Stagflation Is Back

As I have explained recently, inflation is here in both consumer and producer prices. I have also pointed to the low employment level: if we had the same share of the population working as we had this time in 2019, another 5.6 million Americans would be working today.

That would make a major impact on government finances, state as well as federal:*

  • If 5,662,000 unemployed stop collecting an average of $525 in weekly benefits; and
  • If the total taxable economic value they produce is worth $66,450 per year; then
  • The total gain from reduced costs of benefits and increased federal and state tax revenue would equal $305 billion per year.

This estimate is a static, fiscal calculation and does not include multiplier effects from increased consumer spending. It is also based on a straightforward assumption that the total taxes on the added economic value equal ten percent of that value. In reality, the static fiscal gains are likely to be higher, and dynamic gains – factoring in the multiplier effects – much higher.

Sadly, we are not going to see this gain in employment any time soon. The Biden administration and the Democrat majority in Congress seem to be deadset on adding more deficit spending to an already unsustainable budget. There is some resistance from the Republican side, but with the exception of Senator Lummis (R-WY) and a few others, that resistance is not as vocal and as substantive as it needs to be.

Instead of moving back toward the full employment we had in 2019, we are going in the opposite direction. As inflation rises, it has increasingly negative effects on business activity. Costs of production and investment will rise, throwing a wet blanket over capital formation; optimism about the future is gradually perforated by pessimism. As businesses change focus from expansion to survival under higher and less predictable costs, they gradually shift from creating more jobs to making do with the workforce they have.

The significantly slower pace of jobs growth in August and September suggests that we have already reached this point. What comes next is a decline in employment. And this, I am sad to say, is the really worrying part of the story: when inflation is high and unemployment on the rise, we have stagflation.

Figure 1 explains the relationship between unemployment and inflation, but in terms that are more solidly anchored in economic reality. Instead of unemployment, I have used the rate of employment, or the number of employed persons out of every 100 people in the workforce-age population. This is a more accurate gauge of the state of economic activity: when the economy gets really bad, a lot of unemployed simply leave the workforce. Bluntly, we can have a relatively low rate of unemployment and still be in the midst of a serious recession.

On the side of inflation I have replaced consumer prices with producer prices. This variable more accurately represents the information set upon which businesses make employment decisions; the higher the inflation rate in producer prices, the less inclined businesses are to hire more people.

Figure 1 reports a total of 885 pairs of data for these variables. They cover every month from 1948 through September 2021; sorting the observations based on PPI inflation (red) we can identify three interesting correlative segments:

Figure 1

Source of raw data: Bureau of Labor Statistics

Starting from the right, there are periods of economic activity that combine declining producer prices with a rising employment share. These periods are usually connected with strong growth in labor productivity and the incorporation of new technology into manufacturing and the production of services. They can also be driven by expanded competition on growing markets.

The mid-section of Figure 1 represents the “normal” state of affairs in a business cycle: rising employment is associated with growth in total absorption – spending by consumers and businesses – leading to upward pressure on prices; when total absorption weakens, so do price pressure and employment.

The left section, of course, is where our focus should be. When inflation surges and employment weakens, we have the exact opposite of a sound business cycle. We have stagflation.

In the set of data I used to produce Figure 1, there are approximately 100 months that solidly fall within the stagflation section, and approximately another 100 on its outskirts. We have only had one significant experience with stagflation, but the number of months it covers tells us that once stagflation shows up, it will stick around for a while.

Figure 2 reports data similar to that in Figure 1, but chronologically. It also replaces the employment ratio with unemployment, in order to make the time line more familiar to students of economic trends. Behold five distinct periods and how they sort into the three categories in Figure 1 (PPI is measured on the left vertical axis):

Figure 2

  1. This is the growth phase of a regular business cycle, with a slow increase in the PPI inflation rate and steadily declining unemployment.
  2. Stagflation. The usual definition of this period of time is that it began after the first oil crisis in 1973-74. However, there were signs of stagflation-style turmoil already in the early ’70s. Note also how unemployment does not rise steadily, but ratchets upward over an extended period of time. This is a sign of underlying structural problems in the economy, much like we have today.
  3. This is a leap-style growth period where inflation declines together with unemployment. Normally, a historic review of macroeconomic data from the 1980s and ’90s would separate these two decades, but they have so much in common that it makes sense to see them as one long phase of leap-style growth: deregulation and a major overall of the tax code in the 1980s; the big computer-based technological revolution in the 1990s.
  4. A shorter period than the previous, this is again a traditional growth period with gradually higher inflation as the economy increases its capacity utilization. Although the internet evolution continued, it did not have the fundamental growth effect that the ’90s tech revolution had; the Bush tax reform did not come close to the macroeconomic impact that the Reagan reform had.
  5. This is the tepid recovery from the Great Recession, which we sort under the “regular business cycle” category.

If stagflation sets root – and everything points to it doing so – we are likely going to be stuck with it for a number of years. Our ability to get out of it will depend on the presence of fiscal conservatism and political courage on Capitol Hill.

Not a very comforting thought, is it…?


*) The numbers used here are based on averages for each variable, estimated from most recently available data from the Bureau of Economic Analysis (income, value added, government finance) and Bureau of Labor Statistics (employment).

Inflation Update: Producer Prices

Yesterday I explained that consumer-price inflation is not showing any signs of tapering off. On the contrary: it is showing signs of already being entrenched in the U.S. economy. Unlike the nonsense that some economists put out there about inflation being good for the economy, the fact of the matter is that inflation above the two-percent that is consistent with advances in the standard of living is always bad.* The higher inflation gets, the worse it is for the economy.

I also noted that inflation today is way above where it was two years ago, when the economy was operating at the peak of its capacity. Today, only 58.8 percent of the workforce-age population is employed, compared to 61 percent at this time in 2019. The difference does not sound like much, but it is: if we had been at 61 percent employment rate in September this year, another 5,651,000 Americans would have been working today.

This is like getting the entire workforce of Ohio off tax-paid benefits and into paying taxes.

Unfortunately, we are not going to see that happen any time soon. Inflation gradually erodes the confidence that businesses need in order to invest and create new jobs. It also weakens household confidence in the future, with rising costs of daily living prohibiting families from taking on new mortgages, car loans or other debt. This in turn weakens consumption of, among other things, consumer durables, the production of which has significant multiplier effects throughout the economy.

One of the strongest signs that inflation is entrenching itself is the persistent trend of rapid increases in producer prices. In September, the Producer Price Index for commodities (not industries, which does not have an all-covering component) was up 20.4 percent over September last year. It was the sixth month in a row with 15+ percent PPI inflation.

It was also the first month since December 1974 that producer prices have risen at more than 20 percent in a month. In fairness, last year was anomalous due to government forcing a shutdown of large swaths of the economy. There are two other ways, however, to show just how high inflation is in producer prices, the first of which compares PPI to CPI. For the past eight months, producer prices have outpaced consumer prices by a factor of 3.9 to 1: for every one percent that consumer prices have increased, producer prices have gone up 3.9 percent.

This parity is steady and shows no signs of tapering off, which means that producer prices will work their way into consumer prices going forward. The other way to gauge the resiliency of inflation confirms point. We calculate price increases from year to date, i.e., how much prices had gone up in September compared to the start of the year. This measure, which has the advantage of eliminating distortionary effects from last year’s artificial economic shutdown, puts 2021 in grim historic light:

  • Of all the 99 years on record, from 1913 to date, 2021 is the fourth most inflationary;
  • Only 1917 (21.0 percent), 1946 (16.3) and 1933 (16.2) were worse, and 1974 is right behind with 14.1 percent.

Things look a tad better on the consumer inflation side, with 2021 having the 16th highest year-to-date inflation. However, it is ominous to see what years rank higher:

Table 1

Raw data: Bureau of Labor Statistics

Four of the five years of the 1970s stagflation episode had higher inflation year-to-date than we do.

