When More Isn’t Better Money Inflation

Over the last 40 years, monetary policy has caused interest rates to decline from a high of around 20% down to the zero bound. During the same period, the U.S. dollar (USD) money supply has expanded at a rate never before seen in modern history and asset prices in dollar terms exploded to the upside, all while the U.S. average hourly wage has lagged on an unprecedented scale.

Ironically, the growing wealth gap, caused by lagging wages and rising asset prices, has occurred while the Federal Reserve (Fed) has been targeting a 2% inflation rate and pushing the narrative that inflation is good for the economy, good for economic growth and, most of all, good for the average Joe. This makes us wonder why the Federal Reserve, through monetary policy, is adjusting interest rates and setting inflation targets and whether this intervention is really benefiting the economy.

To start, let’s focus on the question: Why are we seeing this intervention from the Fed? The United States has a total debt to Gross Domestic Product (GDP) ratio of 257%.¹ This fragile debt house of cards, which the Federal Reserve has created, has caused them to fear deflation and its effects on the economy. The Federal Reserve is then essentially forced to intervene so that they are not perceived as the ones allowing the economy to collapse. They do this primarily through the lowering of interest rates and through inflation, or in other words, a debasement of the currency through an expansion of the money supply. This intervention leads to an increase in consumption, asset purchases and malinvestment, which, in turn, leads to an ever-increasing debt burden and an ever-greater deflationary headwind on the economy. The cycle then repeats itself with the Fed having to intervene time and time again. The Federal Reserve is stuck in a negative feedback loop which they themselves have created.

What Are The Side Effects Of Inflation?

First, let’s look at the effects of inflation from the consumer perspective. Let’s imagine for a second that the government suddenly doubled the total supply of dollars in the system. In theory, everything would double in price as the value of the currency would be halved. Now, the producers of a product or service essentially have three options:²

They could double the price of their product or service to maintain their current margins. The side effect of doing so is that they will most likely drive away customers.
They could maintain the current price. The side effect of doing so is that they will take a hit on their margins and their bottom line.
They could maintain the current price but reduce the quality of the inputs which make up their product or service. The side effect of doing so would be that they would provide their customers with a lower quality product or service but maintain their margins.

What tends to happen is that the producer chooses either option one or three in order to take the path of least resistance and reduce a potential hit to their bottom line. We, therefore, have this byproduct of inflation whereby the producer now has to either raise the price of the product or service or deceive the consumer by lowering the quality of their product or service. Both of which leads to the consumers losing out.

Second, let’s look at the effects of inflation from an asset perspective. As inflation devalues the currency’s purchasing power, it causes both the price and demand of assets to increase, which in turn artificially increases scarcity. This creates knock-on effects in the form of conflict and social unrest, as disputes arise over ownership of assets. Monopolization then tends to ensue in order for those in power to maintain control due to the increasing scarcity and price of assets. We then have the bigger issue, whereby huge wealth inequality between the holders of these assets and the holders of the currency starts to appear as the currency loses purchasing power. This can be seen in the lagging average hourly wage in relation to assets in the chart below.

Table 1: Asset Price and Hourly Wage Growth Comparison ³ ⁴ ⁵ ⁶

What’s worse, is that over the last decade this lagging of wages to asset prices has only increased (as shown in table 1 under the Jan 2010–Jan 2021 column). This has caused one of the greatest transfers of wealth from the lower class to the upper class in recent history (chart below).

Chart 1: Share of Total Net Worth ⁷ ⁸

To play devil’s advocate, when inflation was initially implemented, the central banks had good intentions. Inflation in the form of monetary expansion, or interest rate adjustment, is a way for the Federal Reserve to attempt to dampen short-term volatility by stimulating the economy in times of stress. However, the issue is that volatility is just energy, which as we know from the first law of thermodynamics, cannot be destroyed. Instead, it is just transmuted, and so by trying to prevent/dampen short-term pain in the economy, this instead delays the pain and amplifies its future effects. This is why the initial bump in debt, in the form of monetary and fiscal stimulus in times of stress, evolves into this beast of constant debt expansion in order to prevent economic collapse.

