Thread by @StuLoren

1/ Wanted to put together a hopefully understandable thread on inflation, interest rates and implications for the level of consumption and services we're used to. In short, I think we're in a Wile E. Coyote moment and most people haven't grasped the "gravity" of the situation.

2/ If you want the detailed story about inflation, rates, the economy and capital market implications with lots of charts (about 150 to be exact), you can check out this PDF I put out last week. I'll keep it shorter here. acrobat.adobe.com/link/review?ur…

3/ OK, let’s start: Here's a chart of US government debt to GDP (in % terms). Up and to the right… We keep borrowing more and more money to support higher levels of consumption and services.

4/ Here are charts showing interest expenses as a percentage of GDP and as a percentage of total federal expenditures. Despite an explosion in borrowing, our interest expense burden is relatively low and has remained stable over the last 15 years.

5/ You may have noticed the big rise in interest expenses in the 1970s and 80s. Why? Interest rates. Here’s a chart of rates (using the 10-yr Treasury yield as a proxy). Higher rates increased borrowing costs. So we ended up with a higher interest burden despite less debt.

6/ Here’s the same chart of 10-year Treasury interest rates (white line) overlaid with inflation, or CPI (blue line). There’s more to what drives rates than just inflation, but as you can see the two are pretty correlated.

7/ So the very basic story is that low interest rates (largely attributable to low inflation) kept driving the US cost of borrowing down over the last 40 years, which essentially meant that we could consume more stuff every year financed by increasing public debt.

8/ What was the secret sauce keeping inflation low? To borrow from Jim Bianco @biancoresearch: a post-Cold War order marked by globalization in which cheap goods, cheap labor, cheap energy/resources and technology efficiencies worked to keep prices stable. podcasts.apple.com/us/podcast/liq…

9/ No surprise, but we're obviously not in a period of stable prices right now. (For more on why, again see my detailed slides linked above in #2, above. But I'll go over a few key points below.)

10/ Given geopolitical tensions, policy missteps, demographics and investor constraints, we might be in a world where costs for labor, goods and energy are structurally higher. (In addition to my slides above, I wrote about these changes in March) linkedin.com/pulse/marine-b…

11/ As for tech deflation, higher rates mean the return hurdle for investors is up. Investors won’t tolerate years of subsidizing losses to gain market share when rates are at 4%+. That means the Ubers and Netflixes of the world now need to raise prices.
nytimes.com/2021/06/08/tec…

12/ While the Federal Reserve can and probably will lower inflation in the next 1-2 years by tightening monetary policy and slowing overall economic demand, it can’t change geopolitics, geophysics or demographics. Nor can it control fiscal stimulus. wsj.com/articles/fed-o…

13/ The key point is that to think we’re going back to 2% inflation in the longer-term is to think we’re going back to a world that no longer exists.

14/ So what’s the big deal if we’re at 3-4% inflation with rates above 4%? Well, if you’re one of those people who buys stuff like food you understand the problem inflation causes. Prospective borrowers understand this as well. See what’s happened to the cost of financing a home.

15/ And it’s really bad for people’s lives and our social stability and politics when inflation exceeds wage gains. It just leaves everyone feeling poorer. That dynamic has a history of leading to populism (but not going to get into that political angle today).

16/ The pressures of inflation and higher rates also applies to business investments. It’s a lot more expensive to finance (or refinance) stuff and that slows the economy. This is reflected in plummeting business confidence (recessions shaded in red in the below chart).

17/ But let’s focus more on the national level. A 4% rates world basically doubles the US government’s cost of financing its deficits and refinancing existing debt. Here’s a conservative estimate of the impact based on work from the CBO and @pgpfoundation. Not a pretty picture!

18/ Even worse, the amount we’re spending on interest expenses relative to government revenues and GDP will explode. Based on the current trajectory, interest payments are going to consume an ever-greater share of our budget. That means less room for critical government services.

19/ To confront this, we have a menu of bad options: 1) Raise taxes to support the same level of spending (not politically popular, especially if the economy is slowing); 2) Cut spending to afford interest expenditures (not popular); 3) Default (not even close to feasible); or…

20/ 4) Inflate the debt away. This would likely involve coordination between the Treasury and Fed to keep interest rates lower than inflation and nominal GDP. IMO, it just delays the inevitable reckoning and results in higher inflation. Also problematic: inflation is unpopular!

