In inflation prices rise faster than wages. And when prices rise faster than wages that puts very heavy burden on modest and moderate income households. When you are facing these basic necessity cost increases, you begin to lose confidence in political leadership. Even though the GDP was in 1970s growing rapidly because of all the military expenditures (Vietnam war), vast majority of households were getting worse off.
In 1970s inflation dynamic had certain major components (in difference from 2021 flash recession): 1. Money supply growth did accelerate and we had 10% increase in the money supply in 1970s and it steadily went up. In that period the velocity of money was stable. When you get 10% increase in money and velocity is stable you get 10% increase in nominal GDP. There was another very critical element in the 1970s, we had the largest devaluation of the dollar in any decade in our history.
When you have rapid monetary growth and velocity is stable and policy is pushing the dollar down than what happens is in a lot of industries the price leader is a foreign producer. When the foreign producer raises prices the domestic producers have an umbrella under which to rise prices. Now the money supply is decelerating, the velocity of money is not only stable, it appears to be decelerating and moreover, unlike the 1970s when you had a massive unprecedented decadal devaluation in the dollar, the dollar is working its way higher. In 1970s you have to take into account what happened to the dollar. The other difference is that we had very powerful demographics. The average age in 1970s was 29. Today we are approaching 40. And we were very lightly indebted economy. The government sector debt was beginning to rise because of the Vietnam war, but the private sector debt was not rising.
Right now about 80% of households are suffering from a decline in their standard of living. Inflation is in base necessities like food and fuel. And for food and energy you don't have good substitutes. The share of basic necessities of modest and moderate income households in their total budget is much higher than the upper income households. And there is also an international effect. In the emerging economies of the World which have considerably less per capita income than we have. The percentage of their budgets for basic necessities is dramatically higher than it is in the US. And their currencies are falling. The commodities they buy are priced in dollars, the dollar is going up, for the emerging economies the impact on modest and moderate income households is very severe.
Inflation is a lagging economic indicator. When recession ends the inflation rate still goes lower. It is not until you get into a well advanced expansion that inflation goes up. When you are coming off a deep recession you need the inflation rate to fall for three reasons: 1. If you have inflation, prices rise faster than wages. If prices rise faster than wages, you immediately throw this adjustment onto the components of the society that are least able to deal with it. You undermine real wages (inflation is a regressive tax). In addition you need the prices to come down so that our manufacturers can sell more to the rest of the world, we need trade deficit to come down. When you have higher inflation you import more foreign goods so trade deficit is higher.
Companies are now stockpiling their inventories. They go from hand in hand inventory just in time, and when hand in hand doesn't work like because of a pandemic, they have more than sufficient inventories in case of problems in deliveries. They go from just in time to just in case. What we are seeing now is that firms are probably double or triple ordering and probably the same thing is happening with job postings. They do whatever they can to obtain employees. 2. You need lower interest rates. This causes nominal rates to fall, which boosts your interest sensitive sectors. There is a good reason that the inflation rate and interest rates need to fall in an early stage expansion.
Lacy Hunt school of thought tells you that housing and autos lead every economic cycle in and out of recession. In September 1969 the jobless claims print as low as we have recently, two months later the economy was in recession.
If inflation were to be sustained over long period of time it would take the bond yield with it. The critical issue is whether inflation is going to be sustained. I'm in the camp that it will not be sustained.
From 1870 to 2000 in real per capita terms we grew 2,2% per annum. There's tons of academic research that shows that by 2000 we became a heavily indebted economy and since 2000 we have became far more indebted. Academic researches showed that once you reach the excessive debt levels that we had at some point in the late 1990s to early 2000s we should lost about one third of our growth rate against trend. We were growing at 2,2% from 1870 to 2000 since than we're only growing 1,1% per annum. At the end of 2019 before the pandemic hit our real per capita GDP was 17% below trend, now we are at 23 or 24% bellow trend. We are falling further and further below the trend. When your growth rate of the standard of living starts falling, the income and wealth divides increase. With all the help from the governments, we're making us all collectively worse off.
