Our Mountain of Silver
When the Spanish explored the new world in search of riches, they eventually reached what is now Bolivia and found a veritable mountain of silver. The flow of gold and silver to Spain from Cerro Rico (pictured) and other mines drove a sustained period of inflation across multiple European countries during the Sixteenth and Seventeenth Centuries. *
The Federal Reserve has created and is sitting on our mountain of silver which today totals $8.5 trillion. Although it is standard practice in our political cosmology to blame everything on whoever is president, the flash point of this inflationary episode was triggered a few yards from the White House at the Federal Reserve.
In the chart nearby from the St. Louis FED, you will see graphic evidence of Fed Chair Jerome Powell’s pandemic panic; increasing the money supply (M2) by 25% in an economy already recovering at a very rapid pace. In fact, by Q1 of 2021, U.S. GDP had already returned to trendline. The labor shortage which restrained growth at the end of 2019, had returned. It was pretty clear that any additional monetary or fiscal stimulus would adversely impact the general price level.
In effect, the $4.1 trillion fiscal stimulus delivered during 2020, combined with the end or relaxation of most state lockdowns was all the economy needed to reach the pre-COVID level of activity.
What about all those container ships off Long Beach Harbor and the demand-supply imbalance? This is the price movement that is truly “transitory”, assuming there is a way to make our outdated ports more productive. The backlog is gradually diminishing mostly because the shipping companies are holding up departures until we clear out the distribution mess on our end.
Last month, Federal Reserve Chairman, Jerome Powell, admitted that the word “transitory” should no longer be used. To reprise some Nixon-era terminology, “transitory” is no longer “operative.” Slow to arrive at this understanding, he now seems to realize that shortages from the logistical snafus were not the whole story.
The Non-Transitory Inflation
From the beginning of the pandemic to October 2021, the Fed had increased the money supply by $5.7 trillion which is $4.6 trillion more than what is normally required to support our economy. Since the economy returned to its pre-pandemic trendline, the government has added $1.9 trillion in fiscal stimulus from the American Rescue Plan legislation, all of it borrowed. Combined, $6.5 trillion was added to an economy running at about $23 trillion – an increase of 28% in only 18 months.
And there is work on an additional stimulus in the form of the Build Back Better which is either $1.75 trillion or $4.26 trillion depending on which analysis you believe.
Picture a flotilla of Spanish galleons arriving in NY harbor loaded with gold and silver. How long will it take us to absorb this massive influx? That depends on economic growth and on expectations.
The Labor Constraint
One goal of Build Back Better is to create good paying union jobs. Since we cannot fill the 10 million open positions we already have, we wonder who is going to do these new union jobs. Or a more likely scenario, these new government inspired jobs will crowd out existing private sector employers – putting addition downward pressure on growth due to the exacerbated labor constraint.
The labor shortage simply means that pricing power is moving to workers. Many would see this as a positive development but it does not come without a price. Higher wages will translate into higher costs for producers and higher prices for consumers as the businesses struggle to adapt and preserve their business models. Those higher prices will form the basis for future wage demands. And so on.
Evidence that this wage-price spiral is well underway is not hard to find. Prices that suppliers charge businesses and other customers jumped 9.6% last month from a year ago, the fastest increase on record.
There is a pernicious emotional aspect to wage inflation. Current consumer inflation expectations have risen to 6 %. That means from a worker’s perspective, any wage increase under that amount is a cut in pay. Once the labor market is accustomed to 8-10% raises it is very hard to change that expectation. As they say, wages are sticky on the downside. In fact, they almost never go down. After the great inflation of the 1970s, it took decades for workers to accept that the standard annual increase was now 2-3%.
The Bottom Line
Government spending does not always add to inflation. It depends on where the money came from and how it is spent. If all of the spending is from tax receipts there is essentially no monetary effect as money is simply taken from the populace and repurposed. If it is spent on projects that will improve productivity, that would also mitigate the inflationary impact.
“The net effect of the inflation in 17th century Europe was more debt (both government and non-government), much more inequality, and a reduced standard living for large portions of the population [the poor and those on fixed incomes]. Despite massive differences in our economies, technology, and monetary system, there are parallels to today.” *
We wondered recently how Powell will manage to lead his team down from the summit of our silver mountain. In his most recent press conference after the FOMC meeting he describe some initial very tentative steps to reduce the pace of asset purchases. This action is certainly too late. It is also probably too little.
In his research, Milton Friedman, demonstrated that, “Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.”
Joe Biden famously told us in April, 2020: “Milton Friedman isn’t running the show anymore.” True, Friedman is no longer with us but the principles of monetary economics did not die with him.
Unfortunately, higher inflation is here to stay. Happy New Year!
* Tony Yiu, Data Scientist, The Alpha Beta Blog