The Breakdown - Why Economic Wars Are Inflationary

Starting point is 00:00:00 Welcome back to The Breakdown with me, NLW. It's a daily podcast on macro, Bitcoin, and the big picture power shifts remaking our world. The breakdown is sponsored by nexus.com, and FTCS, and produced and distributed by CoinDesk. What's going on, guys? It is Sunday, August 14th, and that means it's time for Long Read Sunday. Before we get into that, however, if you are enjoying the breakdown, please go subscribe to it, give it a rating, give it a review, or if you want to to dig deeper into the conversation. Come join us on the Breakers Discord. You can find a link in the show notes or go to bit.ly slash breakdown pod. Also a disclosure as always. In addition to them being a sponsor of the show, I also work with FTX. And finally, this week, I am thrilled to have NIR as an additional

Starting point is 00:00:51 sponsor. Near is a revolutionary yet simple Web3 platform for building decentralized apps. Designed by developers for developers, over 700 projects are now building on NIR's fast, secure and scalable protocol. Whether you're a crypto-native launching defy apps, NFT marketplaces, or play and earn games, or looking to migrate your project from Web 2, NIR makes it easy to build Web3 for the masses. Neer offers developers a variety of tools, resources, and support for building apps, empowering communities, and creating a more fair, inclusive, and equitable future. Start your Web3 developer journey now by visiting neer at neer.org. All right, guys, so for this Longreed Sunday, we are

Starting point is 00:01:31 staying in the realm of the geopolitical and the macro, but doing something a little bit different. Zoltan Pozar is one of the most followed thinkers in macro. Currently, he's at Credit Suisse. On August 1st, he published a massive note called War and Interest Rates. Instead of reading the whole thing, which is very long, I'll be excerpting some key passages. First, the setup and the question underneath the whole piece. Zoltan's question comes from his meetings with hundreds of clients across Europe. The broad sense that they have, he argues, is that inflation is about to peak, and that because of that we are near peak hawkishness from central banks as well. His concern is that this view

Starting point is 00:02:09 doesn't properly take into account geopolitical risk premia. Quote, the risk with this view is that it assumes a stable world with no geopolitical risk premium, where demand management is more powerful than issues related to supply, when in fact we live in an unstable world where geopolitical risk premium are rising, and where supply-side issuers are more powerful than demand management. Zoltan's goal then with the peace is to highlight risks to this peak hawkishness view. So let's turn now to the background. Quote, the low-inflation world stood on three pillars. First, cheap immigrant labor keeping service sector wages stagnant in the U.S.,

Starting point is 00:02:47 second, cheap goods from China raising living standards amid stagnant wages, and third, cheap Russian gas powering German industry and the EU more broadly. U.S. consumers were soaking up all the cheap stuff the world had to offer. The asset rich, benefiting from decades of QE, bought high-end stuff from Europe produced using cheap Russian gas, and lower-income households bought all the cheap stuff coming from China. All this has worked for decades until nativism, protectionism, and geopolitics destabilized the low-inflation world. President Trump's immigration policies to appease nativists has cost the U.S. 2 million jobs,

Starting point is 00:03:22 which is driving the current labor shortages and wage pressures. COVID-19 changed labor markets further. Early retirements and other changes have exacerbated the labor shortages and increased wage pressures further. President Trump's hardline approach to China became a bipartisan stance that drove the imposition of protectionist tariffs on China, and what started as a trade war became a technology war. The U.S. went from tariffs on cheap goods to banning ASML from selling state-of-the-art lithography machines to China to ensure the balance of technological power remains in U.S. hands. President Xi's zero COVID policy continues to frustrate the flow of cheap goods, causing occasional cardiac arrests in global supply chains and backlogs at ports. Trade and economic relations between the U.S. and China became inflationary, in contrast to previous decades where U.S.-China relations were deflationary.

Starting point is 00:04:10 President Putin's efforts to make Europe dependent on cheap Russian gas in order to tip the balance of economic power in Europe away from the U.S. were frustrated by the U.S. sanctioning Nord Stream 2 last November, And President Putin's frustration with the shifting balance of military power in Europe, NATO, then spilled over into a hot war in Ukraine on February 24th, which supercharged the economic war. Both sides went nuclear quickly, economically speaking. The U.S. weaponized the U.S. dollar and then Russia weaponized commodities. All of this, Soltan says, leads to the new reality, the war economy, where heads of states matter more than heads of central banks.