To make this outlook even more frightening: the producer price inflation that accompanied CPI inflation back then did not even peak until 1979 – and it was lower back then. Figure 1 reports year-to-date PPI for 1977-1980 and for 2021:

Figure 1

Source of raw data: Bureau of Labor Statistics

In short: this is not over yet. Not by a long short.

Next up: a comparison of inflation and unemployment for 2021 and for the stagflation era. Stay tuned!


*) The two-percent inflation rate consistent with advancements in the standard of living is derived from an adaptation of Okun’s Law to consumer spending. I explain this adaptation in my book Industrial Poverty.

Inflation Update: Consumer Prices

Inflation is becoming a real problem for the U.S. economy, and – just as I have predicted – so long as Congress maintains its reckless fiscal policy, inflation will set roots, dig in and entrench itself. This will affect us all, and – contrary to what some pundits suggest – not for the better.

What is actually going on with inflation? Some say it’s the highest in 13 years, others, like the Western Journal, claim it’s at a 30-year high:

As measures of inflation hit a 30-year high, the Biden White House is abandoning its happy talk that inflation would be a short-term side effect of the economic recovery from COVID-19 restrictions. White House economic adviser Jared Bernstein told Fox Business that inflation will endure longer than the Biden administration had been saying. His current call is that annual inflation will end at about 4 percent this year and drop to 2.3 percent at some point in 2022. However, even Bernstein said there is no clear idea when in 2022 that might happen.

According to the CPI-U, the consumer price index that covers all consumer goods, the September annual inflation rate of 5.4 percent is the highest in 31 years. Back then, the U.S. economy was at the end of the Reagan growth period and the inflation we saw back then was so-called demand-pull inflation.

The 5.4-percent rate is based on raw CPI data, in other words not even seasonally adjusted. I try to avoid seasonal adjustments and other statistical trickeries, which are often aimed at smoothing trends to make them either look better or give a more purified long-term view of the economy. However, such technical adjustments of raw data always distance the statistical consumer from reality; rather than making things look good from an optical or analytical viewpoint, I prefer to remain as close to reality as we can get. That way I can guarantee accuracy to the highest possible degree in my analysis.

However, there are more important metrics for inflation than a simple year-to-year calculation. The first of those metrics is the year-to-date rise in prices. While the calendar year itself is only a technical construct to give us a measurement of time, in actuality it carries high symbolic value in the political and economic public discourse. For example, the year-to-year comparisons that have appeared in media are ultimately based on calendar year, even when they run the comparisons month to month.

Therefore, in order to track where inflation is heading this year, let us go back to the start of the year and see just how much prices – measured again as CPI-U – have increased thus far through 2021. Figure 1 compares this year to 2019, which was the last year of the Trump economy and the last year before the artificial economic shutdown. So far this year, consumer prices have increased by almost 4.9 percent; by this time in 2019 they had gone up by just two percent:

Figure 1

Source of raw data: Bureau of Labor Statistics

The scary part about the consumer price trend is that it shows inflation both being resilient and rising. We have five months in a row now with 5 percent or more annual inflation; by this time in 2019 we had seen only one month where inflation exceeded two percent (April). Furthermore, we have underlying inflation pressure from producer prices: in 1990, again the last year with sustained 5+ percent inflation, consumer prices rose at a pace 1.5 times producer prices; this year so far, producer prices have outpaced consumer prices by 3.8 to 1.

What does this tell us? that we have strong inflationary pressure from producer prices that has not yet worked its way into consumer prices. It is, in fact, the strongest such pressure in any non-recession year since at least 1980. Therefore, it is highly likely that we will see sustained inflation for a number of months going forward. Which, by the way, is why the Federal Reserve is now signaling a change of tone on inflation: after having talked about it as transitory for the better part of this year, they are now ready to admit that inflation is here to stay for some time.

Some people think this is good. One of them is economist Karl W Smith, formerly with the Tax Foundation, now a Bloomberg columnist. His latest contribution is an argument that higher inflation is a really good idea:

Analysts are concerned that the rise in inflation may be persistent because they see hints of a broader, gentler rise in prices across a range of goods — and, crucially, in the wages of the workers who produce those products. This increase in both wages and prices can lead to the dreaded wage-price spiral.

Not necessarily. There are a number of conditions that have to be met before that spiral gets moving. Most of the research that suggests the existence of this spiral is based on European economies with highly centralized, union-contract based wage negotiations. That does not mean the spiral does not exist in the U.S. economy, but it is far from as obviously a threat here as it is in, e.g., the Scandinavian countries. In fact, our decentralized wage setting structure allows for labor productivity to play a bigger role in mitigating the spiral than in unionized economies. The more productivity affects wages, the smaller the transmission from wage hikes to price hikes.

That does not mean inflation is not a threat to household finances. Inflation caused by bad fiscal and monetary policy lives its own life in the economy, a point that Smith seems to overlook when he says that because inflation

is shared by both households and businesses, the pain is muted. Indeed, a higher rate of inflation, and correspondingly higher wage growth, could be a net positive for the economy.

Nonsense. No inflation is “shared” by businesses. All inflation eventually trickles down to workers. One of the most sure-footed ways this happens is through the long-term effects of the very higher inflation rates that Smith advocates.

Sustained high inflation means more long-term uncertainty in business activities, especially investments. If inflation sustains at a high rate, it has a more upsetting effect on relative prices than if inflation is low. Bluntly: unless all prices rise at the same high pace, a high inflation rate creates larger “gaps” between prices throughout the operations of a business; every such gap injects uncertainty into business planning; the bigger compounded uncertainty is, the less inclined the business is to invest in the future of the business.

A decline in capital formation – even relative in the form of a slowed-down pace of investments – has a negative effect on labor productivity. This in turn weakens the actual support for wage hikes. If inflation stays high as productivity gains weaken, there will inevitably be a price to pay for workers in the form of declining real wages.

Or significantly higher unemployment. Or both.

Smith also makes the argument that higher inflation weakens the cost of debt:

A permanent increase in inflation from 2% (its average over the last decade) to 4% would cause interest rates to rise by roughly 2% as well, as lenders sought to protect themselves from rising prices. Economists describe this as a rise in nominal rates, because the net return from lending — the real interest rate after accounting for inflation — remains the same.

Smith is relying on the Keynes effect on real balances, and he has a point. However, it hinges on a balanced response in interest rates to higher inflation. Most prominently, Smith’s argument presupposes that the Federal Reserve does not roll back its monetary expansion as inflation rises. He might even be assuming that the sustained higher inflation is driven by a continuation of the Fed’s currently highly accommodative monetary policy.

The problem here is that to sustain inflation at the rates we already have, by means of expansionary monetary policy, is to play with inflationary fire. There is no more dangerous form of inflation than that which is driven by monetary expansion – it is not to be confused with supply-side inflation, which is what we saw 40 years ago. Furthermore, the monetary expansion becomes even more dangerous when it is directly linked to fiscal policy:

  • When the purpose of that monetary expansion is to fund a government deficit, and
  • When that deficit is used to pay for entitlements that are to a large degree inflation indexed,

you have an inflationary death spiral going in the economy.

I am not saying that Karl Smith actually proposes monetary expansion to drive U.S. inflation, but he also does not refute the idea. But where else would he get the sustained, higher inflation he wants? As a rare voice for higher inflation, he might want to clarify the macroeconomic context of his pro-inflation argument, because it is a safe bet that he will soon have others on his side. There are a lot of Democrat politicians and pundits out there who would love to find a way to defeat the inflation argument against more deficit spending.

Inflation is a reality in the U.S. economy. It cannot ge higher without causing long-term harm; it is already at a level where it can change economic behavior for the worse.

