Why Choose Sides on Inflation/Deflation? II
Twenty years ago, I worked under the assumption that inflation was purely a monetary phenomenon like Milton Friedman told us in his books and that Gresham’s Law, where bad money drives out good, would prevail. Going into the 2008 crash, we had a big position in double-inverse bank ETF’s, bear funds, gold, and oil.
We did well for clients but our gold and oil positions lost money even as the Fed and the Treasury were creating gobs of new money. Why were the textbooks wrong? Why was our 2-year Treasury position outperforming gold?
A brilliant friend of mine who toiled for the federal government during his career told me to “never underestimate the power of the US government.” He was right. This next chart tells the story of the US economy after 2009 better than any other. It shows us how the government FORCED the economy to remain elevated when the private sector NEEDED a reset.
The chart shows that private sector’s impact on the economy collapsed prompting the federal government to use debt to keep it elevated. It worked on paper but the result was a doubling down on the destructive policies that caused the 2008 crash in the first place. The new Administration is attempting to transition back to the private sector without a hiccup in the economy.
Transfer payments as a percentage of GDP tell a big part of the story because without real private sector growth, transfer payments become a driver of GDP growth instead of a neutral policy choice to support our citizens.
But the conditions in 2025 are much different than 2009. Three subsequent Administrations used and abused the Keynesian playbook to its fullest, allowing Congress to gorge itself on pork and insider trading. Yet somehow, consumer prices never spiked. Consumers remained like frogs in boiling water while the temps were slowly raised, never jumping out - until Covid.
Covid shocked a global supply chain that had been tuned to perfection thanks to a decade of declining volatility in the demand structure. Suddenly, shipping containers were piling up in distant ports, demand became highly variable, as did supply. It was the worst time to send everyone a check in the mail, unable to spend that money on services as they were stuck at home, they spent heavily on electronics.
It was the subsequent payments where the Biden Administration made the ill-advised decision to use transfer payments to drive GDP that sparked the consumer inflation that is destroying living standards. Transfer payments are cash or in-kind benefits given to citizens (and non-citizens) without a direct exchange in goods or services. This is the very definition of inflation!
When kept as a constant percentage of GDP, it represents a society with a strong conscience to do right by our neighbors but when used to grow the economy, it puts us squarely on the Road to Serfdom. If these policies continue, we’re headed for an inflationary economic depression.
Private Sector
If you do not change direction, you may end up where you are heading – Lao Tzu
The private sector of the US economy has been on the decline since the Y2K technology crash. The period of 2001 through 2007 was driven by an asset bubble in the housing market that allowed consumers to borrow aggressively on home values.
Instead of allowing the economy to recover from the excess investment that marked the buildout of the World Wide Web, the government created an asset bubble to rapidly utilize the excess investment of the previous cycle. There was no better way to do this than to allow consumers to gorge themselves on inexpensive, imported products from a growing China while tapping their rising home equity.
New industries sprung up to replace the industrial operations that were rapidly being exported to China. Corporations kept the most profitable parts of the value chain and exported the capital-intensive and cyclical portions to the emerging market economies. In effect, they exported the comparative advantages that made the US economy the marvel of the world to extract some short-term rewards in the marketplace.
The crash in 2008 should have reversed those ill-considered policies but instead, we double, triple, and quadrupled-downed on the mistakes of the previous two cycles. Instead of allowing a recession to reverse the systemic misallocation of capital, the US government expanded its borrowing from $5.5 trillion in 2000 to $38 trillion today.
In 25 years, US government debt expanded by an astounding 600%. The US government showed its immense power by borrowing from the future to create economic stability even as it hollowed out the private sector of the US economy. It was exactly what our economic enemies wanted to see.
Every cycle hits the point of diminishing marginal return and this cycle is no different. Today, we can’t borrow and spend any more without increasing consumer inflation and consumer inflation gets politicians voted out of office.
Misallocation of Capital
The two great aims of industrialism – replacement of people by technology and concentration of wealth into the hands of a small plutocracy – seem close to fulfillment – Wendell Berry
Competition is such that new industries are forced to “scale up” at breakneck speeds lest other companies beat them to the customer. It’s a recipe for capital destruction. AI seems the epitome of this race to failure.
Trillions of dollars are being wasted to build data centers, models, and the necessary infrastructure to empower this colossal mistake – and yes, I mean mistake. AI is a technology that should still be in the embryonic state because it’s not ready for commercialization.
The large language model, while impressive, isn’t capable of producing the results that investors want yet all assume that if they throw enough money at the problem, they’ll overcome its limitations. Consider that a top-of-the-line Nvidia GB-200 chip costs around $65,000 and is expected to last no more than 3-5 years, although 1-3 years is common if the chip is utilized intensively. Heavy usage of electricity creates heat. Blackwell chips will be worse.
