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295: The 900 Pound Gorilla in the US Economy

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Buck: Welcome back to the show. Everyone. Today, my guest on Wealth Formula podcast is Dr. John Horn, who is a professor of practice in economics at the Olin Business School at the Washington University in St. Louis. Welcome to the show. Dr. Horn. 

John: Thank you. Thanks for having me. 

Buck: So I’m eager to have you on the show because I know you’ve been talking about the 900 pound gorilla in the room all over the place, which is the issue of inflation. If you could give me sort of a background on your perspective of where this economy was, what happened and why we are seeing the inflation that we are right now. 

John: Yeah, I would actually go back almost to the 2008 2009 crisis as we were experiencing that the Federal Reserve decided to increase the money supply to try to help stimulate the economy so that we want to have a massive or worse recession than we did. And since then, the money supply has stayed really high. And it’s been sort of a conundrum to economists of why inflation hasn’t kicked off fast forward to 1820 months ago, when COVID started and another crisis happened, the Federal Reserve again decided to try to stimulate the economy with increasing the money supply further. And I would say starting this year, after the stimulus packages were passed and after the economy started to recover and after people started changing their buying habits, the supply chain crunch happened. All these things sort of started to come together resulting in the inflation that we see. And the big question right now, I think on everyone’s mind is what’s going to happen in the next 18 to 24 months, because, frankly, no one knows there’s a really compelling story that says that inflation is going to go back down to the 2% or maybe even below level that like we sort of historically had. Or I can tell a really good story why it’s going to stay five 6% for the next three or four years until the Federal Reserve decides to use a recession to kill off the inflation. 

Buck: Well, let’s start with the idea because Jerome Powell recently came out and said that we should retire the term transitory inflation, which they were using for a period of time, which gives the public a lot of confidence, I guess when they’re doing that kind of thing. But what is he really saying there? Do you feel like he’s in his perspective or the Fed’s perspective at this point? They see this as a real problem right now that needs to be dealt with. I believe we have a meeting coming up, too, right?

John: I’m not sure exactly when it is. I think that in a way it’s semantics. Macroeconomists think in long terms, long time periods. And what the Fed tries to think about is this inflation, which is going to be baked in for the next 5, 10, 15 years if we don’t do anything, or is it something where the economy is going to fix itself and when the economy fixes itself, they call that transitory now to the average person. That sounds, well, then it’s only going to last for a couple of weeks. It didn’t. So the Fed is trying to scramble to say, well, that’s not exactly what we mean as economists. And so they’re just dropping the term. I think the big riddle that the Fed is trying to wrestle with is this idea of is this sort of now baked in the way the economy is going to be going forward of 5% inflation unless we do something, or if we just let the supply chain sort of work itself out, if we let the consumer demand sort of go back to where it was, if we select competitive pressures or sort of cap wage increases and lower prices as firms start competing again, are we going to see inflation go back down to the two percentage or below level we have historically. So do we need to actively do something to get inflation down, or is it just going to go down in the near future by itself? And that, again, is the Riddle? I don’t think they know or anyone knows, because there’s so many different ways you could play this out that it actually is going to increase and other ways. When she said no, we’re coming off of the pandemic. When everyone stopped buying, there’s been a massive shift from buying services to buying products. And when you start buying products, all of a sudden, that’s going to really change supply chain demands and change the crunches that we’ve seen there. If people go back to buying services or say, hey, I bought a new car. I bought a new couch, I bought a new TV. I don’t need to buy one other one for the next 5-10 years. Well, then that massive spike in demand we saw is going to sort of fix itself. The supply chain is in some way already starting to ease itself. And most people think it’s going to fix itself by the middle/end of next year for the most part. So that’s what the Fed’s trying to look at and say, if those things are already going to sort of fix themselves on their own, do we need to step in? Because if we step in on top of people already pulling back on their own, we’re going to cause another recession, and we don’t need a third in the last 15 years. 