At the core of the inflation problem we have the Democrats’ desire to spend endless amounts of money by means of monetized deficits. This makes it particularly difficult to fight to keep inflation out of the economy, yet precisely because of the grave dangers associated with ongoing monetized budget deficits, we absolutely need to continue that fight.

Fed Chair Powell Is America’s Last Hope

We are getting close to the point where the Federal Reserve will start the draw-down of its very expansionary monetary policy. It should start in November, probably right after the next meeting with the Federal Open Market Committee.

We are also getting close to the point where President Biden needs to make a decision on whether or not to reappoint Jerome Powell as the chairman of the Federal Reserve.

Pray to God that he does. At this point, America’s economic survival may very well hinge on his continuation at the helm of the central bank.

The left is putting pressure on the president – and his entire administration – not to reappoint Powell. They know that if Powell starts rolling back the current monetary expansion, the Democrats in Congress will not be able to roll out their absolutely reckless expansion of the welfare state. Putting ideology over the very economic survival of America, they want to convert the Federal Reserve from an independent central bank into a de facto extended arm of the U.S. Treasury.

It’s also known as MMT, Mad Monetary Theory.

The leftist pressure is not only coming from the far left in Congress, but is also mounting in mainstream media. Its most obvious form so far has been their abnormal outcry over the September jobs numbers. The Washington Post cries a river while MSN suggests:

The weak September jobs report offered the latest sign of the coronavirus pandemic’s hold on major sectors of the economy, conflicting with the type of recovery the Federal Reserve forecast back when the nation was entering its recent surge in cases.

And from NPR:

Employers added just 194,000 jobs in September, according to a monthly snapshot from the Labor Department. That’s even worse than the anemic job gains in August and far below the pace of hiring earlier in the summer, when employers were adding around a million jobs a month.

It is unheard of that mainstream media would complain over a jobs report with a Democrat in the White House and Democrats controlling Congress. But all of this, of course, is aimed at putting even more pressure on Jerome Powell to cave to the leftist demands for an MMT-style perpetuation of current money printing.

More on that in a moment. First, though, let’s get the facts clear about the labor market. I do not share the sentiment of disappointment that runs through mainstream media, but that is not to say there aren’t problems with our labor market. There are, and they show up clearly in Figure 1. The share of the U.S. population that is currently working could be a lot higher. That share exceeded 60 percent for two years under the Trump economy: starting in February 2018 at 60.1 percent, the share topped out at 61.2 percent in October 2019, but remained above 60 through February 2020:

Figure 1

Source of raw data: Bureau of Labor Statistics

After having bottomed out at 51.3 percent in April 2020, the height of the artificial economic shutdown, the employment gradually recovered and reached 58.7 percent in July this year. Since then it has been stuck around that level: 58.6 percent in August and 58.8 percent in September.

Compared to historic numbers, the ones for July, August and September are equal to the same months in 2012. In other words, looking at workforce participation, the recovery from last year’s economic shutdown has stalled. We have de facto been thrown seven years back in time.

This, of course, is not good, in part because it hints that we may be on the cusp of a longer period of stagnation. At the same time, there is a distinctly positive trend in the private-public employment balance: the jobs that are being created are predominantly located to the private sector. For the past four months, the private-sector share of total employment has been the highest or second highest in at least ten years. For example,

  • In July, 81.9 percent of the employed workforce worked in the private sector; only July 2020 has a higher number at 82.2 percent;
  • In August, the private share reached 82.2 percent, higher than even the 82 percent flat in August 2019;
  • In September the share was 81.6 percent, again a record for at least the past ten years:

Figure 2

Source of raw data: Bureau of Labor Statistics

But what about the lamenting in the mainstream media? What about the suggestion that this latest month of employment growth was so disappointing? Looking at historic trends, specifically 2012-2019, the average monthly private-sector jobs growth during has been:

  • 0.7 percent in May;
  • 0.8 percent in June;
  • 0.1 percent in July;
  • 0.1 percent in August; and
  • -0.4 percent in September.

Comparable 2021 numbers:

  • 0.8 percent in May, i.e., +0.1 percentage points;
  • 1.2 percent in June, +0.4;
  • 0.7 percent in July; +0.6;
  • 0.1 percent in August, equal to historic average; and
  • -0.2 percent in September, +0.2.

With the exception of June, and possibly July, the jobs growth in recent months has largely followed pre-shutdown trends. Furthermore, the statistically noteworthy deviations we have seen are positive compared to trends. In other words, there is no real reason for mainstream media to lament.

But lament they do, and so does Yahoo Finance. At the same time, they do not beat about the bush, relating as they do the jobs numbers to the Federal Reserve’s plans to start rolling back its heavy monetary expansion. This, of course, gives away the true reason behind the pessimism across mainstream media: to put pressure on the Fed to continue printing money like drunken sailors.

To make their case even stronger, Yahoo Finance enrolled analysts from across the financial industry. It is not working very well. For example:

GARRETT MELSON, PORTFOLIO STRATEGIST AT NATIXIS INVESTMENT MANAGERS SOLUTIONS, BOSTON “It’s not so much that the Fed’s on autopilot. It’s that they’ve been very clear and consistent that it’s pretty much time to start the tapering process. They’ve been telling markets it’s on the horizon for months now.” “I really don’t think this changes the outlook for tapering. A weak print might change the pace but it doesn’t change the start date.” 

All other things equal, I concur. If Federal Reserve Chairman Jerome Powell stands tall, he will begin winding down the monetary expansion within the next two months.

Kathy Lien, managing director of BK Asset Bank Management:

“I think that the Federal Reserve made it very clear that they don’t need a blockbuster jobs report to taper in November, so while you’re seeing a little bit of a pullback in the dollar, I think the Fed remains on track.” 

Along the same line:

CARL TANNENBAUM, CHIEF ECONOMIST, NORTHERN TRUST, CHICAGO “My take: the Fed was hoping for a number large enough so that their decision to begin tapering last month would be an easy one. Now, the discussions on November 2-3 may be more difficult; and the market will have to deal with some additional uncertainty.” 

Some analysts were more generally macroeconomically oriented in their comments. For example, Russell Price, Chief economist of Ameriprise Financial Services:

“This is a stronger report than on first appearance. Sectors other than education still performed pretty well. Manufacturing had a good month despite all the supply constraints it continues to suffer. In fact, the motor vehicle sector dropped 6,000 jobs due to temporary layoffs and construction added 22,000. Even retail gained a strong 56,000.” 

Even though Price does not say so explicitly, his comment hints that the Federal Reserve would be correct to begin its monetary tapering as planned.

Along the same lines, Sameer Samana, senior global market strategist at Wells Fargo Investment Institute:

“Payrolls data came in weaker than expected, but the overall trend of an improving labor market remains intact.” “The internals also suggest some underlying strength with average weekly hours ticking up and wages staying firm.” “The continued healing should continue to underpin consumption and economic growth.”  

Again, a comment suggesting that the Fed has the macroeconomic reasons it needs to start rolling back monetary expansionism. At the same time, it is worth noting that while jobs creation is not worse than historic trend, it could be much better. As Figured 1 shows, workforce participation, and therefore employment, is lower than it was before the 2020 shutdown. If workforce participation had been the same in September 2021 as it was in 2019, another 3,665,000 Americans would have been on the labor market; if all of them would have had a job, we would have had the highest employment number ever for the month of September, with the exception of 2019. But instead of 157,691,000 Americans working, we only had 154,026,000.

These numbers matter, because they suggest that we still have a long way to go before we have restored the economy from the major harm done by last year’s shutdown.

