Government Spending and the Future Value of Money
In the four decades after 1980 much of the developed world experienced either deflation or disinflation, that is a lowering in the annual rate of consumer price inflation.
Though inflation was controlled after 1980, in the U.S. the annual national budget deficits piled ever higher seemingly without consequence, while after 2008 the Federal Reserve, the nation’s central bank, moved to lower the federal funds rate interest rates to near zero.
This led to a puzzling chapter in the U.S. economy history: After 1980, prominent and credentialed macro-economists spent the bulk of careers predicting soaring inflation—but the higher inflation rates never materialized, not in the U.S., or even less so in Europe.
And in Japan, the national economy became something of a poster child for deflation accompanied by large and growing national debts and accommodative monetary policies.
For whatever reason, when 2020 began it appeared the inflation dragon was dormant, if not dead and buried, and orthodox macroeconomics discredited.
But then in a city in Wuhan, China, a new virus made its way into the human population, known as COVID-19. In response to the sometimes-lethal respiratory virus, governments globally moved to lockdowns, travel bans and other business restrictions, all of which actions unemployed millions and savaged business operations everywhere.
Faced with stalled economies and jobless millions, the developed nations around the world moved in near-unison to fiscal easing, while major central banks engaged in near-unified monetary accommodation.
Perhaps understandably, maintaining domestic and global gross domestic products (GDPs) and citizen spending-power were foremost under pandemic conditions.
However, as a consequence of pandemic and global economic stimulation, innumerable supply chains, large and small, became stressed by absent labor, missed deliveries and part shortages. In just one example of thousands, auto-parts factories in SE Asia were shuttered due to COVID-19 mandates in 2021, leading to stalled vehicle-production lines in Japan and elsewhere. Auto prices, even used auto prices, jumped up the U.S.
Global commodity prices soared, from oil to lithium to coffee.
Meanwhile, low borrowing costs encouraged real estate buying. In the US, Australia and parts of Europe, housing costs surged to all-time record highs as MMT, or modern monetary theory, became the de facto macroeconomic policy and boosted consumer incomes and government outlays.
Source: Green Street
Commercial property values in the U.S. also struck all-time records, as seen in the Green Street Commercial Property Index chart above.
Whether for better or worse, in most of the developed world MMT-oriented deficit spending was implemented not through tax cuts and money-financed fiscal programs (that is, direct government printing of money to finance outlays), but rather through expanded government outlays and heavy borrowing.
By 2022, the outlook had radically changed from just two years earlier. The question was no longer why inflation died in the previous four decades, but whether much-higher prices and economic upheavals could be avoided in the coming decades.
To be sure, the actions of central banks and government globally to stimulate economies were successful in many regards, and in 2019-2020 there was no global 1930-style Great Depression or even Great Recession or Global Financial Crisis, as in 2007-9. As seen in the table below, a recession was quickly averted in the U.S.
Indeed, in the U.S. the recurrent topic by 2021 was “labor shortages,” and reports of markedly higher starting wages, whether at local restaurants or national enterprises, such as Amazon or WalMart.
But having ridden the macroeconomic-stimulus tiger, governments across the developed world in 2022 began to face the predicament of how to get off.
For one, how can inflation be tamed, but without triggering a deep recession?
And could debt-soaked national governments, as well as many private sector enterprises, endure the higher interest rates necessary to combat inflation?
Governments, like people and like many businesses, tend to “kick the can,” or a problem, down the road, for as long as possible.
But sometimes, there is an end to the road.
One macroeconomic perspective on inflation and hyperinflation is the “fiscal theory of the price level.” In brief, the theory suggests than when bondholders lose faith in a nation’s sovereign IOUs, they then pay far less for those bonds, or sell those bonds.
The short story is the over-indebted nation eventually faces higher interest-rate costs on borrowing and a deflating currency, especially in international exchange markets. Also, as bondholders sell, they find nothing they want to invest in, but also face rising consumer prices. For many, it makes sense to buy and consume before prices go even higher. So money floods into consumer markets—aggravating the inflationary cycle.
The fiscal theory of the price level is used to explain such macroeconomic events as the recurrent Argentinian inflations or the Weimar Republic hyperinflation.
