[This blog post is an excerpt from a TSI commentary published on 9th May 2021]

The major trends in monetary inflation result in a boom-bust cycle. In particular, a rising trend in the money-supply growth rate leads to increased consumption and investment spending, ushering-in the boom phase of the cycle. A subsequent decline in the rate of money-supply growth reveals the investing errors of the boom and leads to a liquidation process, which is the bust phase of the cycle. In other words, monetary inflation causes the boom and the boom causes the bust.

Once a boom is set in motion by creating lots of money out of nothing, a painful bust that eliminates all or most the boom’s apparent gains is inevitable. The only question is the timing. Even if the central bank tries to keep the boom going forever by maintaining a rapid pace of money-supply growth, all it will do is set the scene for the eventual bust to involve hyperinflation and a total economic breakdown.

Unfortunately, the timing question can’t be answered well in advance of the start of the boom-to-bust transition. However, there are indicators that usually generate warning signals early enough to be useful. Two such signals are credit spreads and the gold/commodity ratio.

When a boom is in progress, credit spreads are relatively narrow or in a narrowing trend and gold is relatively cheap or in a cheapening trend. As evidenced by the following chart, that’s exactly what has been happening over the past 13 months and especially over the past 6 months (the black line on the chart is a credit-spread indicator and the yellow line on the chart is the gold/commodity ratio). Furthermore, although gold has done well in US$ terms since late-March and ended last week at a 2-month high, relative to commodities (as represented by the GSCI Spot Commodity Index – GNX) it tested its 12-month low last week. With credit spreads near their narrowest levels in more than 12 months, this makes sense. It means that the US boom is intact.

When the boom is close to its end the gold/commodity ratio should start trending upward and credit spreads should start widening.

In an article at the TSI Blog in May of last year we explained why the US economic rebound from the H1-2020 plunge into recession probably would look like a ‘V’. Our conclusion at that time was: “There will be a ‘V’ shaped recovery, but due to the destruction of real wealth stemming from the lockdowns the rising part of the V is bound to be much shorter than the declining part of the V. This will lead to a general realisation that life for the majority of people will be far more difficult in the future than it was over the preceding few years.” This assessment was close to the mark, but not totally correct.

During the few months after we posted the above-linked article at the TSI Blog our views regarding the likely strength and longevity of the economic rebound — as outlined in TSI commentaries — shifted. Specifically, in commentaries published at TSI between June and November of last year we began to anticipate a longer rebound with an acceleration of economic activity during the first half of 2021. This was due to a) the central bank’s promise to maintain accommodative monetary conditions for years despite the emerging evidence of an “inflation” problem, b) the eagerness of the US federal government to continue showering the populace with money, c) the expected natural release of pent-up demand as COVID-related restrictions were removed and d) the likelihood of the US government approving a multi-trillion-dollar infrastructure spending program regardless of the November-2020 election outcome. Due to this combination of factors, a full ‘V’ recovery has occurred when measured in GDP terms. This is illustrated by the following chart.

The GDP rebound does not reflect sustainable progress. Due to the way that GDP is calculated, a dollar of counterproductive spending is the same as a dollar of productive spending. For example, if the government pays people to dig holes in the middle of nowhere and then fill them in, the payments will add to GDP even though the process wastes resources and adds nothing to the economy-wide pool of wealth. Over the past 12 months there has been a lot of counterproductive spending.

The popular economic indicator called “GDP” actually reflects money-supply growth more than it reflects economic progress. By simultaneously giving the money supply a hefty boost and pretending that the purchasing power of money is essentially unchanged, the impression can be created that the economy is moving ahead in leaps and bounds while the total amount of real wealth actually shrinks.

When speculating and investing, however, it’s important to take advantage of the artificial boom and not fritter away your personal wealth betting against the monetary tide. Such bets will become appropriate at some point (as determined by various leading indicators), but they haven’t been appropriate over the past six months and they are not appropriate today.

