The following two posts are taken from SITALWeek newsletters on the topic of interest rates and inflation. The first post discusses the difficult path for sustainably higher rates and the second looks at the long term disinflationary trends. If inflation manifests, but rates cannot rise for existential reasons, then targeted policy would be required to keep prices in check. For example, to combat rising housing costs there could be rent increase caps or regulation against institutional home ownership. For rising food costs there could be targeted subsidies. To tamp down runaway asset price bubbles, higher taxation would limit some speculation and aid in redistribution. Ultimately these are all anti-market forces with unknown consequences long term. From today’s vantage point, it is more likely the global economy continues to experience a low rate environment driven by deflationary technology trends and an abundance of debt. Declining birth rates also offer a long term disinflationary force. Ultimately, the economy will move to a distributive mechanism from a growth mechanism.

The Myth of Interest Rate Mean Reversion
(From SITALWeek #257 on August 9th, 2020)

There is a certain profile of investor I call an “interest rates will Mean Revert” investor, or MR for short. There are a lot of really smart MRs with great track records, like Warren Buffett. In May of this year, at the annual Berkshire gathering, Buffett had the following to say:
“So if the world turns into a world where you can issue more and more money and have negative interest rates over time, I’d have to see it to believe it, but I’ve seen a little bit of it. I’ve been surprised. So I’ve been wrong so far...if you’re going to have negative interest rates and pour out money and incur more and more debt relative to productive capacity, you’d think the world would have discovered it in the first couple thousand years rather than just coming on it now. But we will see. It’s probably the most interesting question I’ve ever seen in that economics is can you keep doing what we’re doing now and we’ve been able to do it or the world’s been able to do it for now a dozen years or so but we may be facing a period where we’re testing that hypothesis that you can continue it with a lot more force than we’ve tested before.”

MRs like Buffett believe that there is a certain anti-gravity that should cause rates to be structurally higher (largely to offset inflation stemming from higher debt levels), which they are counting on so that bank stocks rise and value stocks reverse their long period of underperforming growth stocks. There is a funny paradox worth noting about the MR view of rates: companies at lower valuations tend to be more mature and therefore tend to have more debt (though certainly that’s not true in all cases), which means that, if rates rise by several hundred basis points, catastrophe could ensue for those companies unable to sustain their high levels of debt. And, it’s not just value companies at risk, but the whole system, since one company’s debt is another’s asset. Likewise, higher rates could easily create a geopolitical crisis owing to the massive government borrowing around the globe. If borrowers can’t service and pay back that debt, then the debtholders don’t have assets. And that’s bad. I discussed this conundrum in more detail in our mid-year update last month:
“Did low rates increase debt, or did debt demand low rates? As an economy grows and debt increases, the borrowers – those people who need to make the interest payments and eventually return the principle – tend to be disproportionately less-wealthy, while the people who lend money out and make a return on it tend to be wealthier. As time goes on, the wealth of the wealthier is more and more tied to the interest payments from the less wealthy – one person’s indebtedness is another person’s asset. And, as inequality marches higher, the less wealthy have an ever-rising debt burden that can only be maintained by perpetually lowering interest rates. It’s in the best interest of the lenders to lend at lower and lower rates to preserve their assets. This explanation is somewhat at odds with the general narrative – that lower rates are the driving force behind rising debt. Certainly lower rates allow rising debt; however, the common view misses the crucial point that increasing debt necessitates lower rates...” (Note: this concept is explored in more mathematical detail in this essay from Ole Peters).

Now, let’s consider inflation. Rates can go up for different reasons, but one view is that rates should be increased to vacuum money out of the economy to offset inflation (or preemptively counter expected future inflation). The main inflationary fear right now is that excess liquidity from COVID-driven fiscal and monetary stimulus will be the source of that inflation (I’m rather puzzled by this fear because much of the stimulus has been replacing lost GDP, not adding to it, but let’s shelve that point for now). And, there can be short-term shocks which cause inflation – e.g., war can reduce oil supply and drive up prices, or drought can increase crop prices. There are also localized bubbles of long-term structural inflation, e.g., US healthcare costs.