Buck: Yeah. And the other tricky part there is that, correct me if I’m wrong, but I think that one of the challenges that I think economists and the Fed have is it’s not only just about predicting what’s going to happen, assuming no other major catastrophic changes occur. But we’re really reports. And maybe the Omicron thing is not as serious. Maybe it won’t impact us, but we don’t really know. So that creates an additional layer of not only okay, what do we do now? What would we do if the pandemic was over, but on top of that, we’re like, okay, well, we could be right back where we were six months ago, and whatever we do now has to take into account that as well. Right. I mean, that’s the challenge. 

John: And the thing which makes it even harder is that the pandemic is going to have differential effects around the world. And because global supply chains are still global, that it could look like things are fine in the United States. But if Vietnam goes through a spike and they have to shut down or there’s another shutdown on the docks in China or anywhere in the world where we have supply chains that’s going to throw another wrench into that whole system, and that’s going to cause another disruption. So as you said, they have to think, not just about what do I do in the next couple of months? Anything they do in the next couple of months is going to have effects over a longer time period, potentially even a couple of years before they can reverse it. And that really is the challenge for the Fed is that they can turn on this bigot or turn off the spigot of money supply and change interest rates almost overnight. How that works through isn’t going to be changed in the next week. And so once you start those changes, it’s not that easy to pull them back and get the economy to fine tune to the place you want, using the policy that they have again, that’s where they’re facing, how fast we move and how hard do we move given how long these things are going to happen? 

Buck: I want to ask you what I would think is a very elementary question, and I think it’s worth asking, which is I’ve just been paying attention to some of the economists. And over the weekend, even Mohamed El-Erian mentioned that he doesn’t see the even inflation runaway. Inflation is a real concern, meaning double digit inflation is highly unlikely. So then the question is, well, gosh 67%. Inflation still is pretty bad. Right. Well, then I see Paul Krugman, Nobel Laureate, Paul Krugman, asked the question, well, is inflation really bad for poor people? And he posits the question, which I actually think it’s an interesting one if somebody brought up, of course, he got handed it to him on Twitter. But his point was okay. So as real estate investors, we’ve we know that debt is actually our debt in the form of mortgages. This is actually good for us. We’re, eroding, debt. So in some respects, we’re kind of like, hey, this isn’t so bad. I mean, all my money is in real estate, and our group is probably hundreds of millions of dollars in debt, which is, eroding, as we speak. But his point is that, hey, what about all these people who are not well off in this country? They actually have a lot of debt. So maybe it’s not so bad for them. I’m just throwing it out there because it sounds like something that we’ve just taken for granted. And I’m curious on you what your response is to economists take on that? 

John: Yeah, I would disagree with them. What I would say is that if you think of most of the debt of the lower income population, it’s not like a fixed rate mortgage. It’s like variable rate on your credit card and a variable rate. If inflation goes up, the variable rate will go up to. What you have to believe is that the wages that you get as a worker go up faster than the interest rate goes up on paying off that debt. And if that’s true, then yes, you’re better off. The question that I sort of doubt is whether employers are going to continue to keep giving people raises greater than the cost of the rate of inflation. And at some point that’s going to stop. And if prices keep going up, or if prices have gone up and you don’t get a raise that compensates for that price increase, then you are worse off. And if your debt is mostly held in variable rate sort of structures, you’re going to have to pay a higher rate to refinance or to roll it over for the next month or whatever. And that’s where I would say I’m not quite sure. I think if you have a 30 year fixed mortgage, it’s great. Inflation is fantastic. If you got, like a two 3% mortgage for the next 25 years, inflation goes to 8%. That’s great for you as long as your wages keep up. But I think the variable rate would be the one I’d have to look more into to see if it really is good. 

Buck: Yeah. So let’s talk a little bit about the issue of debt. I’m curious, obviously, with all of the money supply issues that you talked about before and fiscal stimulus and all that, maybe not. The question is really not about debt so much for me, but as much as there’s a big government bill that is on the table right now, which again, Canadian stimulus to the economy. And the question is, if you’re already running at 67% interest, should we be holding off on that? 