The Federal Reserve may argue differently, but the saying, “there is no such thing as a free lunch,” still applies to monetary and fiscal stimulus. By stimulating the economy, what they are really saying is “I choose to shift money toward one area of the economy and away from another area.” This other area of the economy ends up getting the short end of the stick, which is nearly always the lower class. No matter how the Fed portrays it, stimulus in the form of inflation, helicopter money or the adjustment of interest rates will always have negative side effects.

So why can’t we just stop this monetary intervention in order to close the wealth gap? Earlier, we mentioned the deflationary headwind. In order to understand this, we have to take a look at the current state of the U.S. debt situation. Combined, federal, corporate and household debt add up to $55.26 trillion against a GDP of $21.49 trillion (as shown below). This gives us a total debt to GDP of 257%.⁹ Simply put, for every $1 of GDP, there is $2.57 in debt. Let’s assume, conservatively, that the average interest on this debt is 3%. This would mean that, in order for the United States to service just the interest payment on its debt alone, it would need to grow by 7.71% year over year before we see any real growth in GDP.

Chart 2: Debt vs. GDP ¹⁰

We then come to the realization that the central bank is stuck between a rock and a hard place. They could let the United States go into a deflationary debt spiral, which would effectively cause the economy to collapse. Alternatively, they could maintain low interest rates and continuously expand the monetary base through inflation, hoping and praying that this intervention will lead to meaningful, productive growth in the economy, allowing the United States to start paying down its debt burden. So far, it looks like the central bank is choosing the latter option of relying on hope. This means it is highly unlikely we will see this debasement of the dollar stop anytime soon.

This then makes us question that if inflation is truly happening, then: Why are we not seeing the USD collapse against other currencies? This is not just a problem in the United States but a global issue. If you think the U.S. debt to GDP is a problem at 257%, globally we are sitting at 356%.¹¹ You’ve probably heard the saying “a rising tide lifts all boats.” This quote hits the nail on the head and is the reason we are not seeing the dollar lose value against other currencies. Every other major fiat currency is in the exact same situation. They are all printing away, trying to outrun their own debt burden and are, therefore, all being debased at a similar rate.

You may then wonder, how can this be the case for all countries? In simple terms, we have another negative feedback loop. Let’s say you have countries A, B and C. If A and B decide to debase their currency through inflation, then C’s currency strengthens against A and B’s. A and B are now struggling to trade with C because of the strength of its currency and they decide to reduce trade with C, primarily trading between themselves. C is then forced to debase its currency in order to maintain its trade relationships so that this reduction in trade does not persist and impact its economy. This cycle then repeats as each country continues to debase in order to keep up with one another. Every country is essentially in a rat race to the bottom, where, in the end, all fiat currencies will be worthless.

Why are we not seeing interest rates rise due to the inflationary effects of monetary expansion? The central banks around the world cannot let interest rates rise. From the calculations above, the U.S. GDP has to grow by 7.71% just to service the interest on its debt, assuming a 3% interest rate. If interest rates were to move up to 5%, then the United States would have to grow by 12.85% to service the interest on its debt. This is why we are seeing countries such as Japan and Australia capping interest rates through yield curve control in order to prevent rates from rising too high. Any meaningful rise in rates could be catastrophic to the economy.

It becomes evident that due to the manipulation intervention from the central banks globally, we cannot use our traditional metrics for tracking inflation such as interest rates and currency exchange rates. Additionally, if you are trying to get ahead by investing in assets, the Consumer Price Index (CPI) isn’t going to help either since it is just the average price of a basket of consumer goods and services. It doesn’t include assets such as stocks, real estate and bonds. Central bank intervention is clouding price and inflation signals on both micro and macro levels and, therefore, impacting economic decision-making. We have very few metrics these days to rely on which are not manipulated.

By now you may have reached the conclusion that if you just invest in real estate, stocks and a small allocation of gold, you should be outrunning this debasement of the dollar. I wish it was that simple. When we change the lens through which we view these assets, a different picture emerges. Instead of using the USD as the denominator, let’s see what happens if we use the Federal Reserve balance sheet.

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