A full GB200 NVL72 rack costs around $3 million. Depending on usage intensity, it can last between 1-5 years which means that, at a minimum, a user needs to generate at least $3 million to cover investment costs. A small AI data center with just 1,000 stacks will cost $30 billion plus land, building, electricity, HVAC, and qualified personnel.
What services are they going to sell that will give them a payback on over $30 billion in fixed costs alone? Add to this that the payback needs to happen within five years before the chips burn out and need to be replaced or become obsolete. There are no services today that warrant this investment. The industry is praying for a breakthrough if enough money is spent.
How about the profits to justify Nvidia’s stock price alone? They’re going to need massive earnings to support a $5 trillion market value. Will it materialize?
Personally, I believe AI is the hill that Nvidia, Microsoft, Google, Meta, Amazon, and Tesla all die on. Not only will they waste hundreds of billions of capital out of fear of missing out, they will open their core operations to competition.
But AI is just the icing on the misallocation of capital cake. Luxury retirement communities, shopping malls, excess office space, McMansions built far away from profit centers, restaurants, electric vehicles, and vacation destinations are among the many types of assets that will be devalued when this cycle ends. Pretty much anything that is a function of the wealth-effect or excess government spending is at risk of devaluation.
The US economy is so badly out of balance that it’s doubtful that devaluing debt, a nice way of saying planned inflation, will help anyone levered to the valuable assets from the past 25 years. It’s out of balance because government policies have promoted FIRE – finance, insurance, and real estate plus health care – industries at the expense of manufacturing.
The problem for these asset holders is a combination of demographics and standard of living. Thanks to policies that favored financial assets, Baby Boomers got to enjoy unmatched prosperity but as I wrote above, the opportunities for financial assets have been used up. Furthermore, GenX is smaller than the Boomers and the Millenials are much poorer. Who’s going to buy the retirement mansion in the Low Country of South Carolina? Or the seven-figure property on an inlet in Florida?
The second problem is one of standard of living. Any attempt to devalue excess debt will be met with lower living standards. It’s happening today to people on the lower side of the income spectrum. We can see this by evidence provided by McDonalds, Walmart, Dollar General, and others. People are being forced to make trade-offs and it’s going to continue until our economy is re-balanced.
Wendell Berry furnished the above quote in the 1970’s and it was prophetic but cycles aren’t linear. They turn at the point of diminishing marginal return where yesterday’s actions no longer lead to positive outcomes and instead lead to negative outcomes. We’re presently on the downslope of the cycle and I expect the opposite of Berry’s quote; I expect decentralization.
Globalism and China
Over recent years, urbanisation, globalisation, and the destruction of local cultures has led to a rise in the prevalence of mental illness in the developing world – Iain McGilchrist
I have long believed that China is integral to the continuance of globalization and the designs of globalists such as the World Economic Forum and European nations such as Germany, France, and the UK. The reason is that globalists need a counterweight to the economic and military might of the US.
In addition, globalists need a success story to expound on the virtues of Socialism bordering on Marxism. A successful China could give them such an example, allowing them to win debates in international parliaments. For a time, it looked like it was going to work but then Xi Jinping came to power in China and ruined everything.
Today, China’s ¥400 trillion banking system is close to collapse. Interest paid on deposits is just above 0% for China’s top 6 banks, which are the strongest banks in the country. The rest of the nation’s banking system is in much worse shape, even after the forced merger of over 500 “country banks.”
Privately-owned manufacturers are starved for capital while losing export orders to other Asian nations. Even state-owned manufacturers are cutting salaries and laying off workers. The foray into electric vehicles and green energy has been a disaster as the world has started to move away from these high-cost and inefficient products.
The housing market continues to collapse and there is no floor in sight. The country is now among the oldest average age in the world with a real birth-rate that is roughly half the reported number of 1.1. Primary schools are closing and consolidating. The private sector is being decimated with a restaurant closing every 6 minutes and a private hospital every 7 days across the country.
The military is large but poorly trained and ill-equipped. The People’s Liberation Army claims to be peer level with the US but that’s just posturing. The military technology they have stolen from the West and Russia over the past 25 years is incomplete and/or they lack the precision manufacturing techniques to duplicate. They are highly deficient in aircraft and maritime engines. They claim to possess 5th generation fighter planes but they are overly large and use 4th generation Russian engines. They are not stealthy.
Without a miracle, there is no way that China can act as a bulwark against US interests which suggests that the continuation of the globalist policies that brought us to this point are unlikely to continue. The problem for the US is that China is still an integral part of the global supply chain, particularly in electronic devices. It’s highly likely that the demise of the Chinese economy could produce a shock for the global economy. Such a shock would produce supply constraints for some products and a sharp drop in demand for others.
Deflation and Chaos
The way you create deflation is you create an asset bubble – Stanley Druckenmiller
China increased money supply by 20% in 2023 yet it did little to stop the decline in the housing market. The entire asset base was built on a deeply flawed understanding of demand dynamics which no amount of money printing can change.
