The great Milton Friedman had many famous quotes. Probably the most well known is the one about there being no such thing as a free lunch (not originally his, but he popularized it). But perhaps the most influential, at least for me, was his observation that “inflation is always and everywhere a monetary phenomenon.”
This was expressed in the equation every young macroeconomics student learns MV = PY which stated the amount of money (M) in the economy * the rate at which people spent money (V for velocity) = the price level, P, * output (Y, commonly measured as GDP).
Friedman’s belief was more money meant (assuming stable velocity, more on that in a moment) more of the combination of inflation and GDP with an emphasis on the former. This used to be true in practice, as well as theory.
However, it hasn’t worked so well this millennium (darn millennials!). Most obviously it has failed since the financial crisis. Money supply has exploded with no sign of inflation. While many said the model failed, what they really overlooked was the collapse in velocity. We can debate whether QE was causal or coincident to the decline in V, but there is certainly a correlation.
Which brings us to my guess at what Friedman would say about inflation if he were alive today. I believe he would amend his theory to suggest increased M = either increased consumer prices or increased asset prices. The P now has two potential states rather than one.
Since the Fed has forcefully squeezed interest rates to near the zero bound, it is difficult to have inflation in the price for goods. However, like a squeezed balloon, the inflation pressure doesn’t disappear, it pops out elsewhere. In today’s world, the exhaust valve is asset prices.
The New MV = PY
So, I am contributing to the economics literature today by introducing the second state of MV = PY…the asset inflation version.
M is still M. No change there. V is now represented by leverage, so instead of looking at how quickly people spend $ in the economy, we measure the rate at which they lever up money through borrowing. Thus, MV now equals the total amount of dry powder to buy assets with.
P changes to P/E (or whatever other valuation metric you like in today’s market). Inflation is observed in asset markets through higher valuations, whether they be P/E for stocks, cap rates for real estate, credit spreads for bonds, etc.
Y is now corporate earnings or cash flow. This means PY = the market cap of the asset, as it is the valuation metric * the return from the asset.
Thus, the amount of buying power in the market, MV, equals the market cap of investable assets, PY. As M or V go up, PY must go up. Like in Friedman’s original equation, it will likely go up through P more than Y.
Observing The Present
What’s fascinating about today’s situation is that while in the “real economy”, V has gone down to offset higher M and keep inflation low, in asset markets leverage has gone up with the money supply amplifying buying powder. This has led to massive upward pressure on valuations.
In the last year, the money supply is up 20% and over five years, it is up 50%. Thus, we get things like $1.5T valuation for Amazon, $250B valuation for Tesla, $75B for Zoom and so on.
There is too much money chasing too few goods. That is textbook inflation. Today we call it TINA (there is no alternative) or FOMO (fear of missing out), but it’s really classic macro 101…too much money chasing too few assets.
Unintended Side Effects
There is an often unmentioned problem that comes along with too much MV. People lose their discipline and mistakes get made. What are often called animal spirits take over (i.e. FOMO). People don’t want to admit they didn’t get rich quick too. So they invest in bad businesses, or worse, frauds.
Every bubble produces fraud. Think of Enron in 01, Madoff in 08. Today, we have Wirecard, Luckin, and others (interestingly, the frauds have all been international this go round).
It also produces capital misallocation. It is why things like Lemonade can come public so easily before they’ve proven their business model is viable.
It’s why private equity is so eager to fund the “class of 2020” even though the opportunity isn’t nearly as good as 2005 or 2001…their hurdle rate is way lower today.
It’s why alternative capital kept getting funded even when prices got too low and losses too high. What else was a pension manager going to buy? Investment grade bonds at historically low spreads?
It’s hard to sit things out and wait for rationality to return. It’s why we have seen day trading return. People will continue to chase low return investments with ever higher valuations. Until the music stops.
The other thing that happens when there is too much asset inflation is unintended losers.
As many of you know, value stocks have been the big loser over the last decade. This happens in most money supply driven bull markets. This time, it is compounded by the preeminence of financials in value indices. Of course, financials have been crushed by the Fed suppressing interest rates.
I found the recent Fed bank stress tests to be pretty ironic. The Fed tested how banks would perform in a major recession that cratered stocks by 50% and real estate by a third. That’s great and all, but that’s not the stress test.
The stress test is the present…ten years of near zero interest rates where banks have very high costs of capital relative to the rest of the economy because nobody will own their stock and limited lending opportunities because credit spreads are too tight.
If the Fed wants a stress test, assume ten more years like the last ten and see how many banks sign up for that or decide they’ve had enough and would rather run it off!
Main Street vs. Wall Street
However, there’s a far bigger issue and it goes back to the original observation that the Fed has squeezed inflation out of goods markets and into asset markets.
The Fed has chosen to enrich the investor class over the working class. This is not meant to be a political statement. It is a conclusion based on watching the results of the Fed’s policies over the last twelve years.
Asset inflation benefits the wealthy most. Yes, the lower and middle class benefit through pensions, low unemployment, etc., but the majority of the benefits accrue to those with access to leverage (V in our equation). If you want to know who murdered moderate politicians and created our current climate of polarization, you will find the Fed holding the smoking gun.
Goods inflation can certainly be injurious to working families without savings if they lose purchasing power. However, if consumer inflation is accompanied by rising wages, there doesn’t have to be a decline in real incomes.
Paying the Piper
There is also a failure to properly understand the costs of retail inflation. National governments have two ways to improve their balance sheets…one, debase the currency through inflation to reduce the real cost of paying down debt or two, raise taxes.
When viewed this way, inflation is not always bad. There may be times when it does less economic damage than raising taxes would. That may be a topic I address at more length in the future.