The Case for a Recession

Good afternoon Ladies and Gentlemen and thank you for clicking on this newsletter. To those of you who are new here to Behind the Wall, welcome, and to those of you back for round two, welcome back. I honestly didn’t know if I would even continue this newsletter after the first week. Even with the best intentions I felt like the story in last week’s newsletter was the only one that I really needed to tell, and inflation seems like a tame (although topical) subject by comparison. It still scares me to have so many people read my words and hear my thoughts. In today’s day and age, it seems like the only privacy we have left is in our own minds, but here you are in mine.

Anyway, thank you for reading, and welcome to week two of Behind the Wall. As I mentioned above, the topic for this week’s newsletter is boring old inflation. I know a lot of you are probably sick of seeing stories about inflation, but I would be willing to bet that you all have felt its effects over the past couple of years and are not happy about it. 

I keep seeing stories in the Wall Street Journal about how robust the economy is and opinion pieces wondering why Americans feel so down in such a strong economy. I don’t know about you guys, but I don’t feel very secure in this economy. It doesn’t matter how much the stock market has gone up, or that GDP has continued to increase. It doesn’t even matter that inflation has started to ‘cool off’. All I know is that I have not felt financially secure in several years and I am not optimistic about the near future.

What I know is that I am now paying over $50 for 10 items at the grocery store, over $60 to fill up my gas tank, and over $2,000 per month for an old, and let's face it, pretty shitty apartment. I genuinely do not know how people with families afford the basic necessities in life. It feels like the days of single income households are officially dead. 

I know I am not alone in this feeling. Despite what CNBC, the Wall Street Journal, and CNN feed us every day, my generation is scared for our financial futures. 

The cause of this feeling is simple, but the solution is not. Over the next few minutes I will make the case not just for a radical reduction in inflation, but for deflation, and by extension, I will make the case for a recession and explain why it could be a good thing.

What is Inflation?

Before we really get underway I think that it is important to define terms. I bet there are some of you who are tired of hearing about inflation, but still do not fully understand what it is, why it happens, and why it is a good thing (according to some). I will try to keep this as simple as possible as this is not an economics lesson (or maybe it is, I don’t know you that well), but it can get complicated.

Inflation, in simple terms, is an overall increase in prices, which leads to a decrease in purchasing power, or a decrease in the value of your money. 

There are various causes of inflation but the simplest one, and the one most commonly attacked by opponents, is a drastic increase in the overall money supply. Simple supply and demand tells us that when supply goes up and demand stays the same, prices come down. Money, like any other product, acts in the same way. 

What critics often get wrong is they claim that government spending is the main cause of a ballooning money supply. It is not the government spending itself that is the problem (in theory, government spending stimulates the economy through monetary circulation), it is government borrowing that is the problem. These two concepts, government spending and government borrowing, almost always go hand in hand in the United States, and some might say that I am making a semantic argument here. But I believe that details matter. And in this case the difference is a boon to the economy (government spending) and economic pain through inflation (government borrowing).

The Case for Inflation

In Keynesian economics, one of the most widely taught theories, inflation is generally a good thing. There are two main assertions that are made that can make a compelling case for inflation, one simple and one more complicated. I will start with the former.

Keynesian economists argue that inflation is the mechanism that allows for you, a worker, to get a raise. Wages are generally sticky, meaning you rarely take a lower salary than the one you already have (unless you are laid off from banking). The argument continues that if you don’t have inflation, wages would be zero-sum, meaning that for you to get a raise, someone would have to get a pay decrease. These two concepts are in opposition and would result in you only getting a raise when someone who makes more money than you retires and their salary returns to the metaphorical pie that all workers get a slice of. 

Inflation therefore, is necessary for wages to increase. For everyone to be happy, the government or central bank would need to increase the money supply just enough to balance wage increases with concerns over purchasing power. This is where the Fed’s 2% inflation target comes from.

