Inflation, Money And Supply Bottlenecks

“The constant refinancing of debt from companies of doubtful viability also leads to the perpetuation of overcapacity because a key process for economic progress, such as creative destruction, is eliminated or limited”.

Inflation, Money And Supply Bottlenecks

One of the arguments most used by central banks regarding the increase in inflation is that it is because of bottlenecks and that the recovery in demand has created tensions in the supply chain. However, the evidence shows us that most commodities have risen in tandem in an environment of a wide level of spare capacity and even overcapacity.

If we analyse the utilization ratio of industrial and manufacturing productive capacity, we see that countries such as Russia (61%) or India (66%) are at a clear level of structural overcapacity and a utilization of productive capacity that remains still several points lower than that of February 2020. In China it is 77%, still far from the 78% pre-pandemic level. In fact, if we analyse the main G20 countries and the largest industrial and commodity suppliers in the world, we see that none of them have levels of utilization of productive capacity higher than 85%. There is ample available capacity all over the world.

Inflation is not a transport chain problem either. The excess capacity in the shipping and transport sector is more than documented and in 2020 new capacity was added in both freights and air transport. Ships delivered in 2020 added 1.2 million twenty-foot equivalent units (TEUs) of capacity, with 569,000 TEUs of capacity on ultra large container vessels (ULCV), ships with capacity for more than 18,000 TEUs, according to Drewry, a shipping consulting firm. International Air Transport Association (IATA) chief economist Brian Pearce also warned that the problem of capacity was increasing in calendar year 2020.

One of the important side effects of the chain of monetary stimuli, low interest rates and fiscal stimulus programs is the increase in the number of zombie companies. The BIS (Bank for International Settlements) has shown this phenomenon in several empirical studies. Ryan Banerjee, senior economist at the BIS, identified the constant policy of lowering rates as a key factor in understanding the exponential increase in zombie companies, those that cannot cover their debt interest bills with operating profits. The constant refinancing of debt from zombie companies also leads to the perpetuation of overcapacity, because a key process for economic progress, such as creative destruction, is eliminated or limited. Low interest rates and high liquidity have perpetuated or increased global installed excess capacity in aluminium, iron ore, oil, natural gas, soybeans and many other commodities.

Why does inflation rise if overcapacity is perpetuated and there is enough transport capacity?

We have forgotten the most important factor, the monetary one, or some central banks want to make us forget it. “Inflation is always and everywhere a monetary phenomenon,” explained Milton Friedman many decades ago. More supply of money directed towards scarce assets, be it real estate or raw materials. The purchasing power of money goes down.

Why did they tell us that there was “no inflation” before COVID-19 if money supply increased also massively?

The big difference between 2020 and the past years is that previously, the Federal Reserve or the ECB increased money supply at or below the levels of demand for money (measured as demand for credit and use of currency). For example, the increase in the money supply of the United States was close to 6% with a global demand for dollars that grew between 7 and 9%. In fact, the world maintains a dollar shortage of about $ 17 trillion, according to Luke Gromen of Forest for the Trees. This keeps the dollar or euro relatively stable and a perception that inflation is low. However, there were red flags before Covid-19. There were protests all over the world, including Europe, against the rising cost of living. The world’s reserve currencies export inflation to other countries.

What happened in 2020?

For the first time in decades, the Federal Reserve, and the main central banks increased money supply well above demand. The response to the forced shutdown of activity with massive money printing generated an unprecedented inflationary wave. The economy did not collapse due to lack of liquidity or a credit crunch, but due to the lockdowns.

The 2020 monetary tsunami launched a global boomerang effect with three consequences: Emerging market currencies plummeted against the dollar because their central banks “copied” the U.S. policy without the global demand that the U.S. dollar enjoys. The second effect was a disproportionate amount of money flowing to risky assets joined by more flows to take overweight positions in scarce assets. That excess money made investors move from being underweight in commodities to overweight, generating a synchronized and abrupt rally. The third key factor is that extraordinary measures typical of a financial or demand crisis were taken to mitigate a supply shock, generating an unprecedented rise in money with no added credit demand. More money in scarce assets is not a price increase, but a decrease in the purchasing power of money.

What is the risk?

The history of money since the Roman Empire always tells us the same thing. First, money is aggressively printed with the excuse that “there is no inflation.” When inflation rises, central banks and governments tell us that it is “transitory” or due to “multi-casual” effects. And when it shoots up, governments present themselves as the “solution” imposing price controls and restrictive measures on exports. It is not a theory. All of us who have lived in the seventies know it.

That is why it is dangerous to pursue conglomerate stocks as an inflationary bet… Because when price controls and government intervention increases, margins collapse.

The risk of stagflation is not small, and the so-called value stocks are not a good bet in this environment. In stagflation, commodities with tight supply dynamics, gold and silver, high margin sectors and bonds of stable currencies support a portfolio. However, most sectors underperform as we saw in the 70s, where the S&P 500 generated very weak returns, significantly below inflation.

What can be different from other episodes?

Only a drastic reaction from central banks can change it. However, the question is: Will central banks tighten policy when government deficits are soaring and even a small increase in sovereign yields can generate a debt crisis?

Will they react to what is clearly — as always — a monetary inflationary process?

About Daniel Lacalle

Daniel Lacalle (Madrid, 1967). PhD Economist and Fund Manager. Author of bestsellers "Life In The Financial Markets" and "The Energy World Is Flat" as well as "Escape From the Central Bank Trap". Daniel Lacalle (Madrid, 1967). PhD Economist and Fund Manager. Frequent collaborator with CNBC, Bloomberg, CNN, Hedgeye, Epoch Times, Mises Institute, BBN Times, Wall Street Journal, El Español, A3 Media and 13TV. Holds the CIIA (Certified International Investment Analyst) and masters in Economic Investigation and IESE.

6 thoughts on “Inflation, Money And Supply Bottlenecks

  1. Esa noticia de que el Ayuntamiento de Madrid tiene un proyecto que apuesta por la industria en 5 años, ¿ qué significa?, ¿bajada de impuestos, desregularización?

  2. In reaction to your writing I asked myself when the FED prints trillions of dollars over the last 5 years atleast their should be inflation now.
    Why is it that there is no inflation as expected?
    Maybe Milton Friedman was wright about the increase in us$ by the FED which results in decreasing purchasing power of the us$.
    However inflation is not what we see now maybe later on when the velocity of money changes.
    However I think the FED cannot accomplish that with their current models.
    For velosity of money is not a FED driven situation but more so a psychological phenomenon.
    Thank you for your weekly very informative writings.

    1. Inflation is there, ad it is pretty evident. Cumulative inflation in the U.S. since 2000 is 52%.

      Inflation is generated when money growth is higher than money demand and it is very evident now. Before we saw massive inflation in financial assets as well.

  3. Double checking the date of your post, I can just only point an update and the little underestimation in your analysis of the side effect of a supereactivation (as seen on unprecedented GDP growth in the short term) of the economy due to monetary stimulus with a large effect on the demand of consumption due to the direct injection of money through checks. This is the reason I belive from my analysis that has made the FED to belive, or the argument they are using now, to be more realistic, to tell us it is transitory. The effects of a large demand would have made a “transitory” Inflation that now should be getting adjusted as the economy slows down, but is not and it won’t. This is not just an injection of money to the asset classes like the FED did in the past. You have made a good analysis pointing out the commodity side effect, as one of many other’s to to take into consideration for a structural and long term inflation.

    Thanks for your analysis and work Daniel!

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