But, let’s try to take a first principles look at systemic, structural inflation – in particular, long-term price increases on the scale of hundreds of years. Why would prices go up, on average, for everything over a prolonged period of time? I couldn’t really find an answer that made sense to me when I researched this question (and, let's generously say that my degree in economics was less helpful here than my degree in astrophysics😁; so, to be clear: I am guessing here). So, here is my interesting, simple hypothesis: a long-term cause of structural inflation would be upward pressure from population growth, which would be offset by downward pressure from technological progress. A growing population outpacing the production of goods and services (produced/provided for their own consumption) and leveraging their growing wealth would cause inflation, while technological progress (i.e., making more for less) would offset inflation. Seems reasonable, right?

Humans (Homo sapiens) took at least 200,000 years to get to a population of ~400 million by the early 1400s (following a dip in the 14th century due to the Black Death). But then we went from 400 million to nearly eight billion in the last ~600 years. One of the reasons for population growth was the burgeoning expansion of the economic pie. A dash of Renaissance, a touch of Enlightenment, and a heavy pour of science and the Industrial Revolution all created a lot of hope for the future – and a lot more people. There was more to go around, and people believed that there would be even more to go around in the future. When you believe the future will be bigger than the present, you are also more inclined to borrow and invest in that future.

Inflation over this 600-year period has been a little over 1% on average*; however, sustainable inflation has been the highest over the last 60 years, at around 2%, which corresponds to a period when aggregate borrowing in the US (both public and private sector) went from around 1.5x GDP to around 3.5x GDP. So, there seems to be at least a modest correlation between a significant increase in borrowing and an increase in inflation (borrowing driving up inflation makes intuitive sense, since lenders are conceptually printing money; that said, certainly a lot else has changed in the last 60 years as well). More recently, inflation has been declining (from its most recent high ~1980) while borrowing continues to grow (US public and private debt).

So, what have been the overriding deflationary pressures that account for this recent decline? The pace of technological development has been massively accelerated and global population growth has slowed. Over the last 60 years, the annual global population growth rate has dropped from around 2% to a little over 1%. And, in the US, the birth replacement rate has been steadily falling to the point where, without immigration, the US population would be shrinking marginally.

While we’ve had a clear, declining interest rate trend since the 1980 peak, real rates have actually been declining since the 1400s*, tracking the population increase, GDP, and, in turn, rising debt. So, in some ways, the trend of rising debt and falling rates has been happening for a long time. Perhaps it is the natural way of civilization, per Ole Peters’ theory referenced above, i.e., falling rates are necessary to sustain the value of an ever-increasing pool of debt (one person’s debt is another person’s asset). Rates may dance around the mean short term, but there’s no historical evidence that suggests we should expect an increasing interest rate trend in the future (indeed, quite the opposite!).

Let’s turn briefly to potential systemic, sustained deflationary pressures we might face, which are a little easier to guess at. Advances in technology, as well as improvements in productivity, are constantly giving us more for less. While we might have a period of oil price shocks, green energy will solve that long term. As the economy becomes increasingly digital, from less than 10% now, to 100% over the coming decades, and as AI increases, we will see unprecedented deflationary pressures. Look at what’s happened just this year – thanks to broadband, our houses have become offices, gyms, schools, etc. – talk about a lot of technologically-enabled bang for your buck!

