former states also began to open their economies to the world. This combination brought a massive amount of untapped labor into global markets within a rather short period of time, which allowed corporations to geographically arbitrage their operations (a.k.a. offshore a big chunk of their labor force and various facilities) to take advantage of this. This was disadvantageous to laborers and tradespeople in developed markets, and advantageous to executives and shareholders, particularly in the US where we shifted towards massive trade deficits in the 1990s. But it did also help hundreds of millions of people rise out of abject poverty in these developing countries, and created hundreds of millions of new global consumers for those global brands as their wealth grew. China experienced a massive increase in the average standing of living, and so did many former Soviet states.
2. Bean counters then optimized on the back of this arbitrage
   
   All sorts of management approaches regarding “lean manufacturing” and “just in time delivery” became popular among corporations and MBA programs during this era. Some of these had their roots in the early 20th-century manufacturing revolution (via Ford, Toyota, and others), but they were basically rediscovered, expounded upon, and brought to a new level in the 1980s, 1990s, and 2000s across the entire manufacturing sector.
   Moontower readers will recognize the MBA mindset of selling options. Engineers build beyond spec, or “overengineer”. Biologists know our redundant kidney is an insurance policy.We constantly trade slack for efficiency as Moloch whistles by. The balance between efficiency and slack (or efficiency and fairness for that matter) is hard to find. So we can count on overshooting until the “gotchas” show themselves.
   
   Of course, this was somewhat of an illusion. Companies basically traded away resilience in favor of efficiency, while pretending that there was minimal downside, and yet this type of approach only works under a benign global environment. Outside of the Middle East and a few localized regions around the world, the 1980s through the 2010s was generally a period of limited war as far as supply chains were concerned, with significant global openness and cooperation. Extremely efficient and highly complex supply chains, with limited redundancy or inventory, could thrive in this stars-aligned macro environment. Any company not playing that game would be less efficient in this environment, and thus would be out-competed.
3. As we enter a new regime, comparisons to recent history are breaking
   
   Going forward, any back-tests about inflation or disinflation that only go back twenty or thirty years are practically useless. This whole 1980s-through-2010s disinflationary period (with one substantial cyclical inflationary burst in the 2000s) was during a backdrop of structurally falling interest rates and increasing globalization, with the sacrifice of resiliency for more efficiency. The world is now looking at the need to duplicate many parts of the supply chain, find and develop potentially redundant sources of commodities, hold higher inventories of everything, and in general boost resilience at the cost of efficiency.
4. The 1940s as the reference point
   
   I’ve been making a macroeconomic comparison between the 2020s and the 1940s for nearly two years now, and the similarities unfortunately continue to stack up. For the most part, I was referring to monetary and fiscal policy and the long-term debt cycle for that comparison, with charts like this that my readers are quite familiar with by now.
   This unusually wide gap between inflation and interest rates is one of the key reasons I regularly compare the 2020s to the 1940s (rather than primarily the 1970s, despite some other similarities there), and I have been making that comparison for nearly two years before the gap became as wide as it is now.
   Since debt was so high in the 1940s (unlike the 1970s where it was low), and the inflation was driven by fiscal spending and commodity shortages in the 1940s (rather than a demographic boom and commodity shortages as in the 1970s), the Fed held interest rates low even as inflation ran hot in the 1940s (unlike the 1970s where they raised rates to double-digit levels).
5. Will Russia’s latest adventure hasten the broader movement to diversify away from USD reserves?
   