John: The simple answer is yes. But if you pump a lot of more spending into the economy when you’ve already got a tight economy and inflation is high, that you’re going to create more inflation. I think the thing which makes me less than I can’t to think it’s going to be a bad thing for inflation is that a fair bit of the funding and the spending is spread over ten years. So it’s not like it’s all going to come in the next twelve months. It’s not a big dump, like the stimulus checks and the covert relief. That was a one time crash course dump money in the economy. The build back better plan is let’s spread it out over ten years. And so the impact in any one year is going to be different. I think if you look at some of the policies in there about sort of like subsidizing child care or child tax credits, those are intended not to say go out and buy a new TV or buy a new car. It’s to say you can now afford childcare so you can go work. And if it does lead to people going out and working, then that’s going to drive more output in the economy, which is going to soak up some of that pricing pressure. And so you wouldn’t necessarily see it if people took all those child tax credits and all the child care spending and just paid for someone else to watch their kids and they stayed home then. Yeah, that’s not going to help. But I think if it does lead to more people entering the workforce, and that has been one of the challenges with Covid a lot of people left and couldn’t go back because of child care. If that happened, then you see a lot of supply increase at the same time, which would sort of mitigate that pricing pressure. Yeah. And this was a question I heard actually. And I think his point was similar to what you’re saying. But just to get some more clarity on sort of understanding the difference between growth in an economy, nominal growth and real GDP, that’s basically what you’re talking about, right. When you talk about how this build back better, really, the idea might be that we’re actually stimulating real GDP, and that’s a different thing. 

John: Yeah. The simple way to think about it is if I have a lot of people going out and saying, I want to buy more stuff, shirts, clothes, TVs, you name it. I want to buy more stuff. And the producers say I can’t produce anything more. Like I’m literally at the Max of what I can produce. The only thing that can happen if prices go up to sort of see who’s willing to pay the most for those things. If people go out and say, I want to buy more stuff and at the same time, producers are like, yes, we can produce more stuff, then they’ll produce more stuff to satisfy the increased demand. You wouldn’t see as much pricing pressure. So if the economy is stimulated on the supply side, this was sort of the supply side or argument is if you can stimulate the supply side of the economy, then you’re going to actually have more output and you wouldn’t necessarily have to see the same increase in prices, because that extra supply that you’re providing to the economy is what is being soaked up by the extra demand that you see, the argument now is you’ve got all this excess demand that people are out consuming and the supply chain crunch. And the producers are saying, I can’t hire workers, there’s no one to actually produce. The stuff means we have less supply, less supply with more demand means prices have to go somewhere. And the only way they go is up. So I think to me, are you going to stimulate and actually produce more stuff? Because if you are, then that’s going to sort of accommodate some of the pricing pressure and reduce it. 

Buck: You’ve talked a little bit. I think I heard you mention something about inflation, sort of developing into a self fulfilling prophecy. Will you talk about that? 

John: Yeah. One of the things that’s really interesting about inflation is this idea of expected inflation that once the workers in particular sort of believe that inflation is going to happen and is going to be stay and lenders. Also, we talked about debt before. If I’m going to lend you money, but I think inflation is going to be 5%. Then I want to increase the rate I charge you by 5% to compensate for the fact that you’re going to pay me back with less. And once we all believe that inflation is going to be five 6% forever, then I’m going to ask for a 5% wage increase. You as the lender are going to ask for 5% higher interest rate. Everyone’s going to ask for that 5% increase, which means when we look back, we say, oh, wait, everyone did get a 5% increase and the prices went up by 5% to pay for all that stuff. Well, then inflation is 5%. So I need to ask for 5%. It becomes a self fulfilling prophecy. It’s one of the challenges that the Fed has, and I think this is one of the reasons why Powell has been out there saying, no, it’s not transitory, but it’s not permanent, but it’s like they don’t want people to start believing that it’s going to be 5% or 6%, because once that happens, it starts to get away from the Fed to be able to sort of tweak that level. And the only way, once it gets baked in, as we believe it’s, five, six, seven or more percent is to cause a recession to snap everyone out of oh, wait, no, inflation is not here to stay. Let’s reset. 

