When All Bets are Off

Pre World War 2

The western part of the world is entering a period of ex-ante geopolitical uncertainty similar to 1939. As a cherry on top of geopolitical instability, the US recorded a 40 year high 7.9% CPI print to jumpstart 2022. In addition to high inflation, gold is no longer backing the dollar like it was back in 1939, which was the year before WW2 began in Europe and also the year that Federal Reserve started purchasing treasury bonds to finance government fiscal deficits. By becoming the US Treasury’s personal piggy bank in 1942, the FED dropped its mandate to promote price stability[1]. In the decade leading up to 1939, compounded US growth was negative including a -2.0% CPI the year before, which probably encouraged FED to purchase bonds[2]. However, from August 1939 until August 1948, inflation spiked and the dollar monetary base increased by over 149%. Despite the often negative relationship between interest rates and inflation, the 1942 FED pegged government long and short term interest rates at 2.5% and 3/8%, which yielded full control of monetary policy from FED to the US Treasury. With newfound monetary power, the US Treasury issued more debt, imposed price controls, raised reserve requirements and increased taxes during the war years. Unlike in1939, the current US monetary system is purely fiat based and thus allows wiggle room for more money printing a la MMT. If we study history of geopolitical uncertainty, a wise move is to not underestimate the possibility of increased taxes and a reversion to low interest rates despite high inflation perhaps in combination with price controls and higher reserve requirements until the Ukraine conflict de-escalates and global supply chains are fully restored. Even with de-escalation and higher interest rates, isolationism may lead to continued supply chain issues and higher prices as production across the world shifts domestically.

Looks familiar?

Lockdown

Current geopolitical uncertainty escalated with the global Covid response, which was a response fueled by fear mongering and lockdowns to prevent death and hospitalizations without regard for economic and political side-effects. Sadly, millions of people with co-morbidities like obesity have passed away with or maybe from a Covid infection. I want to make it clear that Covid is a dangerous disease and that vaccines are probably more beneficial than harmful, but the lockdown strategy was a policy error. The idea of using lockdowns to prevent sick people from overwhelming hospitals ex-ante was well-intended, but the fact is that lockdown policies failed balancing scientific and economic trade-offs. While some researchers argue that lockdown saved lives, other studies, like a well-known study from John Hopkins, argue that lockdowns in addition to unintended consequences including hurting the global economy failed to prevent excess hospitalizations and death. Long-term, the economy and geopolitical instability was impacted negatively by lockdowns because global central banks and governments launched historical economic programs containing unimaginable amounts of monetary and fiscal stimulus to prevent an economic crash. In US alone, FED printed around 80% of the dollar supply existing today and the US Government provided over 4.15 trillion dollars in different fiscal stimulus packages. As a result , risky assets like stocks and crypto went to the moon during Covid, which was great for rich asset owners. However, while the rich experienced excess, the average US consumer simply maintained their standard of living by spending stimulus checks on housing and food, while at the same time dealing with covid. In addition to causing inflation and mental health problems, lockdowns disrupted global supply chains. Poor supply chains in combination with money printing led to more money chasing fewer goods, which is why prices prior to the start of the Russian invasion were higher in 2022 than 2021.

The John Hopkins study - https://sites.krieger.jhu.edu/iae/files/2022/01/A-Literature-Review-and-Meta-Analysis-of-the-Effects-of-Lockdowns-on-COVID-19-Mortality.pdf

Cause of Inflation

The high inflation print in March 2022 is also direct consequence of continuous reliance on short-term fiscal and monetary policy to stimulate the economy since 2008. Specially in 2019, as the global response to the Covid pandemic with lockdowns and direct checks destroyed supply chains and added excessive amounts of money into the system. Pouring gasoline on a souring global economy was the ineffective secular global coordination push for climate change, which created division among nations. Instead of pragmatism, politicians have gambled on deflation and a net-zero carbon future by imposing lockdowns and relying on authoritarian energy sources. Students of history know that inflationary pressure experienced by the likes of the Roman empire, Spain in the 1500s, Germany in the 1920s and US in the 1940s is a precursor for change. Higher prices are basically a tax on the middle class, which is the portion of the population needed for political stability. If the middle class is unable to attain basic needs like food, energy and housing at a decent price then trust in large institutions is vaporized. Internally, uprisings may take place and externally, wars may happen. The Russian invasion of Ukraine will most likely shift the world from globalization to isolationism, which leads to an even higher cost of production and increased prices. However, a Ukraine versus Russia war escalation is likely to cause even further price expansions.