   Diversification of global reserves and payment channels into a more multi-polar reserve currency world, with a renewed emphasis on neutral reserve assets. Much like how COVID-19 accelerated the practice of remote work, I think Russia’s war with Ukraine and the associated sanction response by the West will accelerate that diversification of global reserves and payment channels…In a world where official reserves can be frozen, some degree of reserve diversification would be rational for most countries to consider, and as investors, we should probably expect this to occur over time. This is especially true for countries that are not strongly aligned with the United States and Western Europe.
6. The conundrum facing US policymakers
   
   Unfortunately for the Fed, the US economic growth rate is already decelerating, and basically the only way to reduce supply-driven inflation with monetary policy is to reduce demand for goods, which is recessionary.
   Credit markets are already weakening, the Treasury market is becoming rather volatile and illiquid, and the Fed has ended quantitative easing. The Fed is likely to continue monetary tightening until financial markets get truly messy, at which point they may reverse course to the dovish side yet again.
   Stagflationary economic conditions are inherently hard for central banks to deal with; stagflation is somewhat outside of their expected models. In fact, the Fed might end up being forced to tighten liquidity with one hand and loosen liquidity with the other hand.
   
   This is another reason why countries may shift towards gold and other commodities for a portion of their official reserves. Not only can fiat reserves (bonds and deposits) be frozen by foreign countries that issue those liabilities, they also keep getting devalued with interest rates that are far below the prevailing inflation rate because debt levels are too high to raise rates above the inflation level.
   

We now shift to Cem Karsan. In an interview with Hari Krishnan, Cem discusses how policy in the aftermath of the GFC is misunderstood. This is important because policy is changing, and if you failed to interpret the effect of policy in the last decade, you may be caught flat-footed as the policy changes.

I don’t want to be subtle about the potential problem.

Popular investment strategies have been fit to recent decades. Roboadvisors, 60/40, “model portfolios” and target-date funds are now the default. Once you tell an advisor your age and risk tolerance they strap you into an off-the-shelf glide path and go looking for their next client. And it’s hard to fault them. They have no edge in the alpha game. 60/40 and similar approaches are low-cost, commoditized solutions that allow an advisor to (correctly) not spend time stock-picking. With fee compression in advisory, FAs can defend their net profits by outsourcing the investing portion of the job while focusing on planning and sales. To further cement their incentives, the prisoner’s dilemma of advisory means they can’t stray too far from popular asset allocation prescriptions because the advisors are the one short tracking error volatility.

Lyn believes the macro world is changing sharply. Cem has been beating this drum for the past year at least. Let’s see what he says.

1. Monetary policy came to dominate because it’s relatively free from political stand-offs
   
   My mental model of macro involves essentially monitoring the Fed (ie monetary policy) and then fiscal policy. We’ve essentially had one of those two major pipes sealed shut for 42 years. Our founding fathers in the US created a system that was purposely made to not change laws quickly or easily. That was fine until the economy became more dynamic and quicker. Congress decided they couldn’t act quickly enough to economic crises. So they created the Federal Reserve but they wanted to control its mandate, to not give it broad latitude. So they created a clear mandate of price stability and maximum employment, and only gave them one tool, — monetary policy. Essentially, there’s only been one game in town because the only way things would ever get past from a fiscal perspective is in a crisis. The monetary solution was faster, so monetary policy has been the only game in town for 42 years.
2. The nature of loose monetary policy is to encourage investment
   
   Monetary policy is free-market economics, right? It is empowering nature to go about and, and create kind of optimal outcomes. From a growth perspective, that is GDP-maximizing. We have created a technological revolution, almost unintentionally, but by being monetary policy supply-side dominant. We’ve created the Ubers and Amazons and Tesla’s of the world, companies that never would have existed in previous periods because they wouldn’t have had the cash flow to survive. But infinite cash flow ultimately led to longer duration bets. And this is why growth has outperformed value because cash flows haven’t mattered when money is free. If there’s no need to make money, the need is to capture market share and get bigger, to ultimately make money in the long run. You send money to corporations, corporations make more money. Ultimately, that leads to more globalization. If you send money to corporations, what is the corporation’s mandate, by definition, they have to maximize profitability, maximizing profitability means lowering costs of their goods, right and capturing more market share.
   
   So that’s the power of competition.
   [This echoes Lyn’s discussion of globalization]
   
   Remember Moloch’s main trick for fanning unhealthy competition, is to reduce our values to narrow optimizations. When an institution is highly specialized its incentives become perverse from a society-level purview.
   
   Let’s see why.
   