Thus, it is hardly comforting that the US government has been borrowing heavily ever since the 2008-9 Global Financial Crisis, and that the leveraging up reached flood-stage red-ink tides in the COVID-19 pandemic era as can be seen in the chart below.
The chart illustrates total national debt, and the national debt to GDP ratio, the latter excluding debt held “in-house” by federal agencies, such as the Social Security and military pensions trust funds, which own US Treasuries.
The expectation of many macroeconomic observers is that, due to gigantic and escalating government debt, the Federal Reserve will soon find itself “trapped”—that is, the central bank will at some point no longer allow interest rates to move much higher, as that would skyrocket US government borrowing costs.
The Federal Reserve must then engage in “financial repression” and hold rates on US Treasuries at low single-digit levels, that is perhaps around 2% on 10-year notes, for example.
The simple math does raise alarm bells: At $29 trillion outstanding in total federal debt, if the average interest rate should rise to 5%, then federal taxpayers would have to come up with $1.45 trillion a year just to meet national borrowing costs. In comparison, in fiscal 2022 interest outlays on the federal debt are estimated to run at a much smaller $305 billion.
Obviously, the debt burden would escalate to the point where the federal government would have to borrow money to honor debt payments, the cycle of mounting debt that has bankrupted many a person, business, municipality, or nation.
The renewal of inflation in 2022 after a 40-year downtrend has upset even the best-laid plans of investors. With the possibility of higher rates of inflation in the long-run, the portfolio playbooks of the pre-COVID-19 eras must be reassessed.
Many shrewd investors are cautious, to put it mildly. Entire investment sectors could offer negative returns in the coming decades.
"If you buy a bond, you're locking in a negative real return. Cash is worse than that. Please do not look at your nominal returns and think that's safe, when that's not safe,” advises Ray Dalio, Bridgewater Associates founder, hedge fund manager.
Properly chosen equities, that will see incomes rise with inflation, may be one refuge in an inflationary era.
But likely the best bulwark against inflation and economic uncertainty will be select real estate assets that can generate rising rents, but upon which debts are fixed, that is they were purchased with a fixed-rate mortgage.
The owner of a property with regularly expiring leases can hope to roughly match rents to inflation, even as the relative size of the mortgage on the structure declines.
In addition, thanks to leverage, real estate returns are often amplified.
For example, setting aside transaction costs and taxes, the investor who puts 20% down on an apartment building, and watches the apartment building double in nominal value, does not merely double his money, but rather gets a 500% nominal return on equity. Even assuming 100% inflation in the holding period, that results in a 250% return.
So, for property investors who select real estate carefully, and structure leases accordingly, some inflation, even double-digit inflation, can be tolerated or even utilized.
In 2021, as inflationary pressures mounted, both residential and commercial property performed superbly, more than protecting investors against higher prices. Commercial property prices in the U.S. rose by an average of 21% in 2021, reported Green Street Advisors.
To be sure, much higher interest rates might place a damper on real estate inflation. But as explained above, the Federal Reserve is operating under unusual duress, including the fact that the U.S. government is heavily indebted, and much of the private sector has leveraged up beyond recent norms.
These realities likely will compromise the nation’s central bank, meaning the Federal Reserve will have to tolerate lower interest rates and higher inflation rates than the ideal.
While macroeconomic outlooks are always uncertain, in recent years the risk has shifted from deflation to inflation across most of the world, alongside greater uncertainties regarding real economic expansion.
The COVID-19 pandemic was not planned for, and fiscal and monetary policies were subsequently made under great stress, and without a playbook. In hindsight, stimulus was excessive.
Of all investment categories, hard assets like real estate are likely the best-positioned to hold value in an inflationary era. With luck, property buyers can even “utilize” inflation to magnify returns, as real estate values and rents increase, but the relative debt burdens decline with inflation.
Few investors look forward to an era of higher inflation or economic dislocation. But a diversified portfolio that anticipates the inevitable, heavy in real estate assets, can expose investors to plenty of upside while protecting the downside.
Casey leads the investor relations team at Rising Realty Partners and is responsible for growing the community of accredited investors, fostering investor engagement, and raising capital.