Oh, it’s here alright. But we’re a little squeamish about calling it out.
This is the transcript from my podcast, THE WOLF STREET REPORT:
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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