The news has been dominated by the war in Ukraine and the cost-of-living crisis. Sometimes it might seem as though the latter is entirely the result of the former, but in truth the cost-of-living crisis was already a fact of life long before Russia invaded.
The huge increase in financial and housing wealth has masked the way that the real “economic cake” has been stagnant for some time and is now getting smaller. The very wealthy have been gaining a larger share, so the “slice of cake” left for the rest of us is shrinking.
This shrinking can happen in two ways: there can be job losses and wage cuts and declining incomes (deflation), or prices can rise so much that things become unaffordable. It is through the second way – rising prices – that this is happening now. Either way, most people end up with less: less heating, fewer car trips, less to eat or fewer meals out, fewer holidays.
Subscribe to MoneyWeek
Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE
Sign up to Money Morning
Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter
Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter
Why should the economic “cake” be shrinking? The easy answer is to claim that it is because of coronavirus, the war in Ukraine, Brexit, climate change and the shift to green energy or other global issues that are largely outside the control of national politicians.
Politicians and policymakers would no doubt like us to believe this, but the truth is that the origins of our problems go back to before the global financial crisis of 2007-2009, and are very much the result of poor economic and financial policies.
Blame it on the Federal Reserve
If one country deserves much of the blame, it is the United States, and particularly the Federal Reserve. The Fed, in effect, took advantage of the hegemony of the dollar to implement policies that supported US financial markets and thereby promoted excessive leverage and the over-financialisation of the economy. Successive governments favoured Wall Street and big corporations. These policies had beneficial short-term effects – particularly for the wealthy – but at the longer-term cost of declining economic growth.
Price discovery in financial markets has become so distorted as to inhibit economic growth, rather than acting as a lubricant for it. Capital has flowed to loss-making ventures, many of which will probably never be profitable, while over-indebted failing “zombie companies” have been kept alive by ultra-low interest rates. Financial speculation has become more profitable for many – both individuals and companies – than doing productive work.
What is not well understood – and is critical for investors at this point – are the implications for inflation or deflation. One of my own indicators – which has a reliable long-run record but is admittedly poor on short-term timing – points to a very high risk of a “deflation shock”.
That might seem ridiculous at a time when prices of nearly everything are jumping. But the key to what is really happening is worsening monetary and financial instability. For some years, central banks have used their own balance sheets to protect financial asset prices and suppress financial volatility. But stability breeds instability, as the economist Hyman Minsky explained. This is doubly so when that very stability has been artificially engineered by what amounts to central bank manipulation of financial markets.
Today the clearest sign of this underlying instability is the combination of the extremely elevated valuations of US equities with sharply rising market interest rates and imminent contraction of the Fed balance sheet. The deflation shock indicator is heading to a record level – meaning that the likelihood of a deflation shock is very high and increasing – primarily because the total value of US financial assets is so high relative to GDP. One gauge of this is that the ratio of total wealth to GDP for US residents is about 70% higher than its long-run average. This is an indication that systemic leverage is at an extreme.
The deflation shock indicator is also responding to the fact that money-supply growth is beginning to slow dramatically at a time when cash in the US economy still remains at a lower proportion of total financial assets than it has done historically, despite very rapid growth in the money supply over the previous two years.
System on a knife-edge
The system is on a knife-edge between extreme inflation and deflation. There is nothing in between. Either excess financial-asset valuations, leverage and debt have to be inflated away – a process that would involve the prices of wages, goods and everything else catching up with the levels of financial assets, leverage and debt – or financial asset values have to deflate. The latter would create a huge unwinding of leverage and a “dash for cash”, which cannot be accommodated by a tightening Fed and low money-supply growth.
Fundamentally, there is no way to continue hiding the shrinking of the cake. Unfortunately – and this is an impossibly difficult thing to accept – most people are going to become poorer in real terms. This will either happen through an inflationary process or a deflationary process – or more likely a combination of both. Right now we are experiencing the inflationary part but deflation is likely to come next. Depending on how central banks respond, that may then be followed by even greater inflation.
For investors, being aware of the risks of both inflation and deflation and focusing on where there is genuine value would seem to be the only way forward. In the coming years we almost certainly face the most difficult investing environment of our lives.
Tim Lee is a co-author of The Rise of Carry: The Dangerous Consequences of Volatility Suppression and the New Financial Order of Decaying Growth and Recurring Crisis (McGraw-Hill, 2020).
-
Why you should start investing earlyMost investors wish they had started earlier, and data shows that starting to invest sooner yields greater results over time
-
Rail fares could spike by 5.8% next year – how to save on train travelJuly’s RPI inflation reading tends to determine rail fare hikes in the following year. We look at how much your train tickets could cost, and how to save money
-
'Governments are launching an assault on the independence of central banks'Opinion Say goodbye to the era of central bank orthodoxy and hello to the new era of central bank dependency, says Jeremy McKeown
-
Why investors can no longer trust traditional statistical indicatorsOpinion The statistical indicators and data investors have relied on for decades are no longer fit for purpose. It's time to move on, says Helen Thomas
-
The most likely outcome of the AI boom is a big fallOpinion Like the dotcom boom of the late 1990s, AI is not paying off – despite huge investments being made in the hope of creating AI-based wealth
-
The rise of Robin Zeng: China’s billionaire battery kingRobin Zeng, a pioneer in EV batteries, is vying with Li Ka-shing for the title of Hong Kong’s richest person. He is typical of a new kind of tycoon in China
-
How retail investors can gain exposure to Lloyd’s of LondonIt’s hard for retail investors to get in on the action at Lloyd’s of London. Here are some of the ways to gain exposure
-
The goal of business is not profit, but virtueOpinion Serve your customers well, and the profits will follow, according to a new book. It rarely works the other way around, says Stuart Watkins
-
Earnings estimates are a rigged game – especially in the USThe number of US stocks beating earnings estimates tells us only that guidance has deliberately been set too low
-
Why is Britain's industrial base crumbling?Opinion More and more factories in the UK are closing, and the government doesn’t seem to care. What’s going on?