Starting point is 00:04:46 Within this framework, the policy objectives themselves are changing. quote, central banks went from waging a war against deflationary impulses coming from the globalization of cheap resources, labor, goods, and commodities, to cleaning up the inflationary impulses coming from a complex economic war. Think of the economic war between the U.S., China, and Russia as something that will weaken the pillars of the globalized low-inflation world described before. The process will be slow, not sudden, but it will be certain, where ongoing economic tits for tats will have the potential to drive more and more inflation. Think of the economic war as a fight between the consumer-driven West, where the level of demand has been maximized, and the production-driven

Starting point is 00:05:24 east, where the level of supply has been maximized to serve the needs of the West, until East-West relations soured and supplies snapped back. If you see the special relationship between China and Russia in this context, you can see it as an alliance of resources that supplies the necessities the West needs to ensure social stability at lower ends of the income distribution. Think of Russia as a global, systematically important bank of commodities, and China as a global, systematically important bank of factories. That are the world's biggest producers of commodities and consumer goods respectively, providing two pillars of the low inflation world we described above. By extension, Russia and China have been the main guarantors of macro peace, providing all the cheap stuff that was

Starting point is 00:06:02 the source of deflation fears in the West, which in turn gave central banks the license for years of money printing or QE. But now that the pillars of the low inflation world are changing, central banks are done with fighting deflation with asset price inflation and are now fighting inflation with asset price deflation. Central banks are adapting to a world that's gone from having too much stuff and not enough demand, to a world that has not enough stuff and too much demand. Today's inflation is more about supply and less about demand, and is more about geopolitics than domestic politics. In times like these, security of your assets should be your number one priority. If you want to offset risk as much as possible and still stay in crypto, you need a

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Starting point is 00:08:30 respectively the global balance of power in three domains. The military domain, the technology domain, and lastly the production domain, which links commodity producers, production facilities, and shipping companies in the East to consumers in the West through a complex web of supply chains. If we're right that the economic war is the right context to understand inflation, then Western Central banks will not have any good options to slay inflation. They can surely reduce demand by raising rates, but what if supply curves shift inward faster than demand curves? The market doesn't think much about that. And then we get to maybe the most important line in the entire piece, the line that sums it all up. Quote, the unfolding economic war between great powers is

Starting point is 00:09:09 stochastic and not linear, and what inflation will do in the future does not only depend on the shocks that occurred in the recent past, but also on the many shocks that can happen still. These include more sanctions in the further weaponization of commodities, and more technology sanctions and further supply chain issues for cheap goods. Getting right where inflation goes from here is basically a matter of perspective. Do you see inflation as cyclical, a messy reopening after COVID, exacerbated by excessive stimulus, or structural, a messy transition to a multipolar world order, where two great powers are challenging the might and hegemony of the U.S. If the former inflation has peaked.

Starting point is 00:09:46 If the latter, inflation has barely started and could actually be understood as an outright instrument of war. For as Lenin said, the best way to stabilize the capitalist system is to debase the currency. Today, it's time to think about the risk of inflation staying higher for longer due to economic warfare and less about inflation being driven by a messy reopening process and stimulus. What then about the inflation that we have? Sultan goes on. Today's inflation is mostly a story about the revenge of headline inflation, combined with an

Starting point is 00:10:16 extremely tight labor market in the service sector in the U.S. and the developed Westmore generally. The tightness of the labor market is the result of protectionist immigration policies in the U.S. or Brexit in the U.K., and early retirements and much less global labor mobility due to the pandemic, and the revenge of food and energy prices is the result of the war in Ukraine. After decades of neglect, food and energy prices can't be stripped out to focus only on core inflation. Food and energy prices, basic everyday necessities, are especially dangerous in a structurally tight labor market. As workers demand higher wages, not when discretionary items like TV screens and cars cost more, but when necessities cost more. Inflation today is simply

Starting point is 00:10:55 everywhere. It's plain impossible to talk to anyone who doesn't complain about rising prices, or to read the financial press without articles about inflation. It's also impossible to have a client meeting where inflation is not the center of discussion. So what is to be done? So what is to be done. Simply more of the Volcker-esque inflation breaking interest rates of the 1970s, right? Not necessarily, says Pozar. Quote, perhaps the most unsettling parallel to the 1970s and early 1980s is the feds and the market's assumption that all it will take to break inflation is hiking interest rates with the resolve and determination of Chair Paul Volker.