3. Monetary policy didn’t appear to have side effects because the Fed’s narrow mandate failed to consider wider signs of economic vitality
   
   If you look at incentives, you’ll see the results. The incentives have been to these two simple ideas of price stability and maximum employment. Greenspan realized that the economy had somewhat changed. And that more monetary policy wasn’t causing inflation. It took the natural rate of unemployment down from 6% to 4%. And kept doing more monetary policy, which led to the tech bubble. Without having to worry about inflation their mandate was basically maximum employment. If that’s the case, right? Why wouldn’t you just do more, it’s a free lunch, right. And so the world has had a free lunch now, for 40 years, interest rates have gone lower and lower. Maximum employment has been more and more sticky at the lower end.
   But there was a catch. And it wasn’t the Fed’s job to address it. (In fact, you could argue that thru the “wealth effect” the catch was intended.)
   
4. It’s not really the Fed’s fault. The problem is they didn’t have a mandate for inequality, or a lot of other issues.The Fed is permitted to neglect growing gaps in equality. These gaps finally caught up to us during Covid, but this time the government responded. We ran a giant fiscal deficit with PPE loans, extended unemployment benefits, direct transfer payments, rent moratoriums, and general forgiveness. Support for these measures was broad enough to get them passed.
   
   But perhaps the most important result was the recognition that inequality itself is stark. The keyboard class just hummed along on Zoom, often getting paid more, while having less opportunities to spend. They built up massive savings which if I didn’t know better seems to be conspicuously spent on house overbids and jerking the ladder up with renewed and unprecedented force.
   
   Let’s turn to Cem’s framing of inequality and why it’s a value we cannot ignore.
   
   Ultimately this goes back to Socrates. Do you give the best violin players the best violins? Or do you give the worst violin players the best violins? At the end of the day, we’ve given the best violin players the best violins. And Socrates would argue that that’s what you should do, because it creates infinitely beautiful music. But there are a bunch of violin players that don’t get to make music anymore. So we start talking about inequality about 10 years ago, and it’s really built up in five years, and COVID accelerated that trend. Again, all of a sudden, COVID happens. We get that populist kind of reaction, which had been building, what created Donald Trump and created Bernie Sanders. This is not a political statement. The world has become more populist, because of this inequality that’s essentially been created by monetary policy for two generations. And so now the fiscal response is where we are.
   
   This policy shift is noteworthy for investors. Especially if you have mistaken beliefs about how loose monetary policy affects supply and demand. In the aftermath of the GFC, with the monetary spigot open, the consensus was it would lead to broad inflation.
   
   Cem offers a counterintuitive explanation that fits what we actually witnessed since the GFC.
   
5. The important difference between fiscal and monetary policy — fiscal is inflationary.
   
   Monetary, counterintuitively is not.
   
   This whole thing is important in terms of the pipes and how everything works. That fiscal policy piece that’s been sealed shut for 40 years now has $12 trillion in fiscal policy. $12 trillion in Fiscal policy is an order of magnitude in real terms bigger than the New Deal. It is about the same size as the new deal when adjusted for the size of the economy. The New Deal filled a hole over a decade, which was called the Great Depression. This is not the Great Depression. We spent about one and a half trillion of that $12 trillion, there’s about $10 trillion still in the pipe to come, and we’re about to reopen.
   
   So it is not a surprise that we are having inflation. Fiscal policy has a velocity of one, it goes directly into people’s pockets, sometimes even more with things like infrastructure spending. Monetary policy has a velocity of almost zero, it goes directly to “Planet Palo Alto”. And Palo Alto creates new technologies. They’re sophisticated, futuristic people. They provide new self-driving cars and things getting delivered to your doorstep. They create supply. That’s the thing that people don’t understand — monetary policy actually increases supply, it does not increase demand. And so it is deflationary.
6. The role of the Fed today
   
   When the Fed was created, the economy was very different. It was dependent on labor. The trickle-down effects of a laborer getting paid more was enough to counteract those inflationary supply effects. That is no longer the case. So ultimately, the Fed has a mandate, which is completely unreasonable — to control price stability. With supply-side economics, the only way that they can control this ultimately is to pull back. And slow capital markets decrease via the wealth effect. Ultimately, there’s a significant lag, so they are not in a position to ultimately control inflation without bringing down markets.
   