Buck: I’m curious. Inflation has not been this high since. I think the 1080s. When you look at that as an academic, what kinds of parallels do you see? And ultimately, Paul Volcker just had to raise rates right to get us out of there. Is that the only way out of this scenario, ultimately, or where do you lie in terms of the camp of what’s going on now versus then? And if you were in charge, what do you think we should do? 

John: So I think what the Fed is trying to do is to slow down some of those extra programs. They’re sort of the normal stuff the Feds been doing for decades about buying and selling bonds, government bonds to sort of increase my supply or not. They’ve been adding other stuff like we’ll buy mortgages, we’ll buy anything else to buy and sort of keep the markets functioning. I think tailing off. That is sort of a good first step. If the markets respond and the economy starts to really slow down, that’s sort of a good indication of we don’t need to take our foot all the way off the pedal. It’s sort of give it a little more gas. If I were in charge, I would do things slowly because I think any big shock is going to I don’t think the economy is ready for a shock again. I think the going slow is probably the right thing to do. I still am more in the camp of I think there’s enough that’s going to change in the next 1824 months with the economy in terms of supply chains working out, and hopefully labor markets start to sort of resettle with COVID sort of becoming not a pandemic but endemic to the society that will sort of fix some of these things on their own. And so the Fed doesn’t need to fully step in and get rid of inflation. I won’t be surprised if inflation went down more like 3%. I’m not sure it’ll go below the 2% of the Fed likes on its own. But again, there are a lot of things which can happen in terms of demand backing off and supply chains fixing out and global supply chains starting back up and competitive pressures from firms saying I need to lower price in order to sell stuff. And some of those things I don’t think are going away, and I think will help to reset us down towards a lower inflation. So I’m not in the camp of I think this is on the runaway level to the double digits. I don’t think it’s going there. And I think the biggest risk is if it stays at 5% or 6% through the next 18 or 24 months that it gets baked in as well. That’s just the way the world is now. And then the Fed is going to have to step in to reset down to say two to the 2% they want. And they do that through a recession, which hopefully we don’t need. 

Buck: The people who are listening to the show are thinking, okay, so what do I do with this? Because it’s a little tricky situation, right? I mean, on the one hand, if you want to guarantee losing money right now, just put it in the bank. Maybe you’re losing six 7% or something like that. But on the other hand, I think there’s just a lot of hesitancy from the investor standpoint to actually try to understand what’s going on in the economy. And are we in the presence of some kind of like massive correction or whatever? Certainly we’re not asking to give financial advice, but give us a framework for the individual investor that you think, at least to understand the macroeconomic picture, inflation and how it would affect you as an individual investor and what types of things you should take into consideration?

John: For me if I were going to sort of sit down and help someone think through that instead of just look at the big picture of what’s going to happen to inflation, I would sort of get a little more detailed into what are the types of investments you’re looking at. So if you are looking at sort of long term fixed rate real estate, if you can still lock in a low rate right now, you’re probably fine. If you start to see that the banks are starting to get higher interest rates because of inflation. I’d be nervous because if you lock in a 67% rate and then inflation goes down to 2% in a couple of years or 18 months. You’ve got that rate locked in, and unless you can refinance it, you’re not in a good position. I think investing in the stock market, I would look to see what types of stocks, what type of investments are you thinking of making? What are the industries? Are they hurt by inflation? It doesn’t matter what inflation is. They sort of get compensated. It’s not like micro analysis, but it’s like one level down from just a macro. Inflation is good or bad. Like really think about as I look at this investment. What if inflation does stay at 5% or 6%? Is it still going to be a good investment? And if inflation goes back down to 2% in two years, am I going to be in trouble? And if the latter, I would say I may not necessarily stay away, but I’d think twice about it because I think there is a good story where it goes back down to two 3% in the next 18 to 24 months. It doesn’t mean it will. But if you think that I’m protected, whether inflation goes up stays the same or goes down for the most part, then probably not that much of a risk in terms of inflation on that investment. 

