An Adult Approach – II (Defining Relative Real Value)
In our first installment of An Adult Approach, we attempted to scrub away some misconceptions related to inflation that are embedded in the contemporary economic and financial canon. We sought to raise doubt about the incentives of central banks to share the true loss of their currencies’ purchasing power with the public. When we began to write the follow-up, “Real Relative Value”, in which we apply a forward rate of inflation to current asset values, it quickly became clear that we were spending too much space discussing proper real value. So, this piece, which is now the second in a series of three (we think), will seek to provide a truer sense of money, inflation and real value today, all of which seem grossly misunderstood in the marketplace.
Money & Banking (Cliff Notes)
US dollars and all other world currencies today are not what most people think. The game starts when a central bank (on behalf of its sponsoring government) issues physical currency to you and me through its banking system. A bank can be a bank because it has already deposited assets that qualify as reserves at its central bank, not necessarily because it has deposits. Reserves are typically assets in the form of loans. The business of the bank is to issue credit, which is ultimately claims on physical currency, theoretically in an amount up to a level that does not breach its reserve ratio with its central bank.
The Monetary Base (a.k.a. base money) is physical currency in circulation and bank reserves held at the central bank. Everything else in the monetary system is credit, even including deposit balances held at banks by you and us beyond the amount of aggregate reserves. So then, modern banking systems are fractionally reserved (as is deposit insurance, which as far as we understand has de minimus reserves and zero physical currency).
Credit, regardless of who is contracted to receive it and pay it, is ultimately backed by the physical money printing ability of the central bank. If you go to the bank tomorrow and ask for $10 billion in C-Notes that you have on deposit, your banker will call its central bank, which will then debit your bank’s reserves held there. The central bank will then literally print the C-Notes and put them on an unmarked military cargo plane destined for your personal landing strip deliver the C-Notes to your bank where you can withdraw it.
If your bank runs out of currency reserves held at the central bank, (because either depositors withdraw more than your bank has in reserve or because the value of your bank’s reserves depreciate in the marketplace), then your bank will ordinarily be subsumed by another fractionally reserved bank with enough reserves to make the new, larger entity properly reserved.
The US banking system currently has almost $20 trillion in assets (held in the US and abroad). The US dollar monetary system is supported by about $2.7 trillion in total base money, about $1 trillion of which is physical currency in our pockets and about $1.7 trillion in bank reserves held at the Fed. (The ratios are about the same globally — $95 trillion dollar equivalent bank assets and about $12 trillion in global base money.)
Thus, the global banking system holds about 8.5% of its assets in reserve at global central banks to guard against the possibility that: a) you and we ask for our “money” back, and/or; b) the value of the assets it placed at central banks depreciates. We should not worry (nominally speaking, of course) if either (or both) of these events occurs because central banks can print all the money necessary to meet the demand for money. The good news is that everything else to be learned about modern money and banking is derivative (we mean that figuratively but feel free to apply it as you wish).
Inflation for Grown-Ups
As we have argued, central banks and governments have great incentive to report inflation rates that do not fully capture the rate of purchasing power loss in the currencies they manufacture. If central banks and economic policy makers are not helpful to investors in providing reasonable inflation data, then it behooves investors to seek answers elsewhere. We believe a more accurate representation of manifest inflation may be found in Shadow Government Statistics’ Alternative 1980-based CPI Series[1] (“SGS 1980 CPI”), which calculates the CPI based on the methodology employed prior to 1980. As the graph below shows, were the 1980 methodology still being used today by the Bureau of Labor Statistics then the CPI would show an annual inflation rate of 10.57% (blue line) as opposed to its current version running at 3% (red line).
As we discussed in An Adult Approach I, the perception of “3% inflation” is still too high for the Fed’s tastes and so last month it again announced its preferred inflation benchmark would be the PCE deflator, calculated by the Bureau of Economic Analysis (BEA) within the Commerce Department. We further expect that if/when the PCE deflator no longer provides a sufficiently low public perception of inflation, then the Fed’s thinking will evolve to the point of benchmarking nominal GDP targeting as its objective. After all, who, besides savers and pensioners, will care about 3% or 4% inflation when nominal output is running at 5% or 6%? (Never mind true inflation will be substantially higher than 2% or 4%.) Such sleight of hand rivals those of illusionists who make 747s disappear.
There are real-world consequences when policy makers succumb to the perceived political imperatives of perverting economic data. The graph above provides a fascinating narrative that shows the practical inflationary impact on an economy. In July 2008 the annual inflation rate according to the SGS 1980 CPI peaked at 13.36%. This came just prior to the failure of Lehman Brothers, a credit event that acted as a deflationary catalyst for goods and service prices as well as a trigger for asset price declines. (After an economic lag, in July 2009 the SGS 1980 CPI dropped to a low of +5.4% and the BLS’s headline CPI dropped to -2.1%.)
As we know, the Fed created new base money in the fall of 2008 for the benefit of its member banks (QE, asset purchases, swap and credit lines, etc). Over the three subsequent years banks used these new reserves to profit by buying cheapened assets for themselves, and to extend credit to worthy borrowers and levered buyers of liquid financial assets. Financial markets rebounded quickly. And as the graph above clearly shows, the prices goods and services also experienced a “V-bottom” in large part, we believe, because the new dilution in the USD and other global currencies gave incentive to global commodity manufacturers to demand more currency (higher prices). Commodity prices rebounded quickly and this flowed through to goods and service input costs.
Regardless of how well it is measured, all inflation is not created equal. There is a big difference between the driver of consumer inflation and asset inflation. Changes in goods and service prices are ultimately determined over time by the growth or contraction of physical currency in float plus unreserved bank deposits (what Austrians call “checkbook money”). Changes in asset prices are ultimately determined in an over-levered monetary system by changes in the availability of credit. (After all, that’s why they call them financial markets.)
Asset holders benefitted at the time of the 2008 base money inflation because the Fed deposited newly created reserves into the creditor banking system, re-funding banks and by extension their investors, and allowing investment asset prices to rebound. In fact, the growth of the permanent money stock and where it flowed since 2008 explains much about recent returns. The table immediately below shows how markets have performed in nominal terms since the Fed began substantially increasing US base money:
And the table below shows real returns — the nominal performance in the table above deflated for the SGS 1980 CPI, a more accurate measure of goods and service inflation:
According to the BLS, cumulative CPI has risen 3.6% since August 2008. However, the table above succinctly portrays what we believe American investors know intuitively — since 2008 their asset values have not kept pace with accurately calculated goods and service inflation. In other words, US wealth and income has declined materially since 2008 in real terms regardless of popularly-accepted data to the contrary. (We are reminded of the Texas cad who indignantly demanded of his wife when she caught him in flagrante; “are you going to believe me or your lyin’ eyes!”) In short, asset holdings today are broadly perceived as a “savings pool” that will be exchangeable at current relative valuations for consumables tomorrow. This seems a faulty assumption.
US output has been shrinking in real terms too. Since September 2008, cumulative GDP growth deflated for the cumulative SGS 1980 CPI has been -29.86%. This implies the US economy shrunk in real terms by almost 30% since the Lehman bankruptcy. Does such a startling figure resonate with you or do you find it hard to believe? Before you answer, please consider the current value of your consumption and investments in 2008 dollars. The BEA suggests real GDP since then has been +1.8%. This figure does not comport with our sense of output and pricing.
It should not be considered acceptable to be in a profession – as a political economist, policy maker or investor – in which self-delusion has become a necessary requirement for success and perpetuating that delusion is harmful to the broad economy over time. Yes, but the “public good” you say? Ah, but for how long?
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