Cem is saying that raising rates is a blunt tool. It’s a monetary solution to a fundamentally non-monetary problem because it only works on one side of the ledger. Demand. Rate hikes can only reasonably expect to slow the economy by decreasing demand. It doesn’t address the main problem which is a lack of supply to absorb the demand. In fact, it aggravates it. If you believe inflation is a purely monetary phenomenon this is a belated prompt to unlearn that.

How I relate this to MMT

MMT discourse gets lambasted because it appears irresponsibly profligate. Consider the Investopedia definition of modern monetary theory:

Modern Monetary Theory (MMT) is a heterodox macroeconomic framework that says monetarily sovereign countries like the U.S., U.K., Japan, and Canada, which spend, tax, and borrow in a fiat currency that they fully control, are not operationally constrained by revenues when it comes to federal government spending.

Critics of MMT read that as “these crazy MMTers think you can print as much money as you want and spend it”.

This is a strawman. MMT supporters think it’s not useful to think a government is like a household that has to pay its debt back. This isn’t because they are irresponsible. It’s because they recognize that any discussion of whether a certain amount of debt is reasonable, depends on what it is backed by. Debt is neither good nor bad. Its merit depends on what is productive assets back it.

So an MMTer believes you can run a deficit (so government expenditures do not need to be matched with revenues) as long as the expenditures lead to investments in productive capacity. In other words, is the spending creating projects and jobs that will generate a real return? This is hardly unfamiliar logic. When students enroll in medical school, their loans are collateralized by the expectation of increased earnings power that comes with getting “M.D.” after your name. Constraining their current ability to spend by their current earnings would be a horrible loss of economic efficiency.

MMT is deeply focused on inflation

In the MMT world, inflation is a serious topic because a highly inflationary environment is evidence that the spending was not wise. Inflation is a test.

I direct you to my notes on Jesse Livermore’s Upside Down Markets paper on the mechanics of inflation:

Jesse, in a nod to Adam Smith’s invisible hand, calls the inflation 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 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.

One of the leading MMT theorists, Stephanie Kelton, explains that, if anything, the MMT crowd takes inflation more seriously than mainstream economics. This makes sense if inflation, not the size of the deficit, is the true cause for concern.

In We Need to Think Harder About Inflation, she writes:

It’s the typically cavalier way of thinking about inflation that has come to dominate mainstream economics. Keeping a lid on inflation is the central bank’s job, not something Congress, the White House, or anyone else really needs to waste time thinking about. If inflation accelerates above some desired target, the Fed will knock it back down by tightening monetary policy. Easy peasy. (Unless, of course, the Fed “falls behind the curve,” allowing “inflation expectations to become unanchored” and other mumbo-jumbo.)

All you really need is an “independent” central bank that is deemed “credible” by market participants, and you can sit back and relax. There’s a one-size-fits-all way to deal with any inflation problem. To dial inflation down, simply dial up the overnight interest rate. You might throw in some “forward guidance” to help shape “inflation expectations” but that’s really still about managing inflation via adjustments in the short-term interest rate…

It’s this sort of cavalier attitude and reverence for monetary policy that troubles me. We’re supposed to accept—as a matter of faith—that the central bank can always handle any inflation problem because mainstream economics says so?

The “invisible fist” today

So have we plowed too much money into unproductive projects? Have we overpaid for the projects and startups? The market tries to sort the question out every day.

In keeping any sense of proportion we should recognize that crypto is a tiny portion of the overall economy. But as a metaphor, it poses an interesting question. Have we dumped too much money into cat gifs, figuratively speaking? Are a few becoming insanely rich while society holds the bag?