I see many of the same demand dynamics in the AI market although successful new product offerings can change its future – assuming they can create new products in a timely manner. There are similarities in semiconductors, copper, and oil that when taken together, has the potential to upend the global economy.
China consumes 16.5 million barrels of oil per day. What would happen if this number drops by 10%? Or 20%? It can completely change the supply/demand dynamics for the global energy sector. What if China has a similar decline in demand for semiconductors?
The question is more than an academic exercise because I see this kind of economic decline as a distinct possibility given the way China’s economy is collapsing in on itself. In 2000, China consumed 4 million barrels of oil per day and 9 million barrels per day in 2010. Given the way they financed their growth from 2010 to the present, the retrenchment could be very large, similar to the collapse in their housing market.
In a similar vein, what happens to US wealth if the development of AI takes longer than expected? Given the rapid depreciation of GPU’s, what if the expected products and services fail to materialize? The destruction of market value will be catastrophic, particularly if you consider that index funds are huge holders of Nvidia, Google, and the rest.
McDonalds and Family Dollar are telling us that the lower end of the income spectrum is hurting. 12% of the US population accesses the SNAP program, formerly known as food stamps. A lot of Americans are close to the edge financially.
We’ve had rumblings of stress in the money markets since March when major US banks seemed to “bailout” shadow banks headquartered in the Caribbean. Recall that shadow banks comprise $1.7 trillion in US bank loans. Florida real estate is starting to turn ugly. Private equity is having trouble meeting financial obligations, particularly levered loans. Auto loans are a half step from oblivion. Average credit card rates are above 22% as compared to just 12% in 2015. People who fall behind are getting destroyed with interest expense.
Will adding reserves to the banking system prevent deflation this time? Can the Fed keep going back to the well with the same results? Will the perpetual short-squeeze continue to keep the stock market elevated? When will the marginal short-seller say “no mas.”
How quickly can the US transition back to an industrial economy? Probably not fast enough.
Inflation – The Main Event
In the absence of the gold standard, there is no way to protect savings from confiscation through inflation – Alan Greenspan
I have no doubt that the Fed is going to sharply increase the size of its balance sheet to buy Treasuries from banks and/or lend money to banks through the repo market with the bank’s US Treasury holdings as collateral. When you work through the cash flows, this only prevents a run on banks as they will have sufficient liquidity to meet withdrawal requests. It represents more of a confidence boost than anything else – call it proof that banks have sufficient liquidity for withdrawals.
The significance is that banks won’t need to resort to liquidating loans to raise cash for withdrawals and that means the US won’t experience “fire sale” liquidations like the kinds that were normal in the 1930’s. More than anything, it represents a “stealth monetizing” of federal debt which is why the US Treasury has been able to increase debt so aggressively over the past 25 years.
The US Congress is responsible for money printing through rising budget deficits. The Federal Reserve has merely been an accessory to the crime. To “reset” the value of the dollar, Congress would need to act and that’s not possible today with the divide between MAGA and the Uni-party locked in a “winner takes all” fight.
I have no idea how this is going to “shake out.” I think it will depend on the 2026 elections. If MAGA gets control of Congress, I expect a massive increase in US government borrowing to fund a kind of “Marshall Plan” where the US government hastens the re-industrialization with equity stakes and debt guarantees. If the Uni-party wins, we return to a socialist trajectory with increasing central control augmented by AI.
In the meantime, we’ll continue to move towards deflation, held back by a continuation of short-squeezes to prevent a market rout.
Conclusion
The inflation comes through either increasing the money supply or increasing the government spending, and that’s what happened under Biden – Scott Bessent
We are at a “fork in the road” as a nation but the fork is a year away. In the meantime, I believe it will prove impossible to avoid the deflationary pressures from the levered excesses of the past 25 years. Ultimately, this will result in interest rates approaching the zero bound – or what we currently consider a lower bound. Negative interest rates are a distinct possibility in our future.
Interest rates will fall because there is too much capital chasing too few opportunities. US Treasury bonds represent a flight-to-safety when the negative credit cycle becomes widely known. Think of it as a precondition for higher rates in the longer term.
The real value AI provides is social control. We can see how it’s meant to work in China. AI allows China to finally enforce its 13% value-added tax (VAT). The result is widescale destruction of small businesses.
Such a system is years away in the US which is why I believe the AI bubble will pop before much longer. The combination of bubbles popping at the same time in the US will destroy a significant amount of capital. Interest rates can rise only after that capital has been destroyed. Interest rates can only rise if there is a scarcity of capital, not an overabundance.
We’ll eventually get inflation but probably not for a few years and not without a complicit US Congress. The government shutdown is accelerating the deflation that will ultimately precede inflation. It’s possible to make money over the next few years but it won’t come from the tired, old inflation story that has been peddled for 30 years.
If you’re interested in learning more, visit us at https://geovestadvisors.com/ and contact Paul Hurley.
Philip M. Byrne, CFA