Oh, it’s here alright. But we’re a little squeamish about calling
it out.
It constantly comes up: With all this central-bank money printing and the
zero-interest-rate policies and the negative-interest-rate policies, and all
these central-bank liquidity injections, in other words, with all these
loosey-goosey monetary policies around the globe, why are we not seeing huge
bouts of inflation?
And then, some folks take the next step and say: Well, since we’re not
seeing big bouts of inflation, these loosey-goosey monetary policies should
become standard, perhaps run by the government, instead of a central bank,
and renamed Modern Monetary Theory, or whatever, because it will give us all
this stuff for free and in terms of negative interest rates for better than
free. This is finally the free lunch that we’ve been waiting for since
the beginning of mankind.
But there is a fatal flaw in this logic. Turns out there are huge bouts of
inflation, pernicious dangerous inflation. Here, inflation means that the
dollar, the euro, or whatever other currency is losing its purchasing power.
But this inflation is less focused on prices of consumer goods and services,
but on prices of assets. This includes nearly all asset classes: stocks,
bonds, residential real estate, commercial real estate, and so on.
Assets are highly leveraged. When their prices rise, these higher prices
are used as collateral for more debt, meaning banks and bondholders are on
the hook when prices turn the other way, as asset prices do. And this is when
asset-price inflation leads to – you guessed it – a banking crisis and a
broader financial crisis.
The term “inflation” can mean a lot of things. Here I’m not talking about
“grade inflation” or “monetary inflation.” I’m talking about price inflation.
Price inflation is when it takes more money to buy the same thing. There is
no magic happening here. It just means the currency loses its purchasing
power with regards to those things.
There are several types of price inflation, including:
- Consumer price inflation, tracked by various measures
such as the Consumer Price Index or CPI.
- Wholesale price inflation, tracked by measures such as
the Producer Price Index or PPI.
- Wage inflation, tracked by various measures of labor
costs, wages, and salaries
- Asset price inflation.
In the US, we’re little squeamish about the phrase “asset price
inflation.” When a house sold for $200,000 in 2014, and in 2019, the same
house sells for $300,000, it doesn’t mean that the house grew 50% in size or
got 50% more opulent or whatever. Nope, the house stayed kind of the same, it
just got a little older. But what it means is that the dollar with regards to
this house lost much of its purchasing power. It now takes $300,000 to buy
the same house that five years ago $200,000 could buy.
As homeowners, we would like to think that some magic happened here, that
we got something for nothing, when in fact, we own the same house, but now it
takes a lot more dollars to buy the house because the purchasing power of the
dollar with regards to housing has gotten crushed.
None of the home price indices we commonly use in the US are called “home
price inflation index.”
But not every country is so squeamish about calling a spade a spade, when
it comes to home price inflation. For example, the UK government’s Office for
National Statistics calls its data and indices for house prices, “Monthly
house price inflation.” And it says: “House price inflation is the
rate at which the prices of residential properties purchased in the UK rise and
fall.”
Between January 2013 and December 2018 – so over a period of six years –
house price inflation as defined by the UK government was 37% nationally, and
52% in London.
Over the same six-year period, house price inflation in the US was 42%,
according to the Case-Shiller index. And by metro area, it was 58% in the
Dallas-Fort Worth metro, 65% in Denver, 78% in the Seattle metro, and 82% in
the San Francisco Bay Area.
This just means that it takes a heck of a lot more dollars than six years
ago to buy the very same house. No magic here.
When it comes to stocks, the picture of asset price inflation gets a
little more complex, because, unlike houses, companies do grow. Their
revenues go up and their earnings go up, and these elements are not related
to asset price inflation.
However, the price-earnings ratio, the P/E ratio is a measure of asset
price inflation. It measures how many dollars it takes to buy the same amount
of corporate earnings.
For example, in July 2012, for all S&P 500 companies, the P/E ratio
was just under 15. Meaning that in aggregate for all companies in the S&P
500 index, the price per share was 15 times the aggregate earnings per share.