I’m partial to Michael Pettis’ idea of the bezzle. In Minsky Moments in Venture Capital, Abraham Thomas explains how bezzle conditions emerge. The key insight is that high prices create a positive feedback loop because prices themselves tell you something about risk. High prices signify safety. This is a paradox because a high price is also an asymmetric risk to reward. The paradox tends to resolve itself abruptly:

One way to understand Minsky cycles is that they’re driven by the gap between ‘measured risk’ and ‘true risk’.

When you lend money, the ‘true risk’ you take is that the borrower defaults3. But you can’t know this directly; instead you measure it by proxy, using credit spreads. Credit spreads reflect default probabilities, but they also reflect investor demand for credit products. A subprime credit trading at a tight spread doesn’t necessarily imply that subprime loans have become less risky (though that could be true); the tight spread may also be driven by demand for subprime loans. Measured risk has deviated from true risk.

Similarly, when you invest in a startup, the ‘true risk’ that you take is that the startup fails. But you can’t know this directly; instead you measure it by proxy, using markups. Markups reflect inverse failure probabilities (the higher and faster the markup, the more successful the company, and hence the less likely it is to fail — at least, so one hopes). But markups also reflect investor demand for startup equity. Once again, measured risk has deviated from true risk.

During Minsky booms, measured risks decline. During Minsky busts, measured risks increase. The flip from boom to bust occurs when the market realizes that true risks haven’t gone away.

Squaring all of this with my own priors

We started with Lyn and Cem’s analysis of how we got to today. If the world de-globalizes many of the deflationary headwinds that convolved with loose monetary policy will reverse. The new regime would be inflationary. How inflationary is anyone’s guess. Is the floor for the foreseeable future 2%, 4%, higher?

If bubbles pop and bezzles recede, would that make inflation worse as we discover that spending was wasted and economic supply did not grow where it needed to (ahem housing and energy)?

Or will deflation come roaring back as drawdowns push wealth effects in reverse and higher borrowing costs on huge loan balances crowd out future growth?

My prior is torn between:

a) inflation will fall in a way that surprises people. Low inflation is actually the default because wealth inequality acts as what I call an “inflation heat sink”. Here’s my explanation using the boardgame Monopoly:

In talking to a friend, I was trying to explain what I called the "inflation heat sink" that comes from results from wealth inequality.

It's an idea that I found best presented in @Jesse_Livermore Upside Down Markets paper.

I think I found a decent game analogy… 

— Kris (@KrisAbdelmessih) November 12, 2020

Unfortunately, if you think inflation is going to fall the trade is probably not to buy treasuries since real rates are already quite negative. The related insight is more concerning. Bonds can keep falling as inflation falls and nothing would be glaringly mispriced. Ouch, 60/40.

and

b) Stimulative fiscal policy is inflationary in the short-run (and in the long-run if the spending is unproductive) and while fiscal policy is highly political, neither party is afraid to run big deficits at this point anymore.

If inflation accelerates (or at least fails to abate) it’s not clear what investments it would be good for. People like to promote real estate as an inflation hedge. Given the low affordability already built into prices, outpacing real rates is hardly a given. Maybe that’s where you lose the least? What inflation expectations are already embedded in commodity prices? How to invest for inflation from current prices is a hard problem.

Unwinding imbalances

I tend to believe Lyn and Cem’s story about how the forces that brought us to today are unwinding. If we have spent the past 40 years building a giant imbalance between capital and labor this reversal is ultimately a good thing. But it’s not going to make capital happy. If you have been an outsize winner for the past decade, you’re probably going to moan about it when the imbalance narrows (hey it’s understandable that we respond to marginal changes to our situation, but it’s not reasonable to miss the big picture that prior wins have been out of proportion to contribution). What was given to you easily by the Fed’s support of high duration bets, can be taken away. Don’t expect sympathy.