Buck: The one thing that people don’t seem to be talking about quite as much because the focus is on inflation is debt. And this is an interesting thing that we’ve been kind of talking a little bit on the show. We had one guy who’s very well known investors and very well who is convinced that the future is modern monetary theory, which is essentially that doesn’t matter anymore, right? That it’s really like the theory being that okay. This is all like enterprise value of individual nations, and it’s basically monopoly money. And you don’t what do you think? How does this debt problem? How does this declare itself? What are the different things in scenarios that you can see? And in what time frame? 

John: I’m not as worried about, like the federal debt, about three quarters of the debt of the US government is owned by US citizens. So we sort of are owing it to ourselves. And Japan has our debt to GDP ratio is a little over 100 now. So the debt of the US government is essentially what we produce in a given year. Japan is over 200 and they haven’t defaulted, and they’re not in crisis to the point, wherever it’s like they’re a mess of an economy. They’re not growing six 7%. But they’re not a basket case. And I think to me I look at that and say, we don’t know. We really don’t know. At what level does the world say? You know what? Now the US has too much debt. We don’t want to buy anymore. I think for as long as the US is sort of seen as the safest haven of economies in the world

Buck: The least ugly economy in the world right now

John: It’s going to be hard to see that the value that collapsing for me. I think as long as the interest rates on the debt are below what we think that the economy could grow and sort of pay it back off in the future, then people are going to say there’s a way which this isn’t going to matter in the long run. I don’t believe monetary the MMT is going to work. I’m not a believer in that, because essentially, look at the angst and confusion that’s happened over the 5% or 6% inflation that’s happening right now. The MMT essentially would triple quadruple that amount of money and inflation would go through the roof. And I don’t see how people would be like, oh, yeah, that’s fine, because the debt doesn’t matter. Inflation is okay. Historically, 5% or 6% inflation. We’re used to 2% or one and a half 2%. And so this looks like enormously awful with MMT would just go even worse. And I don’t see how that’s going to really fly, at least as a long term strategy. Right. And that’s sort of what MMT is to me. It’s like, well, forever we’re just going to have this massive funding of the debt through just printing more money that’s just going to lead to even more inflation. 

Buck: Interesting stuff. So one last question, obviously, politics are kind of crazy today, as polarized as they’ve been since before I was born, at least. And how is that going to how is it affecting the decisions that we’re making specifically, as it relates to, say, inflation and policies to deal with the issues that we have? 

John: So the simple answer is that most of the inflation, at least longer term, midterm long term inflation is driven by the Federal Reserve and their choices. And for the most part, they insulate themselves relatively well from what goes on in Congress and the White House. So in that sense, I’m not as concerned that the Fed is going to say, well, that’s what Congress wants us to do, and that’s what the White House wants us to do. So let’s accommodate it. So I’m less worried about that. I think there’s still some concern is that to the extent that if the Democrats are able to successfully get the build back, better plan push through, and if for some reason, they hold on to the House and the Senate in 2022, do they see that as well? Let’s have even more spending, have more plans, or if the Republicans take control in 2024 and say, let’s cut taxes again have deficit spending that way. I think what’s concerning to me is the lack of willingness to talk with each other about how you fix long term debt and how you fix Social Security and Medicare for the long term, because it’s going to need compromise on both sides. And that’s a word which is not the most popular these days. And I think that’s the part that worries me is that neither side can fix it on their own. It needs both sides agreeing to it. That’s what worries me. 

Buck: Good stuff. Doctor John Horn, everybody. John, thank you so much for being on Wealth Formula Podcast. How can we follow you and get some of the information that you’re putting out there? 

John: I actually don’t use Twitter that much. I do have a Twitter handle, but I don’t use it that much. I like talking to people like you about these things. 

Buck: Well, we’d love to have you on again in the coming months. Thanks again. We’ll be right back.