Another focused comment, this one from Kathy Jones, chief fixed income strategist with the Schwab Center for Financial Research. However, unlike the others she explicitly suggests that the monetary tightening might not happen yet for a few months:

“I would say it was a good enough report or a decent report to qualify for the Fed to start tapering.” “It really doesn’t change the trajectory of where (the Treasury market is) going. We’ve had a steeper yield curve, rising yields, expectation for the Fed to start tightening sometime in 2022 — all that seems to be intact. I’m not seeing a huge enough change in the Treasury market to signal that people have changed their views.” 

The one word that has not been mentioned yet is put forward in the one comment that hits the nail on the head:

PETER CARDILLO, CHIEF MARKET ECONOMIST, SPARTAN CAPITAL SECURITIES, NEW YORK “This is a disappointing number and it’s being accompanied by higher wage costs and that’s pointing to higher wage inflation down the road. It’s not likely to derail the Fed’s tapering.” 

Bingo. The Federal Reserve is more afraid of inflation than of its slow hike in interest rates causing a stagnation of jobs creation. As they should be. There is very little evidence that higher interest rates at this low level will have any discernible effect on private-sector economic activity. The Fed probably has at least two percentage points of leeway before it reaches the point where higher interest rates start taking a toll on business and household activity and spending.

Where we are now, inflation is much more of a concern as a weight around the ankle of the American economy. The Federal Reserve seems to agree, and I hope they hold on to their plans for monetary tightening. If they cave to the leftist pressure to continue to print crazy amounts of money, 2022 is going to be a bad, bad year for us all. Inflation will continue to rise and will easily shoot past ten percent, real-sector stagnation will continue and unemployment start rising again, and the federal government will rapidly approach that black hole known as a fiscal meltdown.

To be short and blunt: America’s economic survival hinges on the re-appointment of Jerome Powell as chairman of the Federal Reserve.

Inflation Closer to Our Forecast

Never Bark at the Big Dog. The Big Dog Is Always Right.

Back in January I published two issues of my subscriber-based newsletter where I predicted inflation for 2021 to reach ten percent. Virtually nobody else would touch such a radical forecast with a ten-foot pole. Most people were still speculating about whether or not inflation would even exceed the Federal Reserve’s two-percent target.

I understand them. If you are an insider, with access to mainstream media outlets, a nice position at a renowned think tank or research institution and a social reputation to think about, you don’t want to stand out from the crowd. You can draw criticism, ridicule and even be called names.

Much better to not rock the boat, and to wait for someone else to take the first step out of the mainstream center square.

Since then, mainstream economists have come around, one after the other, slowly but steadily joining a growing chorus of “higher inflation” warnings. Of course, nobody has dared to go all the way to ten percent, as I did, because the pace setters in the main stream are still reluctant to go anywhere near inflation forecasts in excess of five percent.

I, on the other hand, don’t have to worry about their social anxiety. I am independent, I do my own homework, my own quantitative and qualitative analysis, and I am not the least afraid of being ridiculed by stress-ridden mainstreamers.

I stand by my calculation that our monetized inflation gap remains big enough to produce a ten-percent inflation rate before the end of the year.

We are not there yet. So far – that is August – the consumer price index has risen 4.6 percent since the beginning of the year. This means the price increases for the rest of the year will have to be substantial if my prediction is going to come true.

I maintain that this is likely to happen. The CPI and PPI numbers for September will be out on Wednesday and Thursday, but we already have a hint of what they will tell us. Behold an October 7 analysis by Fernando Martin with the St. Louis branch of the Federal Reserve, who suggests an annualized CPI inflation rate of 6.6 percent for 2021.

Martin does a good job of discussing the technical aspects of inflation forecasting, and he eminently includes expectations as a driver of inflation. What he does not tell his readers is that expectations make inflation a self-fulfilling prophecy only when inflation has reached a certain level. When businesses and households see a need to re-negotiate or re-evaluate prices more frequently than at low inflation, by definition they build inflation into their behavior. I have made this point many times: a one-percent mark-up in prices twice a year is much less devastating over time than a one-percent mark-up four, six or 12 times per year.

A simple example demonstrates this point. A business sells its products for $10 apiece. Over the next 12 months,

  • No adjustment of the price will keep it at $10 at the end of the year, thus zero percent inflation;
  • A re-evaluation once every six months with a one-percent price mark up at each re-evaluation produces a 2.01 percent inflation rate for the whole year;
  • Price adjustments every three months, again at one percent each time, compounds into 4.1 percent inflation; and
  • Monthly increases of one percent totals an annual rate of 11.6 percent.

It is not well documented to what extent U.S. price setters have yet revised their pricing frequency, but I have reported previously on the Fed’s predictions from June, where they noted plans among America’s businesses for big price hikes in the coming months. Nevertheless, when the inflation rate changes in such a way that it disrupts regular business pricing plans, they can be expected to revise not only the size of each price change, but also the frequency by which they adjust prices.

This is the mechanism by which inflationary expectations become self-fulfilling prophecies. As hyper-inflation episodes in recent history have shown, it is extremely difficult for a government to break a trend of self-propelling inflation. The key, of course, is fiscal policy: too many hyperinflation episodes, from Weimar Germany to Bolivarian Venezuela, have their origin in fiscal policy. This is a tense topic in today’s American public discourse, because if the Federal Reserve makes too blunt a point about Congress driving inflation with its reckless deficit spending, a certain Fed chairman may find himself out of a job.

Worse: we could find proponents of Mad Monetary Theory on the Federal Open Market Committee. That would be a disastrous turn of events, for the simple reason that it would officially end the independence of U.S. monetary policy from U.S. fiscal policy. This independence has been eroded over the past 20 years, since the 9/11 attacks led Congress, President Bush and Fed Chairman Alan Greenspan to formulate an unprecedented, coordinated fiscal and monetary expansion.

While Greenspan clearly had the intention for this expansion to end – and he did his best to pull out of it a few years after the 9/11 attacks – his successor, Ben Bernanke, basically made monetary expansion a hallmark of the central bank. We got a brief intermission under Janet Yellen, but returned to de facto deficit monetization under Jerome Powell.

Now it looks like Powell has not been aggressive enough for some Democrats, with the New York Times reporting on how Senator Warren (D-MA) leads the charge. In fact, the debate over Powell’s reappointment is reaching levels unheard of for the central bank’s top officials; the New York Times gives us a clue to why:

The administration is under pressure to make a prompt decision, in part because the Fed’s seven-person Board of Governors in Washington will soon face a spate of openings. One governor role is already open. Mr. Clarida’s term ends early next year, leaving another vacancy, and Randal K. Quarles’s term as the board’s vice chair for supervision will expire next week, although his term as a governor runs through 2032.

Let’s be honest about what is going on here. The left wing of the left wing sees a chance to populate the central bank with corporate yes-men who will not object to a perpetuation of large, monetized deficits. If they can get one or two MMT proponents on the Federal Reserve Board, they will have politically conquered the central bank and made clear to future board members who are up for reappointment: we will be watching your record, and if you aren’t onboard with MMT you will be replaced.

The MMT’ers will not get what they want if Treasury Secretary Yellen gets it her way. But until President Biden makes an announcement, anything is possible. Either way, Jerome Powell’s reappointment marks a fork in the road for the Federal Reserve, with a return to monetary conservatism on the right and unrestricted MMT on the left.

America’s Oil Deficit

There is an emerging narrative in some parts of the public discourse that the recent spike in oil prices has nothing to do with President Biden cancelling the Keystone Pipeline. The talking points apparently being distributed is that it is all attributable to “supply and demand”. We are also being told that we have always exported and imported oil, and nothing in particular has changed since the Biden administration came into office.

Is there any truth to these talking points? Let’s find out.

