Memo 5: The Hamster Wheel
We cannot solve our problems with the same thinking we used to create them – Albert Einstein
The lost takeaway from the 70s is that raising interest rates is not a solution to structural imbalances between supply and demand. I think it might even compound the problem.
Last week we introduced the contributing factors to inflation: a supply / demand imbalance where too much money is chasing too few goods. The Fed’s challenge now is to eliminate all the excess demand without eliminating productive supply along with it. I’m not convinced this “soft landing” is possible.
Phase I will be eliminating all the Paper Wealth: all the crypto ponzis, unit-uneconomic growths, Softbank-backed frauds… sayonara! “Nuking the Paper Wealth,” as one subscriber puts it quite nicely, should moderate pent-up demand as well: the Bentleys, the Richard Milles, the $1,850 Balenciaga sneakers – distressed as if they belonged to Mr. Rooney at the end of his day chasing Ferris Bueller – no más. If it was a popular good or service at the F1 Grand Prix in Miami two weekends ago, this is what we’d hope gets eliminated – the excess.
Higher Rates = Higher Prices
But I would bet this is just where the contagion starts. Investment Banking activity is telling a pretty interesting story right now. This is where the intermediation between markets and firms is happening, so we can get a real-time picture of how America’s largest businesses are reacting to the markets. So far, 2022 activity is way down from 2021’s record levels. Year-to-date, US M&A is down 31%, IPOs are down 91%, debt issuance is down 31%, and regular corporate advisory revenues are down 43%. Rates are nuking the frothy IPOs, the wasteful M&A deals, and the dirt-cheap debt. Businesses can’t or won’t raise capital. So what does that mean? Businesses are going to cut back investment. Every dollar not being raised right now is a dollar not being invested. It’s an employee not hired, factory not built, and growth channel not explored.
This is the fundamental issue with the Fed’s plan: it’s not just demand they’re fighting. Supply is also under siege.
I want us to look at housing to fully appreciate this concept – today we’re short millions of homes throughout the country and rents have run out of control. The Fed thinks raising rates will curtail the frenzy by nuking everyone’s portfolios, but this doesn’t decrease the number of people who need houses just their ability to pay. By delivering pain to the consumer, housing prices may come down but so does housing affordability. At the same time that we’re trying to bring rents down, higher rates mean more expensive construction debt. Combined with higher return hurdles for developers, we’re sinking every incentive to develop new housing. We’re still including a critical assumption – that our government doesn’t come to the rescue with sweeping rent control. To clarify, if we go down the rent control road we might as well just hang up our hats. Between lower rents, more expensive capital, and serious regulatory risk, it feels like we’re doing everything we can to discourage the new housing we need to solve this shortage. So what’s the takeaway? On the surface, we may see lower rents and we may even pat ourselves on the back for solving the inflation problem, but when the dust settles and we try to get the economy growing again, the housing shortage, now more severe, will reawaken from its hibernation period and unleash price inflation once again – this time even worse.
Before we had too much money chasing too few goods – we can solve the too much money problem, but can we do it without making the too few goods problem even worse.
6% peak inflation in 1970, 12% in 1974, and 18% in 1980 – each inflation episode worse than the prior. This was the fundamental problem during the 70s and I believe the true cause of stop-and-go monetary policy. Raising rates does not cure inflation, but rather exchanges that inflation for a demand and supply contraction – this trade is understood as the Phillips Curve.
Adjusting rates exchanges consumption now for consumption later – when times are tough, you might drop rates and get folks to pull forward their consumption and spend more than they save, and when times are good and the economy’s running hot, you might raise rates to nudge people to lay off the spending and start saving (this is Keynesian Economics in one sentence). Bottom line, however, raising rates does not create productive capacity out of thin air. Next memo, we’ll discuss the process of unleashing a country’s productive capacity for a sustainable cure to inflation.