21/ For what it’s worth, inflating away debt isn’t that dissimilar from market strategist Russell Napier’s financial repression theory (see the below interview). Financial repression basically penalizes savers in favor of debtors (like the government). themarket.ch/interview/russ…

22/ Or for what I think is another elegant explanation for an imperfect way out of this debt/rates trap with additional thoughts about financial markets, see the below post from @fkronawitter1 (the second half of is particularly relevant). nexteconomy.substack.com/p/black-dynami…

23/ Also, I should note that another path out of this predicament would be far higher productivity growth. But recent trends aren’t that encouraging. Still, you never want to discount the possibility of some technological breakthrough accelerating the economy.

24/ Now let’s turn our attention to government spending. Something needs to give unless we decide to materially raise taxes or just inflate away our debt (a distinct, but unattractive possibility). For some great charts on federal spending see this link: pgpf.org/chart-archive/…

25/ If cuts need to be made, they’re probably not coming from mandatory spending (though I’d argue we need serious reform like new social security age eligibility and income thresholds). It will be from discretionary (and sorry, in today's world cutting defense is a non-starter).

26/ Any cuts here are hard, which is probably why they won’t happen. But raising taxes while we have inflation is politically hard too (sorry Modern Monetary Theory, or MMT, crowd - deficits do matter and it's hard to simply raise taxes to deal with inflation).

27/ So my guess is we get some form of financial repression long term where a higher level of inflation is ultimately tolerated as the least painful option (I hope I’m wrong and we get fiscal religion or that productivity growth jumps).

28/ Ok… Enough about the federal government. The main point was either we need to tolerate higher inflation or lower consumption (via tax hikes or decreased fiscal spending). Not the most fun options, but at the end of the day the US government will find a way to manage.

29/ On the other hand, indebted states and municipalities with major unfunded pension liabilities are – to use a technical term – screwed (looking at you Illinois and Chicago). I have written about this ad nauseum, but the trends keep getting worse.

30/ Let’s start by reviewing the financial situation for US states. Here’s a heat map showing debt per capita and the total debt burden by each US state. Darker blue means higher indebtedness.

31/ The biggest driver of state fiscal health, which isn’t fully represented in the prior statistics/chart, is the funding status of public pensions. The less funded the pension plans, the more in future liabilities.

32/ No surprise for anyone that follows me, but my home state of Illinois scores atrociously on funding status and the size of its unfunded pension liability as a percentage of state economic output. You don’t want to be in the bottom right of this chart!

33/ Poor fiscal stewardship is reflected in credit ratings, for which Illinois ranks in junk bond (or distressed debt) territory. Bs are bad. The worse a state’s credit rating, the more it costs to borrow.

34/ Quick side-note: Chicago also has substantial unfunded pension liabilities and accordingly has the worst credit rating of the 10 largest US cities. See the linked Bloomberg article for more on that.

bloomberg.com/news/articles/…

35/ Now, remember all the options the federal government has in dealing with too much debt and high interest rates? Well, states don’t have the same luxuries. If you raise taxes enough or cut services to levels not commensurate with tax burdens, people move.

36/ States could default (though not declare bankruptcy), but doing so would irreparably destroy their credit ratings. It’s not viable. And unlike the federal government, states don’t have central banks to monetize debt – so neither can they engage in financial repression.

37/ States should renegotiate pensions or cut pension payouts, but they probably won’t for ideological reasons in the states that are in trouble. Also, pensions are constitutionally protected in some cases (such as Illinois).
news.wttw.com/2015/05/08/il-…

38/ What I’ve been hammering on since last year is that states (esp Illinois) need pro-growth policies. Growing the tax base is the best way out of this fiscal mess. This means everything from better public safety to more business-friendly measures.

39/ There's only one USA, but there are 50 states and each state competes for business, residents and tourists who generate revenue and growth. Some do this better than others. But it’s ironic that states with worst fiscal situations have the least growth friendly tax policies...