In Figure 1 the green function reports millions of barrels of oil being produced every month in the United States. The black function reports the price of crude oil (West Texas Intermediate), also on a monthly basis:

Figure 1

Source of raw data: Energy Information Administration

There does not seem to be any correlation between crude-oil prices and production volumes, does it? To make sure, let’s take a more formal look. We calculate the percent changes in price and quantity and let Figure 2 report the 426 resulting pairs of data in order from the largest price increase to largest decrease, and the correlating change in quantity:

Figure 2

Source of raw data: Energy Information Administration

Based on the resulting trend lines we could calculate formal correlation values, but there is really no point. The plain and simple conclusion from Figure 2 is that there is no correlation between changes in crude-oil prices and the quantity of oil produced.

It is worth noting that Figure 2 reports short-term observations; it is entirely possible that a sustained higher level of prices will motivate a higher level of production. However, such a correlation is difficult to produce without data “clustering” (one set of observations from one period of time vs. one set for the other variable from another time), a technique that easily puts an unhealthy amount of distance between us and reality. Therefore, I will gladly leave it to others to look for longer-term correlations between oil production and price levels.

Given that we accept the limited price-quantity correlation, there is a reasonable explanation to the almost U-shaped production trend in Figure 1. To begin with, we are comparing crude-oil prices to production, not total consumption. As Figure 3 explains, the downward trend in domestic production from the mid-’80s to the turn of the Millennium could be explained not by a decline in oil demand, but by a substitution of imported oil for domestic oil. Going back to 1991, Figure 3 reports the U.S. trade deficit/surplus in petroleum product quantities, i.e., a net-barrels balance:

Figure 3

Source of raw data: Energy Information Administration

Assuming that the downward trend – growing net imports of petroleum products – stretches back to at least the mid-’80s, we see more clearly why there was no apparent correlation between the crude-oil price and domestic oil production.

The trends in prices, production and trade balance change after 9/11. Domestic production flattens at first, then starts to rise again. As this happens, the trade deficit begins to shrink.

This turn-around correlates with sharp increases in crude-oil prices, making it reasonable – all other things equal – to suggest that the rise in prices is the cause. However, that part about “all other things equal” is essential: the rise in crude prices began already in the late ’90s, without a reaction in oil trade and production volumes. Furthermore, the price had to go from $40 per barrel to approximately $75 before there was a clearly visible change for the better in domestic oil production.

From about 2005 to 2015 we saw significant volatility in crude-oil prices. It is well known that price volatility leads to lower production volumes, as sellers are weary of getting their product out at a price that pays production costs. The oil markets have sophisticated price-insurance products to mitigate such swings, but those products – term and options contracts – can only mitigate, not eliminate, price volatility. In other words, they govern but do not alter price trends.

That said, there is a sustained period of high oil prices from 2010 to 2015 that likely plays a role in the steady rise in domestic production. The reason why it would have a stronger effect on production than prices had previously, is that it motivated a shift in production technology: this is the period of time when fracking made inroads and opened up new oil reserves.

Toward the end of the Obama presidency, the upward trend in domestic oil production is disrupted. By this time the fracking technology has reached the industry and is established, making it unlikely that the trend shift is caused by the drop in prices. Once a production technology is established, its operating costs are almost always minor compared to the fixed-cost investment in its establishment. Therefore, the price drop should not have had a direct effect on domestic production.

A more likely explanation is an increased regulatory presence from the federal government and a ramp-up in advocacy group activity to vilify fracking. This explanation is reinforced by the price-production trends during the Trump presidency: while the crude price fluctuates violently, oil production rises sharply and steadily all the way to the 400 million monthly barrel production mark in early 2020.

Since the Trump administration worked hard to roll back regulations, it is likely that the rise in production on his watch was due more to deregulation than to any particular changes in crude-oil prices. However, it is difficult to quantify the impact of regulations to such a degree that it can be compared statistically to established variables, such as the oil price and the production volume.

It is interesting to note that according Figure 3, the American trade deficit in petroleum products is replaced with a trade surplus under Trump. This is directly the result of the sharp rise in oil production on his watch, but it is also indirectly the result of the more muted increase that took place during Obama’s second term.

Figures 1 and 3 suggest that the U.S. economy needs to produce about 400 million barrels per month to be independent of foreign oil. Since the break in the positive trend from the Trump presidency has happened under the current administration, it is likely that the current trend will continue: we are, in short, en route back to the days when we depended heavily on faraway countries to supply us with oil along vulnerable supply chains with multiple choke-point bottle necks.

I find it humorous to listen to people on the left who complain – sometimes rightly – that our military presence in the Middle East is driven by our oil dependency. Instead of helping us maintain our energy independence, those very same leftists are often quick to criticize and try to stop domestic oil production, thus making us even more dependent on that oil for which they say we go to war. Then they turn around and suggest we all drive electric cars, which make us more dependent on minerals extracted in some of the most conflict-ridden parts of the world: the Congo and Afghanistan come to mind.

As if our exploitation of child slave labor in Africa would be any more acceptable than our immoral wars to protect our unnecessary foreign oil-supply chains.

Nothing would contribute more to peace and prosperity in America and the world than for every country to become as energy independent as possible. We can easily make it happen – all it takes is political courage.

Tax Hikes on Tax Hikes

I have been active in politics since I was 14 years old. I have been an activist, an elected official and a professional, full-time public policy wonk. I have spent the past 16 years working as a political economist with focus on helping voters, taxpayers and lawmakers make better choices.

It is a very mixed experience. I have met, and continue to meet, many intelligent and well-meaning politicians whose work is dedicated to actually making America a better place.

Unfortunately, I also see a lot of mediocrity at work. (I could use a stronger term, but let’s save that one for another day.) For some reason, this is more common in economic policy than anywhere else, and it is not limited to Congress. In fact, sometimes our state legislators really step up to the plate in order to show us what it means to not engage the top gear before you make policy.

If you want to find examples, my own home state Wyoming is probably the best place to look. To understand why, let’s go back to D.C. for a moment, where the Democrats are hard at work to roll back the economic success of the Trump tax reform. Blinded by their ideological campaign against freedom and prosperity, they want to significantly raise taxes on 96 percent of America’s businesses – so-called pass-throughs – as well as raise the corporate income tax to one of the highest in the world.

You don’t have to be an economist to understand the negative impact of those tax hikes. All you need is common sense and a moral preference for letting people live their lives without being stifled by government. It looks like those character traits are missing among more than half of the members of Congress.

Unfortunately, they are not alone in failing to understand that higher taxes are bad for the economy. Here in Wyoming, leading state legislators have been campaigning with fervor and vigor for years now to raise taxes.

Republican legislators, I should add. I spent several years working full time to stop these tax hikes. When I left that fight last year I predicted that the tax hikers would not give up, but instead ramp up their efforts. Behold: on Thursday, Oct. 7, the Wyoming Tribune Eagle reported (pp. A1-A2, print ed.) that the state legislative Joint Revenue Committee is considering a seven-percent tax on business income. Their September meeting led to a bill for the 2022 legislative session that would require

businesses to disclose their total gross receipts, the portion of their gross receipts earned in Wyoming, and the home state of the company or corporation for income tax allocation purposes, among other information.

Furthermore:

The committee also voted … to draft a bill imposing a 7% tax on people who have “income from business activity in Wyoming”.

This tax is nothing more than an income tax on businesses. The disclosure mandate is a way to create the information collection system for the tax, and even though the implementation of the tax would be delayed by four years after the tax is passed, its impact on the Wyoming economy will be immediate.

For anyone looking at Wyoming from the outside, this idea of a seven-percent business income tax comes across as an attempt by the state’s political leadership to make the Cowboy State commit economic harakiri. That impression is entirely valid, for reasons I will return to in just a second. First, though, let’s take a step back and look at the bigger picture.

