America’s Stagflation

The accumulation of monetary policy errors by the Fed is increasingly certain to culminate in the credit crisis that always marks the end of the credit cycle. Credit crises are the result of globally coordinated monetary policies nowadays, so the timing of the forthcoming crunch is not only dependant on the Fed’s actions, but is equally likely to be triggered from elsewhere. Candidates for triggering a global credit crisis include economic and financial developments in Europe, Japan and China.

The next crisis is set to be more serious than the global crisis of 2008/09, given the greater level of debt involved, and the exceptionally high rate of monetary inflation since. It is a story I have covered elsewhere.ⁱ This article will concentrate on the prospects for the US economy ahead of the next credit crisis, and the implications for the dollar and its associated financial markets.

Other jurisdictions face a similar problem, with domestic consumers being maxed out on their credit cards, auto loans and expensive overdrafts. Rising interest rates after a prolonged period of zero and negative interest rates will increase the cost of mortgages, an acute problem for home-owners, particularly in North America and Britain. In the coming years, economic expansion for all highly-indebted nations will be driven by China’s Asia-wide expansion, in some cases more than by domestic factors. China will even suck in outside capital for the infrastructure development planned in both Asia and China. Demand for non-financial bank credit from all sources will be increasingly allocated to this task, leading to the selling down of the banks’ investments in both dollars and short-term sovereign debt.

It is the single greatest challenge faced by the major central banks in the coming months, and we cannot be certain they are fully aware of the forthcoming dangers. The Chinese currency is already rising, reflecting the start of these capital flows. It is likely to radically change international portfolio managers’ attitudes to their dollar exposure and bond allocations.

We can only conclude that the rise in short-term government bond yields that follows from the reallocation of capital to non-financial activities means the central banks have probably lost control of interest rates already.

Consumer stagnation

Our starting point for describing the outlook for the US economy is to concede that under President Trump, America is isolating her domestic economy from the China-led economic expansion that is revolutionising not only her own economy, but that of the whole Eurasian continent. The US economy now depends for its growth prospects on domestic manufacturing and consumption, financed by yet more bank credit.

The conventional measurement of economic growth, the yardstick used by neo-Keynesians, is changes in real GDP. The statistics that make up this gauge of the state of the economy, nominal GDP and its deflator, are unfit for the purpose. GDP, being a money-total, tells you nothing about economic progress, and how technology and time are improving the average person’s standard of living.

As for the deflator, I challenge anyone to say by how much the general price level is changing, with John Williams’s ShadowStats inflation figures indicating it is rising at between six and ten per cent, depending which of his indicators you use. The Chapwood index confirms the latter ShadowStats figure, finding prices of commonly bought items have risen by an average of about ten per cent annually over the last five years. The Fed targets two per cent for core personal consumption expenditures (PCE), which was up only 1.275% year-on-year to August.

It is clear the Fed’s inflation targeting is being set against the most favourable statistic, from the point of view of those who believe in suppressing interest rates. But while the Fed apes the three wise monkeys over price inflation, the rise in prices is creating significant damage to consumption prospects. It is a process that has continued broadly uninterrupted since the 1990s, financed by increasing consumer debt and hardly at all by higher wages. Consequently, the average American consumer is burdened with unsustainable levels of debt, and is running out of an ability to finance continued spending beyond his income. And those who depend on inflation-linked wage increases and subsidies have been progressively screwed down by the CPI’s under-recording of the true cost of living.

Instead of taking the CPI, let us assume Chapwood’s estimate of price inflation as closer to the truth. On this basis, over the last five years, price inflation has been running at an annual average of 10%.ⁱⁱThis means the consumer’s dollar has lost 41% of its purchasing power since 2012. Meanwhile, wage increases tied to the CPI have only increased by 7% over the same period, while total consumer credit has increased by 32%.ⁱⁱⁱ

These numbers confirm our thesis, that it is mainly debt that is financing higher prices. It cannot continue indefinitely. Meanwhile, business is cutting costs where it can, and that requires capital investment. Banks are increasingly prepared to lend to businesses, partly because they perceive lending risk has diminished, and partly because the main alternative use of bank credit, which is investing in short-term government bonds and related financial instruments, is losing them money. And now that the yield on US Government five-year bonds is back above 2%, the momentum of bank sales of government debt is set to increase, as will the pace of bank credit expansion in favour of non-financial businesses.