Welcome to another edition of The Mueller Report!
I missed another week because we were on the road. Our trip from NJ to CO actually took 11 days and included visits to Hillsdale and Arkansas. We all had nasty colds by the end but we are starting to settle into life in the mountains nevertheless.
This week I have some thoughts and articles/talks to share about the economy and about framing our political discourse.
The Economy
Let’s face it – no one really knows what is going on with the U. S. and the global economy.
This past week Elon Musk said he had a “super bad feeling” about the global economy and plans on cutting about 10% of Tesla’s employees. Jamie Dimon, the CEO of the world’s largest bank, has said a “hurricane is right out there down the road coming our way.” The things about storms is that even though you can see them on the radar, your current weather/environment might be nothing like what is coming (which is why so many people get caught unprepared for blizzards, rainstorms, hurricanes, etc.)
On the other hand, you have President Biden (and others) touting a strong jobs report from last month. The economy added 390,000 jobs in May according to the bean counters at the Labor Department. The unemployment rate remains low below 4%. And many people think that inflation has peaked and will begin coming down over the next year or so.
Let’s take different sectors of the economy one at a time.
Inflation
As Milton Friedman liked to say, “inflation is everywhere and always a monetary phenomenon.” He was also famous for breathing new life into the quantity theory of money (MV=Py). That theory suggests that changes in the amount of spending (Money * Velocity at which it is spent) must be equal to the monetary price of everything bought (Price level * quantity of goods & services sold). If M rises while V & y remain constant, then P must also rise. Inflation hawks argue that the past two years have seen a massive increase in M, without much change in V or in y, leading P to increase.
Alternatively, some folks argue that supply chain problems and the pandemic significantly reduced y and that stimulus checks may have temporarily increased V, in addition to increases in M. The argument about inflation being “transitory” rests on the idea that 1) production of real goods and services will rebound (higher y) and 2) that velocity will fall again with the stimulus checks being behind us.
My own thought is that inflation is likely close to or past its peak but will not fall rapidly. That assessment depends on two assumptions:
1) The Federal Reserve continues to raise interest rates through the end of the year and continues to reduce its balance sheet (i. e. pull money out of the economy).
2) The Federal government does not run multi-trillion dollar deficits over the next year or two. On this front, things are interesting. The federal deficit at the end of April 2022 was significantly better than at the end of 2021 because tax revenue is way up and spending is down (no new big stimulus / Covid spending). Still, debt held by the public rose from 22.0 trillion at the end of April 2021 to 23.8 trillion by the end of April 2022.
One last thing to note on the inflation front is another Friedman adage: There Ain’t No Such Thing As A Free Lunch (TANSTAAFL). The massive government spending over the past two years (or past 20?) is not “free.” Even though tax rates are not dramatically higher than they were ten or twenty years ago, Americans have been taxed more nonetheless. And they are continuing to be taxed.
They are taxed every time they go to the grocery store, or the gas pump, or when they buy a house or a car or when they pay rent. Inflation is a tax on currency (the old name for it is seignorage). And it is, if anything, a regressive tax – one that impacts poor people more than wealthy people because 1) much larger portions of their budgets are inelastic to rising prices; and 2) because wealthy people by definition own more assets which tend to rise with inflation and can more than offset the higher price of milk or gasoline.
Employment
While it is certainly much better to have a large increase in jobs rather than a decrease, as well as having a low unemployment rate, we should keep in mind what is being left out. 1st, it suggests that inflation may not be slowing all that much – more people working and being paid means more spending power, not less. And 2nd, the unemployment rate only measures those in the labor force who are looking for a job but don’t have one. One of the big problems of the past thirty years has been people dropping out of the labor force altogether – they are not looking for a job. So even though they are not working, they also don’t count as unemployed. This low unemployment rate does not address the low labor force participation rate.
The other issue to note is that the wages employed workers are paid matters too. Again, according to the bean counters at the Labor Department, wage growth for workers has lagged inflation for the past year quite significantly. That means that the real value of people’s wages have been falling for over a year.
What may ultimately come to a head is: will people begin to hold out for higher wages, leading to higher business costs and lower profit margins, or will an economic slowdown and/or rising prices pressure people to take whatever jobs they can find – especially as large government stimulus, unemployment, and assistance subsidy programs begin to run dry?
My own view is that employers are going to begin seeing their labor costs rise dramatically over the next six months or so as their employees try to renegotiate their contracts. Because of nominal rigidities in the system (long-term contracts), there can be lags between when inflation happens and when certain prices (wages being one of them), fully adapt.
Asset Prices
Again, sharp disagreement exists over what is going to happen to the price of assets like stocks, crypto currency, and houses over the next year or two. The bears predominate at the moment, but some people are still optimistic that asset prices will continue to rise/rebound. Let me make a few predictions:
Housing prices will not continue rising at the rates they have over the past five years – this should not be controversial. Will house prices flatten out in nominal terms, while falling in real terms with inflation over the next couple years? I think that is quite possible. Will house prices begin falling? Maybe – if the Fed follows through on its rate hikes and if 30 year mortgage rates rise (which I think they will), then yes, housing prices will begin to come down.