Suppose, for the sake of argument, that the Democrats in Congress get the tax hikes they want. Here is what, according to the Wall Street Journal, they want to do to non-incorporated businesses, in other words LLC’s and other pass-through’s:

One key change in the Democratic plan would limit the 20% deduction claimed by most pass-throughs to $500,000 for joint filers, meaning the benefit would no longer be available on business income above $2.5 million per household. Congress created the deduction in the 2017 tax law to give pass-throughs a rate cut equivalent to what corporations were getting. The proposed legislation would also create a new surcharge on high-income individuals, adding a 3% levy on income over $5 million. In addition, it would extend a 3.8% surcharge on net investment income to married taxpayers who earn more than $500,000 (and individuals above $400,000) and don’t otherwise pay employment taxes. That tax currently applies only to taxpayers receiving investment income and not to those actively involved in the business. The top marginal tax rate would also rise to 39.6% from 37%.

The Journal also reports that the

top marginal tax rate for owners of pass-through companies could jump to 46.4% from 29.6%, an increase of nearly 17 percentage points

which is a tax hike not seen in the industrialized world in modern economic history.

Again, only four out of every 100 businesses are incorporated, which means that this massive tax increase is practically a universal cement block dumped on American business activity. Add to this the increase in the corporate income tax, and we can safely predict a rapid reversal of the positive effects that came out of the Trump tax reform. The cuts that Congress passed in the Tax Cuts and Jobs Act helped create four million new private-sector jobs in just two years.

In the fourth quarter of 2019 the unemployment rate was 3.3 percent for the age group 20-64, 3.45 percent if you count everyone 16 and older. This was the lowest unemployment rate in 50 years. Workforce participation actually increased, after years of decline under Obama:

Figure 1

Source of raw data: Bureau of Labor Statistics

The latest employment numbers for the U.S. economy were apparently a surprise to everyone who thought the Biden economy would continue the V-shaped recovery that began under Trump. I was not surprised: it is well established that the mere talk about tax hikes will cause businesses to halt job creation and cautiously remain on the sidelines to see what actually happens. This is exactly what is happening in the U.S. economy: with the exception of last year’s economic shutdown, we saw a larger decline in the workforce in September than we have seen since 2015.

There were 2,551,000 fewer people in the workforce in September this year than in September 2019, and the gap is growing: in June the gap was only 1,953,000. In other words, the Biden economy is discouraging people from participating in the workforce, and the Democrats’ obsession with raising taxes is only adding insult to injury.

It is in this macroeconomic climate that the legislators in the economic wasteland that used to be Wyoming want to raise taxes. In the second quarter of this year, Wyoming had the 18th highest unemployment rate – 5.6 percent – with all its neighboring states except Colorado at much lower rates: Montana 3.7 percent; Idaho, 3.2; South Dakota 3.1; Utah 2.9; and Nebraska at the nation’s lowest rate of 2.4 percent.

Colorado’s rate was a smidge higher than Wyoming at 6.1 percent.

In the first four months of this year, Wyoming had the second-slowest growth in private sector paychecks of all the 50 states. Only North Dakota was worse. First-quarter GDP was 5.8 percent smaller than in Q1 of 2019, again with only one state – Hawaii this time – doing worse. Work-based income growth in the second quarter was the worst in the country. And so on.

It is on this economy, with the Democrats’ federal tax hikes hanging like a perfect-storm cloud above us, that Republican lawmakers here in Wyoming want to slam a seven-percent business tax.

What could possibly go wrong?

The End of China’s Economic Miracle?

In the past quarter century, China has made two remarkable achievements:

  1. They have elevated their population from abject poverty to a global standard of living comparable to other industrialized countries; and
  2. They have shown that economic development (the real kind, not the sleaze that American politicians engage in when they hand out cash to favored businesses) is possible without the kind of system-threatening political instability we saw in Russia after the collapse of the Soviet Union.

The Chinese have rightfully earned the world’s respect for these two achievements. Unfortunately, it looks like the progress and growth from the past couple of decades may soon be coming to an end. The world’s most populous country appears to have run into the same statist brick wall that we in the West are all too familiar with.

Big government.

Before I get there, let me first stress what the Chinese did right. Back in the ’90s they watched how the Russians botched their liberalization efforts in the wake of the collapse of the Soviet Union. Based in good part on ill-conceived advice by a couple of impressively stupid Swedish Austrian-theory economists, the Russian leaders abolished existing regulations and overnighted away a government presence that had shaped the nation’s political, social and economic behavior for seven decades.

The result was catastrophic, with mafias forming out of the rubble of the fractured state, the disintegrated Soviet communist party and already-existing crime families throughout the former empire. The totalitarian state was replaced with lawlessness, thuggery, theft and a complete disrespect for the rule of law. It was not until Vladimir Putin ascended to the presidency that Russia began functioning much like every other developed nation.

That is not to say Putin’s Russia is without problem. Corruption and authoritarianism are still staples of Russian life, but under Putin the crooks are at least honest crooks. They are predictable and want the same thing as most people do: a Russia that is strong, prosperous and stable.

Whether or not they can keep it that way is a different story. But the Chinese communist leaders witnessed what happened in Russia and sought a different path. They were given advice on how to do that from a prominent American economist (I have pledged to withhold his name) who told the CCP leadership to more or less use Russia as a reversed indicator on how to reform the country. Maintain a stable, predictable political leadership, keep core functions of government – rule of law and enforcement of contracts – predictable and free of corruption, and deregulate the economy from the ground up.

Which, by and large, is what the Chinese did. That is not to say they have succeeded on every item, but from a macroeconomic and macro-political viewpoint, this was their strategy. Given the impressive transformation of the Chinese economy, initially they were successful. Very successful, in fact.

However, their success story is now coming to an end, and the reasons are – ironically – to be found in the very strategy that generated their impressive economic evolution.

In a thorough and very informative opinion piece in the Epoch Times of September 29 (print ed.), Cheng Xiaonong, a U.S.-based expert on Chinese politics and the Chinese economy, explains the systemic problems of the Chinese economy. Cheng previously served as aide and policy researcher to former Chinese premier Zhao Ziyang. He has also been the chief editor of Modern China Studies.

Cheng exhaustively explains why the Chinese economy is facing fatal imbalances that may bring its epic progress to a halt, and may even throw the country into economic regress. But before I get to Cheng’s analysis, let me first say a few things about the Chinese economy in general.

To begin with, it is notoriously difficult for an outsider to confidently establish any statistical picture of the country. The world has gotten used to hearing all sorts of exceptional numbers coming out of China, not the least of which have had to do with its GDP growth. However, over the years it has become increasingly clear that we should take Chinese national-accounts data with more than a little grain of salt. For example, in 2016 Business Insider Australia reported that the official Chinese GDP numbers for 2015 had “drawn scorn and ridicule from many noted market participants”. Few people seemed to believe that the 6.9-percent reported growth rate was anywhere near accurate.

There seems to be a consensus across the international community of China analysts that Chinese GDP growth is being over-stated by about two percentage points per year. This may sound insignificant, but it quickly balloons into a major statistical black hole: if the real, actual GDP growth of a country is five percent per year over ten years, and it is over-reported by two percentage points – in other words seven percent per year instead of the actual five – then after ten years the statistically inflated economy is more than 20 percent larger than the economy actually is.

This has major consequences, both domestically and internationally. To begin with, you run into all kinds of market forecasting errors. A forecast of future growth in Chinese markets, such as for consumer products, always depends on past performance of the economy in general and the market in question in particular. If that past performance is overstated in official statistics, a forecast of future market performance increasingly decays into guesswork.

As a result, businesses over-commit to a market that may be marginally or substantially smaller, with much less purchasing power, than official statistics would suggest.

