Stagflation & Redistribution: A Longer-Term Macroeconomic Outlook

June 4, 2020

In my previous article, Insolvency: A Short-Term Macroeconomic Outlook, I talked about the economics of the pandemic. I believe that with news focused on the pandemic, most people have not focused on the impact of the pandemic on financial assets.

I talked about the short-term being characterized by contraction in demand due to mass insolvency for companies and individuals. As a result, money supply would contract as debtor defaults reduce assets for debt holders. I expressed concern that the stock market would reflect those economic realities.

Domestic Redistribution of Capital

In the next five years, as the economy recovers from this mass insolvency event, fiscal policies are going to pick winners and losers. We are going to see massive back-to-work programs. The likely winner will be the Green New Deal, where the government will commission the construction of massive green infrastructure, and invest in new green technologies.

In the last 20 years, globalization has made local labour compete with low-cost labour in emerging markets resulting in no aggregate real wage increases.

Governments may enact massive programs to redistribute wealth such as debt-forgiveness programs and wealth taxes. We are going to see a decoupling with China because China has a public relations problem. Additionally, companies with too much China exposure have seen issues with too much country-specific exposure. Fueled by existing xenophobia, we are going to see more manufacturing return to the U.S. and other developed economies. All of these are inflationary for consumer goods.

The wealth gap will narrow, thus starting a new cycle.

The Great Dollar Crunch

Traditional economics would dictate that the dollar should weaken in a time when money supply is being increased by trillions. Counterintuitively, we will likely see a contraction in money supply as defaults and tight money conditions force lending to decrease significantly, which contracts the money available to buy goods and services.

In troubling economic times, there is a flight to safety. Money pours into the U.S. to buy just about the only “safe” asset worldwide. In order to buy treasuries, you need to buy dollars first, which strengthens the U.S. Dollar.

This is further exacerbated by emerging economies. Asian countries have roughly $1.4T of dollar denominated debt. Emerging market non-bank lending institutions had $3.7T in USD denominated debt, according to the Bank of International Settlements in their October 2018 release, with total dollar-denominated debt held by institutions outside of the United States at over $12 trillion.

What do all these institutions do when the US Dollar have a sharp increase? They try and protect their borrowing rate by purchasing dollars or engaging in dollar swap lines to hedge the loans that they have outstanding. While the International Monetary Fund (IMF) is providing $1.4T to combat this issue, with demand for these lines outpacing the facility’s size significantly, the IMF has an impossible choice of who to save.

When does this all end? In the 1944 Bretton Woods Agreement, the United States, Canada, Western European countries, Australia, and Japan created a fully negotiated monetary order. Because of the Great Dollar Crunch, I believe that the U.S. Dollar’s strength will further reinforce strength, and the insufficient liquidity will result in collapse of emerging-market economies. Eventually, the strong dollar will become too strong for the US as well. Within the next three years, I believe another agreement on the monetary order of the world will be reached to govern monetary relations and settlements. At that point the U.S. Dollar will likely no longer be the world currency and will be devalued significantly.

I expect gold prices to strengthen as currency uncertainty increases and everyone is searching for stable currency.

Global Insolvency Crisis

This is a global crisis, with most worldwide economies being ground to a halt. The central bank response to the last crisis included low interest rates and buyback of financial assets which resulted in the worst personal and corporate balance sheets in 50 years, incentivizing stock buybacks with leverage, and encouraging spending on credit.

Central banks and governments don’t have tools to deal with insolvencies caused by a demand crunch. Liquidity can’t solve insolvency problems, and the federal government can’t bail everyone out indefinitely. As government support runs out, we will see more and more personal and corporate insolvencies over the next four years as cash reserves deplete.

Government Policies

With a global crisis, each government will have to decide between austerity and inflation in order to pay back or inflate away debt that was created during this pandemic. Developed economies will choose inflation because it is a less obvious manner of taxation. Debt will inflate away at the expense of those that hold cash or other money denominated assets.

Inflation

After the great recession, debt remained extremely cheap. While two Bills were enacted to send relief to those who needed it, ultimately, holders of stocks, bonds, and other financial assets disproportionately benefited from the stimulus. As a result, price increases impacted assets of those people who benefited, such as investments, high cost real estate, and luxury goods.

For this crisis, success of back-to-work programs will greatly impact where price levels increase. If income is redistributed more uniformly, we will see price increases in goods which the middle class buy. Affordable real estate will likely see quicker recovery, while more expensive real estate may see a more protracted and long-term recovery.

The current stimulus will knock major economies into stagflation (low or negative growth coupled with inflation). In stagflation, growth depends on increasing productivity driven by great innovation. Government and angel funding could not be more important in these coming years to grow the economy. The pandemic has trapped people in their homes, has reduced economic activity to a near standstill, and there is significant indication that funding has slowed by early funders. When uncertainty fades and we set into a new normal, that part of the funding ecosystem could not be more important to drive growth forward.