I picked up a set of real estate listings here in Leadville. The prices are absurd. You’ve got houses or apartments 1/5 the size of our place listed for double or triple what we paid for it. And consider this, the higher the price of real estate, the larger the loan people will take out to buy it. And the larger the loan, the more their monthly payment will be affected by the interest rate on that loan.
For example:
The interest cost on a $350,000 loan rises from $875 per month at an interest rate of 3% to $1604 per month at an interest rate of 5.5% (about the current 30 year mortgage rate), and then to $2188 per month at a 7.5% interest rate.
So, if someone borrows to the hilt and can just barely qualify for the $350,000 loan at 3%, to qualify for the $350,000 loan at 5.5%, their annual pre-tax income would have to jump about $26,244. And to qualify for the same loan at 7.5%, their annual pre-tax income would have to jump an additional $21,024 to $47,268 per year higher than what they needed to earn to qualify for that first loan.
Another way to look at it is, if their income didn’t change, someone who could qualify for a $350,000 loan at 3% would only qualify for a $190,910 loan at 5.5% or a $140,000 loan at 7.5%. Obviously, that would affect their ability to bid on, demand, or otherwise buy houses at their current price configuration.
This also explains why the average price of houses has risen relative to the average income of Americans – they can “demand” more house and bid up the prices with larger loans at lower interest rates than they can at higher interest rates.
The 30 year mortgage rate is an important barometer of what will happen to housing prices…
Regarding the stock market, I have no idea where things stand. The S&P 500 is down about 13% from its peak, rebounding from bear market territory of being down 20% a few weeks ago. The Nasdaq is down a little over 20%, again rebounding from being lower. Normally this would suggest a good buying opportunity. The problem is that we are coming off a massive asset bubble fueled over the past couple years by massive money creation, low interest rates, and increasing speculation.
So, are prices now a “good deal” or have the returned to a “normal” high water mark (as opposed to an absurd once in a century high water mark)?
My own sense is that we have not reached the bottom by any means and that if/when the Fed continues to raise interest rates and pull money out of the economy, we will see more downward movement in stock prices.
The critical questions that no one knows the answer to are:
1) How long will the stock market fall?
2) How low will it fall?
3) When will it rebound?
Cryptocurrency
Cryptocurrencies are down a lot (about 50% or a little more for the biggest most popular ones). What does this mean? I think it means that a lot of the run up in crypto valuations was due to significant speculation – people buying crypto based on the expectation that it will rise in value. The problem with speculation is that it runs in both directions. When people begin to panic or doubt that the value of the asset will rise, they rush for the exits and the price of the asset falls.
Does this mean that crypto is worthless or done for? Not at all. My own view is that cryptocurrencies have important technological advantages over traditional fiat currencies, and that they provide valuable services whether through contracts, remittances, hedges against inflation, etc. The problem is that only a minority of the current demand for cryptocurrencies are driven by these things – most of it has been driven by speculation.
But, if the number of people who use/value crypto for these more fundamental reasons grows, the value of cryptocurrencies will become more stable and will also grow over time. So I remain bullish on the long term prospects of crypto (especially bitcoin and Ethereum), though I can’t say over what time frame they will continue to rise. As such, buying some while they are down is not the worst idea.
Two-dimensional Political Spectrum
I listened to a fascinating talk about our current political climate that I highly commend to you. Tim Urban argues in this talk that we should try to think about our political divides in two dimensions, not just one. So instead of saying there is a left-right divide and that our social problems stem from far-right and far-left radicalism, with moderate political beliefs being ideal, Urban claims that there is a vertical dimension to political divides as well. The vertical dimension has to do with the way in which people come to their political beliefs and how they engage in discourse and debate.
The upper left and the upper right of the four quadrant system could represent “high-brow” intellectual views. People in the upper quadrants, he argues, genuinely care about the truth and are intellectually curious. Very importantly, they also don’t identify strongly with their views on various issues. He says that people in this upper quadrant treat their views or theories as a kind of machine they built that they want to hold up to friction, abuse, and criticism. They welcome others critiquing or criticizing their views thoughtfully because they want to make their “machine” better because they genuinely care about arriving at the truth.
On the other hand, those in the lower half of the diagram treat their political views as sacred and as part of their identity. Their views/theories are not machines to be tested, challenged, and improved, but more like cute babies to be protected. Therefore criticism is not simply challenging the robustness of their “machine” but akin to kicking a baby. And we cannot tolerate those who kick babies…
So the long and short of Urban’s idea here is that the lower left and the lower right (as opposed to “far” left or right) are the ones who want to silence and demonize those who disagree with them. They also tend to be deeply dogmatic and tribal. This has always been the case, Urban argues, but the upper left and upper right have always served as a kind of immune system preventing the lower left and lower right from shutting down all conversation and speech.
The big challenge we face is that over the last decade or two, in large part due to social media, the lower quadrants have had great success in by-passing and/or intimidating the upper quadrants into silence. Cancel culture, wokeness, “owning the libs,” are all examples of how the lower quadrants have begun overpowering the upper quadrants – leading to what appears to be a massive increase in tribalism and vitriol across the left-right divide.
This is only one model of politics, but I found it both thought-provoking and insightful. I hope you do to and are able to give the whole talk a listen.
That’s all for this week – stay tuned for the next Mueller Report!