But the problem is not limited to consumer markets, which – as we will see in a moment – have been relatively under-developed in China. Inflated economic data lead to errors in forecasting returns on investments in equity markets. Those markets, from real estate to stock, depend on the overall performance of the economy. We may blow a lot of hot air into our stock market by means of artificial liquidity infusions (hello, Fed?) but there always comes a point when the next market investor looks at the P/E ratio and chooses to keep his money in the bank for now.

At that point, the balloon starts to implode.

Which, incidentally, is what we are now beginning to see in the Chinese real-estate market.

However, the errors in macroeconomic data do not just affect investors in equity markets. If you want to build a manufacturing facility in an economy with unreliable data, you have to consider the consequences of compounded statistical errors. When errors begin to multiply and reinforce each other, you gradually lose your ability to navigate your economic environment.

Bluntly, you fly blind in the dark.

I am not saying this is actually the case for all investors in China today, but it is a problem that is reaching systemic proportions. Errors in national accounts have long-term effects, which show up only after a sustained period of time. That said, once they do surface, the error is already significant, as evidenced by a 2019 article in the Financial Times reporting that the Chinese economy is 12 percent smaller than official statistics would suggest. At that point, it is almost impossible for anyone who is not a national-accounts expert to reverse-engineer that error and get a “real” picture of the economy.

In addition to concerns about China’s national accounts, there is also the issue with the nation’s inflation data. In 2019, the Economist Intelligence Unit explained the serious consequences of China’s allegedly manipulated inflation data. Focusing specifically on the GDP deflator, the EIU explained that Chinese officials are not transparent about how the deflator is calculated,

in contrast to the practice in most economies. This generates suspicion that the deflator is manipulated to arrive at a preferred rate of real GDP growth. During economic downturns, the GDP deflator may have been used to artificially lift real GDP growth; during upturns, it may have been used to suppress it.

If official Chinese statistics producers misrepresent the difference between nominal and real GDP, they make price increases look like actual market expansion. This compounds greatly the problems for outsiders in assessing investment and general business opportunities in China. But it also creates problems for the Chinese government, for example in the form of revenue from its value added tax. When inflation numbers are inaccurate, it means that product-price data is misrepresented. If you use erroneous GDP data – real and nominal – you will inevitably miscalculate revenue from taxes such as the VAT.

Down the road, you also get erroneous estimates of all sorts of taxes, from foreign trade to corporate and personal income.

Inaccurate inflation data also casts a shadow over the role of monetary policy. It is well documented that China has engaged in significant monetary expansion for an extended period of time. An economy that is being subjected to this gradually builds up inflationary pressure in both equity markets and consumer markets. While the latter is fairly well known – though again not necessarily well represented in Chinese economic statistics – the latter has been less explored as a genuine threat to the stability and future growth of the Chinese economy.

When money supply expands faster than money demand (as proxied by GDP) there is an increasing amount of idling liquidity in the economy. Liquidity works like water running down a hill: it always finds a way forward. Idle money makes cheap credit, which leads to lending, which leads to inflated calculations of collateral.

Behold real estate values.

But there is also another aspect of inflated equity values that is not as apparent in the economic and financial reporting on China. There is a real oddity in Chinese GDP numbers: an almost artificial trend of growth in business inventory investments. This item, which is part of national accounts, has likely been inflated in the Chinese data because businesses have over-invested in fixed capital. Businesses defer revenue by piling up inventory – actually or statistically.

This over-investment, in turn, is the perfect storm of three factors:

  1. The aforementioned inflated GDP numbers;
  2. Access to cheap credit; and
  3. A national growth policy emphasizing capital formation over domestic absorption.

This last point is very important, probably more important than the other two combined. China has an extremely high level of capital formation: at approximately 40 percent of GDP it is consistently larger than private consumption. This means that businesses in China are building a lot more productive facilities than their domestic economy can possibly provide a market for. But any examination of Chinese GDP data also suggests that exports cannot possibly provide enough revenue to keep the capital stock afloat, especially not from a financial viewpoint.

Bluntly: the Chinese economy suffers from a big over-investment bubble in terms of capital formation, and i t is not limited to the manufacturing sector. As Evergrande has shown, the real estate sector is also heavily over-capitalized.

Ironically, one source of this over-capitalization has been the Chinese government’s determination to use exports as a macroeconomic growth generator. They were successful in this regard: unlike Western welfare states, money is not printed in China to fund government spending. Its is printed to prevent currency appreciation. The Chinese central bank uses a wide range of instruments to sterilize the exchange rate.

However, such currency sterilization measures inevitably flood the banking system with large volumes of liquidity, i.e., cheap credit. To mitigate this problem, the Chinese central banks has been trying to “retrieve” the liquidity and prevent or dampen over-lending. The problem is that over time, this cannot be done without outright confiscation of bank assets; so long as the currency manipulation continues, the resulting monetary expansion will continue to flood credit markets with more cash.

Herein lies a major dilemma for the Chinese government. Aforementioned Chinese policy expert Cheng Xiaonong explains that China has gone through two phases in its economic evolution, the first being led by an exports boom, the second by a capital formation boom:

China’s economic growth and prosperity in the past 20 years mainly relied on the booming of exports and construction projects. Since China became a member of the World Trade Organization (WTO) in 2001, the surge of foreign capital flowing in has since brought its export growth to more than 25 percent annually. The booming of exports drove Chinese economic growth for 10 years.

This, however, was not a sustainable strategy, Cheng notes:

While the regime enjoyed economic growth, it overlooked a problem: China has a big population and the global market is too small. China’s labor force accounts for 26 percent of the global employment population. Even if China occupied the entire global market and all industrialized countries stopped exporting, the export boom could not go on indefinitely.

Having seen the consequences of this crude, one-trick-pony strategy for economic growth in the wake of the Great Recession, when demand for Chinese exports plummeted across the industrialized world, the government in Beijing shifted focus and decided instead to rely on capital formation – business investments – as its new growth generator. Cheng again:

In order to maintain high economic growth, China promoted infrastructure construction and real estate development, thereby stimulating a round of booming construction projects. The construction investment share of GDP rose to 20 percent from 18 percent before 2008, to 35 percent in 2013 and 2014. Although the construction boom has supported Chinese economic growth for another 10 years after the export boom, a real estate bubble has quietly formed.

The same has happened in the manufacturing sector that is dimensioned for rapid, and steady growth in exports.

The one sector the Chinese government appears to have continuously overlooked, is private consumption. As mentioned earlier, this variable, which accounts for 70 percent of GDP in the United States, is smaller in China than business investments. Even the addition of private consumption and net exports cannot provide enough cash flow to merit the Gargantuan capital formation across manufacturing, real estate and infrastructure.

Only one economic agent can balance out the imbalances: government. However, its abilities to do so are limited, simply by virtue of the same laws of public finance and macroeconomics that apply to all economies in the world. Once the Chinese government starts committing to saving financially troubled investments across the economy, it will be faced with two choices:

  1. Monetize deficits like we have in the United States and Europe, or
  2. Go cold-turkey on the equity markets and let them fail.

The latter alternative is the only sustainable one, but the Chinese government is unlikely to choose it. The reason is simple: it would lead to major social unrest.

Which brings us back to the systemic error in the Chinese growth strategy itself: to maintain political stability while the economy is deregulated. So long as information control is a key part of political-stability management, the average guy on the street is not going to have a clue as to what major problems his country is facing. We may not have the most intelligent public debate here in America, but it is open and vigorous and provides all sorts of information for anyone willing to search for it.

In short: Americans are much better prepared to deal with systemic crises than people are in China.

On top of this, the maintenance of the communist power structure has kept in place a large bureaucracy that constantly needs to legitimize its existence. With economic liberalization, people begin to see that they can live their lives, provide for their families and go about their daily business without relying on government. Unless this bureaucracy is dismantled, sooner or later it is going to reassert its role in society and in the economy.