[This blog post is an excerpt from a report published at the TSI website on 25th April]

The US stock market was reminded last Thursday that the Biden Administration plans to increase taxes to cover part of the cost of its spending proposals. This caused a pullback in the S&P500 Index (SPX) that lasted only a few hours. The next day the tax risk was forgotten and a marginal new all-time high was recorded. Does this mean that the stock market is immune to higher taxes?

Before we answer the above question it’s worth pointing out that there always will be a substantial economic cost to a substantial increase in government spending, regardless of the method used to pay for the spending. Of the three possible payment methods an increase in taxes is probably the most honest, because it’s the method that makes the cost of the spending most obvious to everyone.

Another method of paying for an increase in government spending involves adding to the government debt pile via the sale of bonds to the private sector. As discussed in a TSI blog post last week, the main cost associated with this method is the transfer of private-sector investment to government spending.

In essence, when taxes are hiked to pay for increased government spending then the cost to the economy is a reduction in private-sector income, whereas when debt is used to pay for increased government spending then the cost to the economy is a reduction in private-sector investment. Both methods will hinder economic progress.

The third method is to use “inflation”, a.k.a. “financial repression”, to pay for the spending. This is what happens when the central bank monetises the bulk of the debt issued by the government to finance an increase in its spending. In effect, the real value of the debt is lessened over time by depreciating the money in which the debt is denominated. This causes a reduction in average living standards due to an increase in the cost of living relative to wages. It also magnifies economic inequality because it hurts the asset-poor to a far greater extent than it hurts the asset-rich. In fact, the asset-rich often profit from the debt monetisation process.

Returning to the question we posed in the opening paragraph, higher taxes or the risk of higher taxes could be the ‘excuse’ for the intermediate-term stock market correction we think will happen during the second half of this year. However, we doubt that tax increases will reverse the market’s long-term trend. The reason is that the long-term upward trend in nominal equity prices is driven by the Fed’s idiotic belief that currency depreciation is helpful and the relentless flow of money into “passive” investment vehicles.

The most likely cause of a long-term trend reversal in the stock market is the general belief taking hold that inflation is “public enemy number one”. Until that happens, every substantial decline in the US stock market will be met with a flood of new money courtesy of the Fed.

Current government debt loads will never be paid off. Instead, new debt will replace expiring old debt. Also, new debt will be issued to pay the interest on existing debt and to finance increased government spending, thus ensuring that the total debt pile continues to grow. At a superficial level it therefore seems as if government debt is neither a cost that will be borne by the current generation of taxpayers nor a cost that will be borne by future generations. After all, how could a debt that no one will ever have to repay be a genuine financial burden?

The mistake that most people make is to assume that the main cost of government debt is associated with the obligation to repay. This assumption leads to the conclusion that if for all practical purposes there never will be a requirement to pay off or even to pay down the debt, then the debt effectively is costless and there really is such a thing as a free lunch. However, the assumption is wrong.

If government debt is purchased by the private sector, then the main cost is actually immediate and is due to the transfer of private-sector investment to government spending. For example, money that would have been invested in building businesses that add to the wealth of the economy is diverted to government programs. In general, politically-motivated spending does not add to the economy-wide pool of wealth. In fact, it often does the opposite.

To put it more succinctly, adding to the government’s debt converts one form of spending, the bulk of which would have been productive in a relatively free economy, to a different form of spending, the bulk of which will be unproductive.

But what if government debt were purchased by the central bank using money created out of nothing? According to MMT, such debt would be costless as long as there was sufficient slack in the economy (as determined by “inflation” statistics).

In this case the cost of the debt is not immediate. In fact, when an increase in government spending is financed via the creation of new money the short- and intermediate-term effects usually will be positive, with the costs only becoming apparent years later in the form of busted bubbles, major recessions and slower long-term economic progress. The most important costs of such policy stem from the falsification of prices caused by the injection of the new money. Many of the investments that are made in response to these misleading price signals turn out to be of the “mal” variety and end up being liquidated.

Summing up, the main cost of government debt has very little to do with the future repayment obligation it implies. If the debt is purchased by the private sector using existing money then the most important cost is an immediate reduction in productive investment, whereas if the debt is financed via monetary inflation then the most important cost will be a long-term reduction in economic progress due to the mal-investment incentivised by the new money.