The most direct way to correct the imbalance would be to heavily tax high earners and the rich but it’s not politically viable. But there’s a backdoor. The combination of fiscal stimulus, especially if done in a progressive way, will bolster the economy while we raise interest rates. The net effect will offset labor’s pain in an economic slowdown. But it will still be inflationary since we are supporting demand (by giving $$ to those who actually spend it) while constraining supply (by raising hurdle rates on capital expenditures). To a rich person invested in growth and expensive real estate, this will feel like stagflation as labor’s slice of the pie increases relatively while demand for the rich person’s assets slows (opposite of how loose monetary conditions created inflation for homes and stocks but not labor and importable goods). It would be a shadow progressive tax using inflation to take back financial wealth while creating conditions for lower-wage earners to keep up with the price of goods and services.

No matter how the economic picture unfolds, the theme that feels alive under the surface is imbalance. It doesn’t matter that the average American lives better than a 16th-century king. We relentlessly compare and that’s never going to stop. The imbalance matters. We have accumulated massive amounts of debt. If the debt isn’t truly backed by the collective wealth of the individuals who make up the economy, eventually a catalyst will shatter the illusion that we can continue rolling it over.

Mechanically, that debt is of course backed by the sum of our assets. But when push comes to shove, how is it apportioned? What is the fair attribution? Do our anti-trust laws and tax policy divide the risk and rewards fairly (whatever that means from an equitable and efficiency perspective)? It’s not as easy as saying “the market gets this right”. The rules are political. Power is not accorded solely due to merit (whatever that means). So sure, the debt is backed by our assets, but good luck calling the loans back in.

I recently re-watched Ray Dalio’s How The Economic Machine Works. I assigned it to some young teens who are trying to learn about the economy. The video shows how the macroeconomy is built up from everyday transactions. A loan (ie credit) is one such transaction. The credit cycle is endemic to the economy itself. Dalio overlays the short-term credit cycle (small squiggles) on the long-run cycle.

The end of long-term debt cycles are times of massive upheaval. Historically this has meant violence, currency devaluations, and victors dividing the spoils regardless of who was previously listed as a creditor.

Dalio, uses a highly understated word for this adjustment. Deleveraging. The default process (whether outright or via inflation) is redistributive. Politics determines the winners and losers. It’s always been give and take. But we need to keep talking.

If we cannot find a way to cooperate, the problem of imbalance and feelings of injustice don’t just disappear.

Redistribution finds a way.

Addendum

I realize MMT is a polarizing topic. I have a cursory understanding of it, so feel free to correct me: I think the core insight that a government doesn’t need to run like a household is correct mechanically. The problem is how the debt is allocated to the citizens in the form of taxes and transfer payments. So from a policy point of view, I don’t know if MMT frameworks lead to effective practical policy. Effective is always a matter of debate and depends on your constituency’s perspective. In that sense, MMT is no different than any other framework that claims to have good reasons for how it grows and splits the pie.

The great personal dividend of MMT is how it popularized the sectoral balances approach to understanding the economy. Similar to Dalio’s video, it views the economy as a collection of small transactions. Since every buy is someone else’s sell, we can use a giant T account of credits and debits to understand the economy from basic accounting. Those credits and debits flow through the household, government, corporate and “foreign sectors”. Economists associated with this approach include Godley, Pettis, Kalecki, and Levy.

To demonstrate the power of this lens, I encourage you to read Jesse Livermore’s Upside Down Markets paper. It completely reshaped my understanding of macro into something that I believe is closer to reality. Whenever I hear a macro argument, I at least try to place it within the sectoral balances framework to see if it is at least self-consistent. The advantage of basic accounting identities is they are identities. They are tautologically true and that’s a useful razor for an initially evaluating an argument.

Jesse’s paper is a beast. Many people won’t read a 40k word paper. I encourage everyone to read this one. While it’s a dense exploration of timely macroeconomics ideas, Jesse’s rare ability to tackle the complexity in an approachable, step-by-step progression is an amazing opportunity to learn.

Having said that, I realize many people still won’t read the paper. So I decided to try my hand at creating this explainer. I completely re-factored it to turn it into a personal reference. You can use it too:

✍️Moontower Guide To Jesse Livermore’s Upside Down Markets (link)