Starting point is 00:11:28 Paul Volker is no doubt responsible for the deep recession of the early 1980s. But we shouldn't assume that rate hikes in a recession are all that are needed to weed inflation from the system. Recessions can help but may not be enough, especially if Ray Dalio and Larry Finker right and we are headed for stagflation, i.e. an environment where inflation is persistent, whether there is growth or not. Zoltan points out that there were two additional things that helped Volker. First, billions of dollars that went into the development of new energy projects in the late 1970s that led to the collapse of oil prices in the early 1980s, and second, Reagan firing air traffic controllers who went on strike, which Zoltan argues killed the institutional practice of linking

Starting point is 00:12:06 wage increases to the rate of inflation. In this way, our moment is very different. We've just completed a decade of very little investment in oil, in part because we had been turning away because of ESG, and second, because short-cutting a wage price spiral isn't just about political will. Quote, we have a bigger problem, a shortage of labor, particularly in services, which is due to a mix of factors such as tougher immigration policies to appease nativists, early retirements and labor market changes driven by the pandemic, and extreme wealth gains sapping labor force participation on the one hand, feel rich work less, and driving demand for services on the other, feel rich, spend more. It's a mess. It's easier to deal with the politics of wage setting that

Starting point is 00:12:45 it is to grow people, even in the matrix that's possible only over time. Until then, we are stuck with a labor shortage, and President Biden's top labor lawyer is the anti-Ragan. She's encouraging the unionization of workers from Amazon to Starbucks. Now, when it comes to what the Fed needs to do, Zoltan thinks that the discourse is off. Quote, The market's recession slash no recession soul-searching is ridiculous. If the inward shift to supply curves across multiple fronts, labor, goods, and commodities is the main driver of today's inflation. If demand needs to be curved significantly to slow inflation, and if a substantial

Starting point is 00:13:19 reduction of aggregate demand means an L-shaped path for the economy, why is it so bloody hard to see that we need a recession to curb inflation? Instead of the question of whether, why don't we think about the depth of the recession needed to curb inflation. The market can talk all at once about a soft landing, but as explained above, we need an L-shaped adjustment in activity, and an L-shaped has two parts. The first part, which you can think of as a vertical drop, perhaps a deep recession, second, a part which you can think of as a flat line, stagnation as in stagflation. Zoltan wraps by basically arguing that the Fed pivot is wishful thinking. Quote, once you go down the path of invoking Paul Volker's legacy, you can't avoid making good on that

Starting point is 00:13:58 promise. If you do, you damage the Fed's reputation irreparably. The risks are such that Powell will try his very best to curb inflation, even at the cost of a depression, and not getting reappointed. Between a deep recession and damaging the Fed's reputation as an institution, the deep recession is the lesser of two evils. The former is public service. The latter is public disservice. The former is a central banker's clear conscience. The latter is a lifelong burden. So I'm going to wrap there. I highly recommend that you read the whole piece. Hold aside all the specifics. The question at the center of it is basically what if we're thinking about inflation in all the wrong ways? And that instead of this inflation comporting

Starting point is 00:14:41 to an old cycle, this is actually the beginning of a very new cycle, where what is driving inflation and what can cause inflation in the future comes from a very different set of factors. I think I probably run the risk of over ascribing things to larger geopolitical contexts versus some of these more cyclical factors. But I think given how little that's the discussion in mainstream financial discourse, it's worth spending some time with the argument. Anyways, guys, a lot of food for thought on this Longreed Sunday. For now, I want to say thanks again to my sponsors, nexus.com.com.

Starting point is 00:15:15 Chainalysis, FTX, and NIR. And thanks to you guys for listening. Until tomorrow, be safe and take care of each other. Peace.

The Breakdown - Why Economic Wars Are Inflationary

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