Learning Market N°2: Fantastic Macro Article by Lyn Alden
Summary of the Lyn Alden June 2022 Newsletter: Demand Destruction
This is not a crypto piece. But understanding macro is really important if you want to protect your bags.
Lyn Alden is a fantastic researcher, and she has a free monthly newsletter that’s always impressive. Here’s my summary of the last one.
Lyn Alden June 2022 Newsletter: Demand Destruction
If policymakers realize they are in an environment of persistent currency disinflation from various trends, what do they do? They print currency!
At first it starts from monetary policymakers expanding the monetary base, but then it spreads to fiscal policymakers when the situation remains stagnant
The main consequence for policymakers to print and spend too much fiat currency with large deficits, is that it can cause runaway inflation. So, when inflation is measured to be low or even negative due to excessive debt in the system, they aggressively print and spend. Eventually they overshoot, but that consequence comes with a lag and feels good at first.
Comparing the 1900s to the 2000s
The 1920s and 2000s decades in the US were both periods of easy money and speculative excess in financial assets, driven by monetary policy, capital flows, and other factors. The 1920s bubble culminated in the 1929 crash, and the 2000s bubble culminated in the 2008 subprime mortgage crisis. These were the two biggest financial crises of the past century, and in both cases interest rates quickly went to zero for the first time in generations.
The 1930s and 2010s decades were both periods of economic stagnation, disinflation, and bank recapitalization in the aftermath of those financial crises.
The 1940s and the 2020s decades (thus far) were both periods of major fiscal dominance, or “wartime finance” after a long period of rising populism, economic stagnation, and an external catalyst.
Faced with a war in the 1940s and a pandemic/lockdown in the 2020s, the federal government performed absolutely massive fiscal spending, and drove federal debt/GDP to around 130% in both instances. Broad money supply expanded rapidly, and price inflation followed with a lag. However, because debt levels were already so high, the Federal Reserve was slow in both cases to raise interest rates, resulting in significant currency and debt devaluation. The Federal Reserve’s short-term interest rate is currently 1.5%, which is about 7% less than the official inflation rate. The last time that gap was this wide was during and shortly after the 1940s.
To put it bluntly, when debt gets this high relative to GDP, the only way out is to default in some way. If the debt is denominated in a currency that the government can’t print (like for emerging markets with dollar-denominated debt), it eventually leads to nominal default. If the debt is denominated in a currency that they can print, it usually leads to significant devaluation of that debt via inflation, where inflation (and along with it, nominal GDP) runs much higher than interest rates for a while.
At that point, the ability to get out of inflation depends on private markets’ and policymakers’ ability to create new industrial capacity for goods and services and commodities. In other words, high levels of productivity must be re-established, or the pain continues in one form or another.
Differences between the 2020s and 1940s
In the 1940s, the US was a rising power in terms of its share of global GDP, and ran a structural trade surplus. The closest comparison to what the United States is going through in the 2020s, is what the United Kingdom went through in the 1940s. Back in the 1930s and 1940s, the United Kingdom had the global reserve currency, but was running a structural trade deficit, was losing ground in terms of its global share of GDP, spent a lot of its resources on World War I, and began doing even more massive fiscal spending to fight World War II.
In the 1940s, fiscal spending went towards things that increased productivity. In contrast, most of the stimulus during 2020 and 2021 went to keeping consumers and businesses solvent.
Demographics: government deficits to support senior citizens’ retirement and healthcare systems are quite big. There is no ability in the foreseeable future for developed countries to practice fiscal austerity, unless they’re willing to blow up all of these systems and nominally default on some of their government debt.
The Federal Reserve’s Dilemma Today
There is currently massive debt-to-GDP in the system, both in the private sector and at the federal level. So, raising interest rates above the official inflation rate (e.g. over 9%) would result in widespread insolvency.
The US Federal Reserve is projecting an unemployment level of 4.1% a year and a half from now, which is higher than the current rate of 3.6%, and their policy decisions are aiming towards that direction.
This could bring down price inflation for a period of time, but most likely at the cost of a recession. Historically, reductions in employment lead to vicious cycles of less consumption and more reductions in employment
We might have stagflation. We have disorganization and frictions, with a lack of surplus capacity for several of the key things we need. And now that policymakers are tightening monetary policy, it is putting a brake on consumer spending patterns.
Why Demand Destruction Probably Won’t Work Well
The problem is that this inflation is happening at a time of near-record debt levels, and so there is a thinner-than-usual tolerance for stagnation to occur without triggering debt liquidation.
Where we are standing today:
Total debt is 370% of GDP.
Money supply growth mainly came from fiscal spending, and price inflation is more so a supply-scarcity issue rather than due to particularly strong demand.
Energy supply problems are primarily due to a lack of sufficient capex and development over the past several years
If inflation is reduced by reducing global energy usage over the next year (a.k.a. severe recession), while the supply-side problems remain mostly unaddressed, then inflation would be ready to return as soon as demand destruction ceases.
Geopolitical Game Theory
For the world as a whole to shrink energy consumption in a year, means quite a lot of economic devastation is occurring.
Developed countries have become less energy-intensive relative to GDP.
The marginal energy demand now comes from developing countries.
Getting access to electricity, the internet, better transportation, a home with various comforts like air conditioning, and more nutrient-dense food- these are all things that require more energy consumption and improve the standard of living rather directly.
Getting sustained demand destruction, especially for energy and commodities which are a global pricing market, is hard to do due to the realities of geopolitical game theory.
Any individual country practicing austerity doesn’t work well for solving global supply-side problems, especially when debt is already this high after a century of not practicing austerity. A country can practice fiscal and monetary austerity, and still face a lot of inflationary pressures as a result of other countries gobbling up commodities.
To the extent that the Fed and Treasury can strengthen the dollar, they can squeeze a bunch of dollar-indebted emerging markets and slow down their demand too
A strong dollar historically results in weaker global growth, weaker US corporate profits, weaker foreign demand for US Treasuries, and a host of other problems for the US and other countries. Eventually, a strong dollar comes back around and hits the US because the US ends up having to finance more of its own fiscal deficits, in what basically becomes a balance of payments problem.
Destroying demand in the face of supply constraints is like running away and hiding from a monster in a closet, so the monster just sits outside and waits for you to come out again.
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