Putting all the variables together, we see inflationary pressure from increased borrowing and deflationary pressure from slowing population growth and increased technological progress. Of course, there are a thousand other variables – like how quickly AI can destroy or create jobs, whether or not de-globalization will follow decades of globalization, etc. It’s incredibly complex. Indeed, the world’s economy is a complex adaptive system, and no one can accurately and narrowly predict its behavior given its sensitivity to small perturbations and propensity for spawning fat-tail events. With near certainty, we can say that short-term inflationary shocks will happen, but when, why, and how big are anyone’s best guess. Moreover (MRs pay attention here), it seems clear that we can no longer treat the “symptom” of inflation with the “cure” of raising rates because it would destroy the asset value of our highly leveraged global economy. Therefore, government tactics will likely turn to treating the localized inflation directly via offset, e.g., using fiscal stimulus to offset an oil or food price shock. Sure, fiscal stimulus could temporarily add inflationary pressure; but, unless we somehow deleverage the economy without destroying it, it’s hard to make a case for structurally high rates. However, I am rather obsessed with making a case for higher rates since I cannot find one that passes both logical and mathematical scrutiny. For years, I’ve searched for answers that would support the counterargument, and have utterly failed thus far. So, if you have a theory for why rates will be sustainably higher that considers or falsifies what I’ve written here, please let me know!

*several numbers in this section were taken from this post for convenience, but are generally available across the web as well.

Can We Harness Technology’s Deflationary Pressure?

(From SITALWeek #258 on August 16th, 2020)

Can We Harness Technology’s Deflationary Pressure?
I studied prior disinflationary/deflationary periods in the Industrial Age this past week (thanks to a suggestion from a reader!). Historically, significant advancements in technology seem to be coupled with: 1) investment cycles (funded by debt), 2) a digestion of overinvestment, and 3) disinflation or outright deflation (majority of cases). One theory put forth by Irving Fisher in the 1930’s paper The Debt-Deflation Theory of Great Depressions would suggest that any borrowing-driven inflation would likely be overwhelmed by disinflationary/deflationary forces wrought by the unserviceable debt burden following the (largely inevitable) bust. A more common market view is that low rates drive increased borrowing, which in turn drives inflation, putting less emphasis on the risk of deflation (on a longer time scale, however, increased borrowing causes low rates rather than the other way around; see our mid-year update, as well as the end of SITALWeek #257, for more details).

Fisher was perhaps on the right track; but, I wonder if it’s the technological advancement itself that causes the subsequent long term disinflation/deflation pressure, while the debt-fueled bust/recession is a smaller, secondary factor? For example, putting your delivery on a canal or train (anteceding technological advancements) was much cheaper than the horse/person-powered alternative. Canals and rails were heavy, physical, capital-intensive advances. But, what about technological investments in today’s Information Age? Forging leading-edge technology is capital intensive for a handful of large cloud infrastructure providers, but the resulting productivity increases and technological advancements far exceed the capital invested. Think of the productivity output of a single Nvidia A100 system: a $100,000 investment could produce a breakthrough that creates billions of dollars of value...every day! So, although (at present) we are in a period of significant debt expansion in the economy, we are in a much more significant, overarching phase of ever-accelerating technological advancement. If I were to attempt a first principles analysis on this topic, I would start with the following question: does accelerating deflationary pressure – from nonlinear advances in technology – enable the expansion of the money supply without the corresponding risk of inflation?

This question is perhaps even more critical now that we are on the cusp of unprecedentedly rapid change/disruption as we move from the Information Age to the AI Age. Around 40 years ago, the pace of technological advancement went from analog speed to digital speed, and with AI it’s about to go to ludicrous speed. Technology was always jumping ahead with nonlinear improvements, but the pace of change accelerated even more with the introduction of the PC and the software revolution. Many activities and ways of doing business in the year 2000 would have been unrecognizable in the year 1980. Indeed, I have a difficult time remembering what it was like a decade ago without a smartphone and ubiquitous high-speed connections; so, in many ways, 2010 is unrecognizable to me today (and vice versa). I expect 2025 will look unrecognizable to us from today’s viewpoint. And, to follow this acceleration, 2028 may look unrecognizable from 2025. 2030 from 2028, 2031 from 2030, etc.