How does it do that?

By re-regulating the economy. Which is exactly what is happening now. And it is happening just as the Chinese economy is beginning to pay the price for a growth policy that has promoted everything except the two variables that build an economy from the ground up: private consumption and individual freedom.

In short: China is at a critical point economically. Unless its government re-commits to economic liberalization, and adds the dismantling of its political bureaucracy, the country’s future looks increasingly bleak.

Buying Socialism for $3.5 Trillion

I can understand the desperation among Democrats to get their $3.5 trillion reconciliation bill passed. After all, it might be their last chance in a long while to expand our socialist welfare state. Republicans are fighting back, and vigorously for a change, in ways reminiscent of their resistance to Obamacare a decade ago.

Republican resistance is based primarily on the cost of the bill. There is nothing wrong in this: cost of the bill is outrageous, especially since it piles even more debt onto the shoulders of our grandkids. In fact, funding this bill with deficits is the absolutely worst way to expand the welfare state like the Democrats now want to do; paying for it with taxes would in some ways have been less harmful, at least for the long term.

Before anyone construes that as an argument for tax hikes, let me make clear: the choice between funding a welfare state with deficits and funding it with taxes is the choice between being garroted and being hanged. It is not the choice between a path to prosperity and a path to poverty; both the tax road and the deficit track lead to the same destination: a fiscal and macroeconomic disaster for America.

Given the bad fiscal and economic consequences of the bill, it is refreshing to see Republicans fight back. Among them, Senator Lummis (R-WY) has stood out as a leader. But Republicans are still not using all the arrows in their quiver, and they need to do so in order to win this battle, or at least mitigate the losses to America.

The most significant policy achievement of the $3.5 trillion spending spree is its expansion of the American welfare state. This expansion, in turn, is entirely ideological. As I have explained in two books, The Rise of Big Government and Democracy or Socialism: The Fateful Question for America in 2024, the American welfare state is built according to the very same ideological architecture as, primarily, the Swedish welfare state and, secondarily, the broader democratic-socialist ideology that shaped much of the social and economic evolution of Western Europe in the decades after World War II.

In short: what we have here, disguised as an “infrastructure bill” is a package of legislation aimed at further aligning America with Europe’s most notorious welfare states. The alignment comes in the form of new and expanded entitlement programs. Let’s take inventory:

  • Two years of free community college. By making college tuition free, government eliminates individual responsibility for higher education. Its status is changed from a service you buy to improve your career prospects, to an entitlement that you have the right to simply by virtue of being who you are. In an ideological meaning, this is no different from government providing you with housing, food or the means of transportation.
  • Tax-paid child care and two years of universal pre-K. While child care will not be entirely free for all entitled parents, this bill would take a big step in that direction. The universal pre-K reform has the same effect. In both cases, the service provided is transformed from a matter of personal responsibility to an entitlement. Proponents point to K-12 and ask if that is also an entitlement, and the answer is simple: yes. Our public school system is an entitlement. What we think of it from an ideological or less complex moral viewpoint, is a different matter. But it is also important to remember that when parents lose the responsibility to care for their children, they also lose the interest in financially providing for their family. This as broad consequences rarely brought into the picture in the debate over government-funded child care and pre-K.
  • Medicare expansion to include dental care, among other things. This is the first step toward integrating dental care into government-provided health insurance (Medicaid would be next) and government-mandated health insurance. Eventually, dental care will become a component of a single-payer health care system that replaces what we have left of a privately funded system. I should point out that in Sweden – the dreamland of the American left – dental care is not part of the single-payer health plan. It is fairly costly and can often cause financial problems for patients with modest incomes.
  • De facto permanent child-tax credit. Here we have yet another cash handout, mimicking the child-benefit checks paid out in countries like Sweden and Denmark. Over there, they have been independent of the parents’ income, but that does not change the fact that they are classic examples of entitlements: you get them simply by virtue of belonging to a group deemed eligible by government. The American version is tied to parental income, but the threshold is so high that a large majority of families will qualify.
  • Subsidies and regulations to reduce prescription drug prices. The Medicare system will be given the authority to negotiate for prescription-drug prices. This is a dangerous path to go down. First of all, it turns a private product into a government-provided good: the price is no longer market-based, but will be based on the value that government assigns to it. Thereby, the product will de facto be provided by government, with the incentives to sell the drug being driven not by patient need but by the price preferences of the government. These preferences, in turn, will be based on how government prefers to allocate its subsidies: if, e.g., government does not want to subsidize – and negotiate down the prices of – medicine for dementia, and instead prioritize tobacco addiction treatment, then patients who would like treatment for dementia are left to fend for themselves.

In other words, personal choices are replaced by government priorities, and government priorities are always based on ideological preferences. Possibly with the exception of national defense, government never makes priority decisions without considering the ideological outcome of the decision. When Congress decides to spend more money on entitlements generally and less on national defense, the priorities are driven by an ideological desire to increase income redistribution and reduce economic differences between individuals and families.

Likewise, the decision to create these new entitlements – should Congress pass the $3.5 trillion monstrosity – is ideological. It is driven by a desire to increase benefits for low- and middle-income families relative families with higher incomes. Even when a benefit is provided without an income cap, it is still a tool for economic redistribution: the value of the benefit is the same to all entitlees, making it relatively more valuable to those with lower incomes.

It is always tempting to expand the welfare state for reasons of general benevolence: why should we not give everything to everyone for free? It is also tempting for opponents of the socialist redistribution doctrine to humbly bow their heads and refrain from opposing the perceived benevolence of the socialist. After all, who wants to come across as evil and as denying the poor, hungry, starving child a fighting chance in life?

The problem is that this image is a complete non-sequitur of the socialist redistribution argument. None of the entitlements proposed in the $3.5 trillion monstrosity does anything to elevate anybody out of an existence in the gutters with rags and an empty stomach. Our society has long passed that level of poverty; the homeless problem we see across the country today is almost entirely driven by drug addictions, mental illness and other individual problems – it is not driven by generic poverty. Therefore, it is simply false to try to claim that we need to further expand the welfare state in order to cure girl-with-the-matchsticks poverty.

It is also worth noting that we as a society would not accept widespread poverty at that level, even if we had no tax-paid welfare system. We would use charitable organizations as a means to provide adequate help. Anyone objecting should ask him- or herself:

  • What would you do if your neighbor starved – leave him be or help him?
  • Why do you think other people are less inclined to help than you are?

In other words, compassion and charity are not government monopolies. The alternative to the socialist welfare state is built in the intersection between private charity and personal responsibility. It is right there that America’s conservatives need to build their ideological counter-argument to the unending effort by the socialists to expand the welfare state.

Which brings me to the one point that perhaps perplexes me the most with the conservative movement. There seems to be a premise underlying their efforts to counter the left: every step the left takes to grow government is an isolated incident. Conservatives tend to believe that if they just defeat this one entitlement idea; if they just win this particular ideological battle; they will have won the war. Nothing could be further from the truth. As I explain in my book Democracy or Socialism: The Fateful Question for America in 2024, socialists keep growing government simply because their ideology prescribes as much.

Simply: socialists will grow socialism until their ideological end goal is reached. That end goal is simple: the elimination of all economic differences between all individuals in society.

The only way to stop this incrementalist movement of America toward the socialist finishing line is to engage in a coherent, well formulated and thoroughly determined ideological counter-campaign that:

  • Exposes the socialist agenda for what it is and what it wants to accomplish;
  • Lays out an ideological alternative; and
  • Explains how the alternative to socialism is better for the poor and the destitute.

Are America’s conservatives up for it? Do they have what it takes? Not right now. But my book Democracy or Socialism: The Fateful Question for America in 2024 gives them a lot of mileage.