It took under $15 to buy $1 in earnings.
Now the S&P 500 aggregate P/E ratio is around 23. In other words, it
takes $23 to buy the same $1 in earnings per share. This is 55% more than in
2012. By this measure, the asset-price-inflation component of stock price
increases was 55% since mid-2012.
Over the same period, the S&P 500 has risen 120%. So nearly half of
this increase was due to pure asset price inflation. The remainder was due to
other factors, including earnings growth and financial engineering such as
share buybacks which reduce the number of shares outstanding and therefore
increases earnings per share even if earnings do not increase.
Other asset classes have gone through similar increases over the years.
And this type of asset price inflation – whether its in housing or stocks or
bonds – was the express purpose of the monetary policies during and after the
Financial Crisis. QE was supposed to trigger the quote-unquote “Wealth
Effect,” where asset holders feel wealthier due to asset price
inflation, and then start spending and investing this wealth to boost the overall
economy. QE and the low interest rates have accomplished precisely that. They
created asset price inflation. And a lot of it.
But asset price inflation has pernicious consequences over the longer
term.
In housing, the issue is that house price inflation in effect devalues the
fruits of labor, when it comes to buying a house. So if there is 50% house
price inflation in one city over a five-year period, but wage inflation is
only 10% over the same five-year period, it now takes much more labor
to buy the same house.
People who make their money by working, and who depend on their salaries,
are “priced out of the market.” Their labor no longer suffices to buy the
house. Or if it still suffices, the costs of the house now eat up much more
of their labor, and they have less money to spend on other things, and less
money to save and invest.
With house price inflation, there are definite winners, namely the asset
holders; and definite victims, namely the people trying to buy a house from
the fruits of their labor. This is why house price inflation eventually runs
out of steam, and reverses course, with house prices heading south. Because
house price inflation kills demand.
Houses are highly leveraged. In the US, there is about $10 trillion in
mortgage debt outstanding. In a housing downturn, some of this debt will go
into default. Last time, it worked like this: Years of rampant house price
inflation was followed by the inevitable downturn in house prices, that then
triggered an avalanche of mortgage defaults that then brought the financial
system to the brink of collapse.
Stocks are leveraged too in myriad ways, from margin loans to banks
holding stocks among their assets, which many of them do. A reversal of asset
price inflation in stocks can have a nasty impact on banks. This is why a
stock price crash figures into the Fed’s bank stress tests.
If a stock-price crash is combined with mortgage problems, as it was last
time, it sure helps in pushing banks closer to the brink.
There is another side effect of asset price inflation: yields fall. This
includes yields from bonds, loans, and commercial real estate. Yields mean
income for investors. Falling incomes mean that investors will take more
risks and take on more leverage in order to maintain their incomes. They are,
as it’s called, “chasing yield.”
Assets are used as collateral by banks and other lenders. Inflated asset
prices support larger debts. But when asset prices deflate and the borrower
defaults, the collateral is no longer enough to cover the debt, and these
lenders take big losses.
Asset-price inflation feels good because it translates into
seemingly free and easy wealth for asset holders, but when it deflates, it
tends to pull the rug out from under the banks and the broader financial
system and it causes all kinds of other mayhem.
Asset price inflation is not benign. It’s not a free lunch. It loads up
the financial system with systemic risks and future losses.
The Fed has expressed this worry in various forms for three years. Certain
corners at the ECB have started to grumble about it too. And even the Bank of
Japan is murmuring about the “sustainability” of its QE program, and its
impact on the financial markets.
This is why money-printing cannot be maintained without setting the stage
for another, and much bigger and even more magnificent collapse of the
financial system, and all the real-economy mayhem that this would trigger.
It doesn’t make any difference whether this money printing takes place at
a central bank or at the government. This is a cosmetic distinction. It
always destroys the purchasing power of the currency with regards to assets,
and therefore it destroys the purchasing power of labor with regards to
assets, such as housing. And it pumps huge risks into the financial system
that eventually lead to big losses that invariably get very costly for
society to resolve.
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