40/ ... And the worst business environments. Actually, ironic might be the wrong word choice. It totally makes sense that states with high tax burdens and unfriendly business environments have the worst fiscal challenges. Not sure which is the chicken and egg, but they’re related

41/ Inflation is really going to crush these poorly run states. Borrowing costs have moved up substantially since 2020 (with the worst run states having the highest credit spreads and financing costs). Just like the federal government, interest expenses on new debt will balloon.

42/ Again, unlike the federal government, states' options are narrow (and I wouldn’t bank on federal bailouts). Raise taxes or cut services and people move. And you can’t manage interest rates without a central bank. Inflation and higher rates are going to hurt poorly run states.

43/ To use Illinois and Chicago as examples, about ¼ of the 2022 budgets already go to debt servicing and pensions (and they’re still woefully underfunded). In a higher rates world there won’t be much left over for actual services.

44/ And in a higher inflation environment, the costs of providing government services will increase requiring either higher taxes or a cut in services. Pro-growth policies would be most ideal, but let’s not kid ourselves about the current policymakers in charge of these states...

45/ Heck, in Illinois we’re trying to codify public union protections in the state constitution! Why go broke gradually when you can do so suddenly, a la Hemingway... illinoispolicy.org/get-the-facts-…

46/ Another underappreciated point: if we have elevated inflation, pension returns will suffer (and have suffered). There’s some benefit in higher rates reducing plan liabilities, but that’s probably offset by the hit these plans are taking on asset performance.

47/ This is particularly the case for progressive states because they are so ideologically opposed to natural resource firms. This does nothing to change energy demand, but it’s great for missing out on what’s usually the best performing asset class during periods of inflation.

48/ For a much deeper dive on asset returns during periods of inflation, see this @FT article or the below linked SSRN paper. I don’t think the political overseers of these pension programs have brushed up on it…
ft.com/content/88ebab…

papers.ssrn.com/sol3/papers.cf…

49/ Instead they are largely hiding out in tech dominated large cap indices or private markets that “shield” their portfolio volatility. Well, the major stock indices have gotten whacked. And PE and VC portfolios are about to get marked down as well.

ft.com/content/e00fd2…

50/ Unfortunately, poor pensions returns are just going to create a bigger drain on public funds. Taking more money away from services. States like Illinois are going to just become places where people work to pay people who are retired. It’s not sustainable.

51/ Either (1) there will be a voter shift away from profligate progressive spenders to those supporting fiscal sanity, (2) enough people will leave states like IL, NY and CA to force changes to entitlement programs regardless of constitutional protections, or...

52/ ... (3) these poorly run states and their unfortunate residents will just live with much higher costs, worse services and lower growth.

53/ Broader point now: but we risk some sort of social reckoning. Of younger working people turning against the political class for diverting so much of their income to pay people in retirement while the level of public services deteriorates and their cost of living goes up.

54/ Tax and fiscal policy are social policy and for whatever reason the US and many states have favored those who are older and do not work over younger people and families. I’m exaggerating a bit, but it seems like we spend more on the last 5 years of life than the first 50.

55/ As I learned from my grandparents aging, when something is “free” like healthcare, there’s every incentive to use a lot more of it. So, I’m very much not advocating for socialist garbage (see below), but just a rethink of spending and tax priorities.

56/ I get the concept of a social safety net, but we’re taking it to extremes. Rising costs are definitely making it harder to start families.

57/ Also, like you need more babies if you want to pay everyone who is not working! The dependency ratio is moving in the wrong direction here... So even if you favor generous welfare policies, the effects they’re having are counterproductive.

58/ That’s probably enough political ranting here for now… Anyways, higher inflation and higher interest rates means lower consumption and a lower quality of living anyway you cut it. We're out of shortcuts. The benign economic 30-year post-Cold War period is over.

59/ So the main point here is (that unless we luck out with a productivity explosion) we're going to need to adjust to this new economic environment through either painful spending cuts or the corrosive effects of inflation over time as we inflate away our debt.

60/ Unfortunately, that means getting used to having less, doing less and expecting less for awhile until we get out fiscal house in order (and some sanity around policies like energy).

And on that bright note, have a great day!