Monthly 12-month inflation rate in the United States from February 2021 to February 2022. Remember this is pre-oil spike in March 2022.

Russia and Ukraine with Resulting Sanctions and Climate Change

The 7.9% inflation print in March 2022 excludes the price shocks on energy, rare metals and food resulting from the invasion of Ukraine by Russia. With responsibility of over 12% of global oil/gas exports and 20% of wheat exports, Russia is one of the largest producers of energy and food. With escalating sanctions imposed on Russia by Europe and NATO, Russia has surpassed Iran and is now by far the most sanctioned nation in the world. In response to accelerating sanctions, Russia is likely to eliminate energy and food exports to Europe. In addition to energy and food export, Russia is also one of the largest exporters of rare earth metals like 28% of global nickel exports, which are used as components when generating battery, solar and wind power[3]. The energy sector and transportation sector for the largest polluter in Europe, Germany, accounted for 33% and 22% of emissions respectively in 2020. In their mission to move to climate friendly substitutes, Germany outlines the need for smarter grids, improved charging stations and more efficient batteries to achieve the net zero carbon objective by 2045[4]. The German net zero carbon strategy does not include the possibility of a global war that would eliminate import of rare earth metals from the largest producers in the world. The push for a net zero carbon future is one of the reasons behind inflation and therefore have a perverse consequence in slowing down the western transition a net-zero carbon future. Building up supply chains or finding substitutes to replace energy, food and metals shortage is dangerous because it causes further inflation in the west. Higher inflation means that a strained middle class will hurt even further.

Road to renewable energy

The typical Budget of an average US Household

The fact is that all US consumers are about to experience more pain from rising inflation, but perhaps more so the middle class. In 2021, the average household income was 61,000 dollars and that income was spent on different parts in the economy as outlined in Figure 1. The table in Figure 1 outline scenarios in which household salary increases by 3% and inflation by 10%, 20% or 30% spanning 2022-23. The very last row of Figure 1 illustrates that consumers earning 3% more per year must decrease consumption between 14-59% relative to income in this example. A 10% increase in inflation for 2022 will especially create demand shocks for entertainment and apparel. That demand shock will generate hardship for certain business sectors directly and others indirectly, which could potentially bring the US economy into a recession. Inflation is now mainly caused by supply chains and will have a disproportionate impact on transportation, food, housing and energy production. These areas also represent a majority of household consumption. Proactively or in response to inflation, the FED and Treasury may send checks or impose price controls so that US consumers can maintain their standard of living. Otherwise, there may be a great deal of instability in the upcoming two years. The Treasury will most likely also raise taxes on the very rich to shift wealth from those least impacted by inflation. The income tax during WW2 for those earning over 200,000 USD was 94% in 1944-45, we might see taxes approach those levels again as politicians will call the tax a patriotic duty in the fight against inflation.

Conclusion

War has no rules. Economic sanctions against Russia by the west will disrupt supply chains perhaps enough for the FED to fix yield curves at low rates and for US Treasury to impose price controls on energy and food. In addition, increased isolationism may ensue as seizing of assets from foreigners imply that property right is an illusion empowering western companies and governments for both good and bad. For example, how will countries rely on Visa for credit and debit cards, Facebook and Instagram for social media and Swift for international payments when US companies can remove services with the push of a button. As a result, nations must expand domestic production. In turn, costs will go up and the net zero carbon future is jeopardized. Combining isolationism and disrupted supply chains with dovish monetary and fiscal policy will drive further inflation. There is certainly a possibility that FED will raise interest rates a number of times in 2022 as stated continuously, but I wonder if they can do that when already slammed US consumers are now forced to experience higher rates on a mortgage, credit card loan and car insurance. Historically, periods of inflation generate political uncertainty and a craving for strong men. In the US, we all know what that implies with a guy claiming that the last election was stolen from him.

[1] https://www.federalreservehistory.org/essays/wwii-and-its-aftermath [2] https://www.minneapolisfed.org/about-us/monetary-policy/inflation-calculator/consumer-price-index-1913- [3] https://www.atlanticcouncil.org/blogs/econographics/beyond-oil-natural-gas-and-wheat-the-commodity-shock-of-russia-ukraine-crisis/#:~:text=Accounting%20for%20more%20than%2028,exports%20respectively%20(Figure%206). [4] https://www.mckinsey.com/business-functions/sustainability/our-insights/net-zero-germany-chances-and-challenges-on-the-path-to-climate-neutrality-by-2045