In December of last year, via The Trouble With MMT, we laid out an explanation of the inflationary boom-bust cycle, as driven by unproductive spending and excess debt.
Given the “busts” in various inflated assets as of late, it seems timely to revisit that particular section of the post…
Productivity – tangible assets and the volume of real goods and services provided – is what counts as genuine wealth. The digital 1s and 0s riding on top are just manipulated transaction mechanisms.This is why it is so important to distinguish between productive spending and unproductive spending. Productive spending (investment) adds to the real wealth of the real economy. Unproductive spending does not.
Quality of spending (and borrowing) thus has powerful impact on inflation and deflation, as we are about to see visually…
The Stable Inflation Model
In the most desirable of circumstances for a modern economy, inflation is “low” and “stable.” What does this mean? How can we characterize this favorable situation?
The above compares “total credit flows” – all the credit and debt in the economy, created by various means public and private – with the size of the real economy itself. Total credit flows naturally include currency, loans, bond issuance etc, as they are multiple sides of the same coin. (“Money” is fluid and takes many forms.)
So, as long as there is a dynamic yet stable relationship between credit flows and the ‘real wealth’ of the underlying economy, inflation will be benign. This is due to a match-up in the relative size of the two entities.
Furthermore, if the size of total credit flows and the size of the real economy grow at roughly the same rate, this happy situation will persist – not unlike two cars traveling in parallel at the same speed.
In a perfect world, general price levels would be stable and there would be no inflation at all. But that level of matchup between credit flows and the economy is impossible, because the overall process is too dynamic. Loans are constantly being extinguished and recreated, productive output and profits are fluctuating up and down, and so on.
So rather than zero inflation – which is too close to deflation — central bankers aim for a “stable rate of inflation” instead, a situation where total credit flows are more than required for the real economy to run smoothly, but just by a little bit. (Thus talk of a “stable” inflation rate in the 1 – 2% range.)
The Supernova Boom
Now we see what happens when unproductive debt levels expand and widespread malinvestment kicks in. As the government blatantly attempts to massage credit flows, investor risk appetite increases. As a love of risk comes to dominate, unproductive debt levels rise along with poor choices of investment.
The specific problem with an unproductive debt boom (and gross malinvestment to go with) is that the taking on of such increases the total amount of credit flows, WITHOUT a corresponding increase in the real wealth of the economy.
In practice, this phase of the cycle is marked by lots of folks making lots of dumb decisions:
- Investors chasing risk assets to nosebleed valuation levels
- Consumers leveraging themselves beyond prudent levels
- Aggressive business capacity expansion based on false signals
As more bad debt decisions are made, total credit flows increase well beyond the needs of the real economy (as malinvestment does not create corresponding productivity or real wealth). This leads to a classic supply and demand situation where there are more credit flows on hand than required – and so the extra flows push prices up (i.e. cause inflation)!
Of course, just where this inflation shows up varies from case to case. Sometimes the results of an unproductive debt boom can show up as pure, unadulterated asset inflation. This is the heroin and cocaine of Wall Street – when all those extra flows push up the value of stocks, real estate, junk bonds etcetera while leaving the Fed’s traditional inflation warning gages untouched. Party!
Also of course, paper asset inflation can be just as destructive as any other kind of inflation. Think of the self-reinforcing nature of the housing bubble, as more and more builders and flippers and real estate buyers piled on the leverage in a self-perpetuating orgy of myopia and greed.
Note this process is entirely consistent with the Von Mises prophecy. And once the debt boom finally hits critical mass, we get…
Supernova Debt Collapse!
As Walter Bagehot, 19th century editor of The Economist, observed: “at particular times a great deal of stupid people have a great deal of stupid money… At intervals, from causes which are not to be the present purpose, the money of these people — the blind capital, as we call it, of the country — is particularly large and craving; it seeks for someone to devour it, and there is a ‘plethora’; it finds someone and there is ‘speculation’; it is devoured and there is ‘panic’.”
Though Bagehot died in 1877 – more than 130 years ago – his description of the boom-bust cycle is still accurate in this era of “modern” monetary systems. That is because the boom-bust cycles of today, just like those of yesteryear, are driven by a build-up of malinvestment and unproductive debt.
The key distinction is not between “public” and “private” but “productive” and “unproductive.” This is because productive credit flows facilitate corresponding growth in the real wealth of the real economy, whereas unproductive credit flows do not.
When the artificial boom implodes, the result is dramatic – and deflationary. As with a collapsing star, the relationship of available credit to the functioning real economy goes from “massive overabundance” to “massive shortage” in the space of a market crash. Where banks would lend to anyone before, suddenly they lend to no one. Where investors were brazen before, suddenly they are terrified.
During a supernova collapse, trillions of dollars in private credit flows evaporate into the ether – the result of loans being extinguished in a panic but not replaced. It is this type of situation where the authorities can find themselves helpless, as the size of privately created credit flows is gargantuan compared to what the Fed can gin up on short notice.
False Trend Application
As an added bonus, this model has great utility for traders willing to exploit the false trends of Soros fame.
Note the blue arrows – during the time when the supernova is expanding, you don’t want to be ignoring or fading the false trend… you want to be riding it!
The unproductive debt boom can create excellent opportunities for the trader willing to stay long on the way up, while watching closely for the time to go flat (or even reverse and go short) as the supernova threshold approaches.
Note, too, that this model is consistent with the increasingly feverish waves of investor sentiment as the unproductive debt boom reaches critical mass. The supernova burns at its hottest and most expansive not long before imploding.
It’s the Real Economy, Stupid
Note an important theme running all through this critique: It’s the real economy that matters. Always has been, always will be.
Real wealth is not created by a printing press or punched out by government decree. Real wealth is assets, savings, goods and services – the productive output of the underlying economy itself.