When you coordinate monetary and fiscal policy (monetary policy was supposed to be independent of federal reserve policy) you didn't want the two central policymakers doubling up on policymakers. When you coordinate monetary and fiscal policy you move the total economy further and further in the direction of command and control. The influence of the government sector over the economy is becoming greater. The debt finance government multiplier is negative after three years, maybe sooner. Now it is negative 30 cents. If you engage in a dollar of debt financed activity, at the end of three years you get the increase in one dollar of debt finance something, but you lose private spending of dollar and thirty cents. When you go in the direction of command and control you reduce the private sector activity. The private sector has positive multipliers. When you increase command and control component, you increase the government activity and they have negative multipliers. When you move further and further into the direction of government control you get increasingly inferior economic results (the law of diminishing returns). The result is, we are falling further and further below the trend. Where are we taking the economy with these decisions? Are we making people better off by these decisions? The end result is that we are not.
The production function says that economic output is determined by technology interacting with land, labour and capital. If you begin to make use greater use of one of the factors of production such as debt capital initially economic output rises. We call that increasing returns. If you make further use of debt capital, GDP flattens out. It is called steady returns. And than if you still insist on using more debt capital, you go to negative returns. What the law of diminishing returns says is there is a phase in which debt can be used productively, than there is a phase when it is not effective, but it's not harmful. But now we are at the phase, where the overuse of debt capital is so great, that it is detrimental.
Velocity of money in the US peaked in 1997. Every new dollar of new money created two dollars and twenty cents of GDP. We're now down to one dollar and ten cents. In the EU velocity of money is 0,85. Each dollar of new M2 money is only creating 85 cents of new GDP. In Japan and in China the velocity of money is under 0,5 in both areas.
The average age in China is approaching 41. They had one child per family policy and they had more boy babies than girl babies. Every two years the average age in China is going to go up one year. We (USA) are at 39. Positive demographics have a major impact on economic growth and inflation. Negative demographics are huge anti-growth, anti-inflation force. The demographics work through investment on economic growth and inflation. Think about the cost of forming a household, raising children, and the investment that that requires, cost of educating the children, investment required by firms producing for growing households, investment that has to be made by state and local governments, you need more water and sewer, more schools. Demographics will not give us higher inflation because we have fewer bodies to produce, that effect is there but it will be overwhelmed.
If you give the FED the power to spend (FED has the power to lend, but not the power to spend) than in that case you will begin to get rampant inflation. In case of FED CBDC the US central bank will become the spender of last resort and in short order we would trigger Gresham's Law the bad money will chase out the good and inflation would take off. MMT has already been tried, tested and failed (in last recession governments sent support directly to the people). What happened is that the government debt levels have gone up and the net result is that the economic growth rates have gone down in real per capita terms. The key to economic prosperity is hard work, creativity, ingenuity and that's really the source of our wealth. It's not in some government program. Over-reliance on debt is not a solution. To make FED's liabilities legal tender is moving further into the direction of command and control. In the USSR was not shortage of Rubles, it was shortage of everything else.
Dual mandate of the FED: price stability mandate and labour mandate. Burns is charged with holding the interest rates unchanged and as economy started heating up in 1972 as a result of the major appreciation of the dollar and few other things that were marginally helpful, he had to keep increasing the money supply so the inflationary air pressure is built. The labour unions had made it very clear, that they would not agree to the wage controls unless prices, interests and dividends were controlled. When you meld the two, than you violate the basic fundamental purpose of keeping the federal reserve and fiscal policy makers separate, bad things happens. FED should be simply committed to keeping the inflation rate low. That is the most beneficial thing that you can do for employment and for the well-being and welfare of the overwhelming majority of your households. It may seem that you are more caring to have dual mandate, but if you really want to help the most people you keep the inflation rate low.