The late-1970s/early-1980s pivotal shift from analog to digital likely played into other society-changing forces that began around the same time, including increased globalization (enabled in many ways by digital technology and communication) and the beginning of real earnings stagnation for a large part of the population. The accelerated pace of change and the shift from an assets- to an information-based economy helped accrue wealth for the wealthy, and steadily declining rates over the last four decades enabled wealth concentration as well (again, for more detail on this see our mid-year update as well as the end of last week’s SITALWeek #257). For the last four decades, the pace of change has become much more nonlinear and exponential.

For millions of years, we experienced progress as iterative analog changes. Our evolutionary heritage hasn’t really prepared us for exponential, ongoing advances. So, in some ways, the onset of accelerated, nonlinear change is breaking down our ability to cope. Most of us are struggling to adapt and react as the ground shifts faster and faster underneath our feet. As we wrote in Pace Layers: Tech Platforms, Regulation, and Finite Time Singularities: “Historically, we would expect fashion or technology to have slow and small impacts on the thousand-year-old institutions of Culture, but recently the increased velocity and transparency of information flow is causing rapid behavioral shifts in humans.” I suspect much of the turmoil and rising problems of society we have now, including inequality, nationalism, racism, fake news, etc., stem from humans’ inability to process rapid, nonlinear change (our fallback coping mechanism for uncertainty/misfortune is: if you can’t identify the real motive force or enemy, invent a story and create one). Fear of the increasingly unknown has been subconsciously motivating human behavior.

That said, we humans are remarkably intelligent, resilient creatures. And, a younger generation – whose adaptable neural networks were established during the increasingly nonlinear world of the last 40 years – may have enough of an edge over us older folks in coping with rapid change. With any luck, they will engineer solutions to the difficult socio-economic problems we now face. In any case, let us hope we can figure out a way to harness the power of our technological wild ride before its spawned problems become totally overwhelming. Returning to the point above, it seems quite plausible that our current era of unprecedented technological growth offers its own solution – providing sufficient disinflationary/deflationary pressure that we might be able to buy our way out of our current, untenable societal problems, but time will tell.

Interest Rates’ Historical Downward Trend

(From SITALWeek #305 on July 18th, 2021)

A new working paper from the Bank of England (PDF link) has one of the more detailed looks at interest rates’ downward march to zero over the last 700 years. I’ve covered the myth of interest rate mean reversion in detail in #257 as well as the deflationary impact of technology in #258, which I believe to be vastly underestimated in analysis of long-term rate trends. Whenever I see a chart on long-term rates, I am reminded of an essay by Ole Peters that I’ve previously discussed: “Did low rates increase debt, or did debt demand low rates? As an economy grows and debt increases, the borrowers – those people who need to make the interest payments and eventually return the principle – tend to be disproportionately less-wealthy, while the people who lend money out and make a return on it tend to be wealthier. As time goes on, the wealth of the wealthier is more and more tied to the interest payments from the less wealthy – one person’s indebtedness is another person’s asset. And, as inequality marches higher, the less wealthy have an ever-rising debt burden that can only be maintained by perpetually lowering interest rates. It’s in the best interest of the lenders to lend at lower and lower rates to preserve their assets. This explanation is somewhat at odds with the general narrative – that lower rates are the driving force behind rising debt.”

The BoE author reached a similar conclusion: “There is no reason, therefore, to expect rates to ‘plateau’, to suggest that ‘the global neutral rate may settle at around 1% over the medium to long run’, or to proclaim that ‘forecasts that the real rate will remain stuck at or below zero appear unwarranted’ as some have suggested...the long-term historical data suggests that, whatever the ultimate driver, or combination of drivers, the forces responsible have been indifferent to monetary or political regimes; they have kept exercising their pull on interest rate levels irrespective of the existence of central banks, (de jure) usury laws, or permanently higher public expenditures.” As previously mentioned, I like Brian Arthur’s views that we are entering the distributive era of economics. Rather than rates cracking through zero and continuing to negative infinity, it seems much more likely the wealth of the world will be redistributed in a way that creates some inflation to offset dropping rates. In a potential Goldilocks scenario, deflationary pressure from technology would make the porridge of inflation, rates, and redistribution taste just right over the long term.

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