The other, and slightly more complicated argument in favor of inflation is that it is necessary in order to have lending. 

One of the first concepts you learn in a finance class is that debt is leverage. While it can be scary when it accumulates too quickly (kind of like inflation), debt is a very good thing. It amplifies your spending power allowing people to buy things that it would otherwise take years or even whole lifetimes to accumulate enough cash for. Think of your mortgage (if you are lucky enough to own a home) and how much harder it would be to buy a house if you needed to pay the full listing price up front. My generation already feels that a house is out of reach, and it truly would be without debt. 

The catch is that banks will only lend you money if you pay them back more than they lend you through interest payments. The money you pay in interest has to come from somewhere and if there was a finite money supply then banks would own everything (well maybe they do anyway). In this framework, the only way for you to have your own money and for lending to be possible is for the money supply to increase.

Now think of the above example on a much, much larger scale. Like a $34 trillion scale. The government wants to spend money to stimulate the economy, but if the government runs at a deficit, it needs to borrow money. In order to borrow money it needs to pay interest on that debt and in turn the money for interest has to come from somewhere, and that ‘somewhere’ is more often than not, the printing press.

I’m not here to debate government policy and it doesn’t matter if you think government borrowing is a good thing or not, they are going to keep doing it. The point is that in order for the government to be able to borrow, and for you to be able to borrow for that matter, there needs to be inflation.

There is a lot more that I could go into about economics (I nerd out on this stuff) and maybe I can write a future newsletter on my views on Keynesian economics, but this should be enough context for the time being. This newsletter is getting long and I still need to make my case for deflation.

The Case for Deflation

The United States may not be in a technical recession (two straight quarters of GDP decline), but it certainly feels like we are for many Americans. Since June of 2020, the Consumer Price Index (CPI), the government’s favorite measure of inflation, has increased over 20%. The price of everything you buy has gone up over 20% on average; the value of a dollar has gone down over 20%. If you haven’t received a raise in the past 3 and a half years, you have received a 20% pay decrease thanks to Uncle Sam.

And honestly, a 20% drop in the standard of living feels low. I don’t know about you, but to me it feels like prices have increased by more than that. If you feel the same way, just know that you aren’t crazy, you are right.

The CPI under-estimates inflation (sometimes drastically) by excluding food and energy. That's right, the two things that you spend most of your money on (other than rent) are not even included in the government’s calculation of inflation. Businesses go along with this altered metric because it means they can give you a lower cost-of-living raise each year, but everyday Americans feel it in their wallet. The price of gasoline has increased 55% since June of 2020 and the price of food has increased by over 25% over that same period. 

These price increases wouldn’t be nearly as harmful if the Keynesian theory of economics worked in practice. If workers had received a 20% to 30% raise since 2020 this would have barely made up for the loss in purchasing power. I feel like I need to repeat that, a 25% raise would leave you no better off than you were before. That is bonkers for me to think about, and I don’t know about you, but I have not received a 25% raise since 2020. 

More and more Americans are falling behind financially, which brings with it even more problems for individuals and families (think of using credit card debt to fill the gap). Inflation has caused a spiral of financial burden, discouragement among workers, and fear of the future for young people. 

Despite the reality on the ground, the government and the media constantly tout that inflation is under control and is continuing to cool off. While it is true that inflation is no longer as high as it was over the past few years, even if inflation returns to the Fed’s target of 2%, the price of your gas, groceries, and everything else is still increasing.

Inflation “falling” does not mean that prices are coming down! It means that prices are going up more slowly than they were before. It means that even with the Fed’s 2% inflation target, next year your groceries will cost 27% more than they did in 2020 (they currently cost 25% more than they did in 2020). Again, even if the Fed achieves their goal, food will still continue to become less affordable than it is now. Unless there is a drastic increase in wages without causing more inflation (unlikely to the point of satire), this means that we, as a whole, are permanently worse off than we were just a few years ago. Unless we have deflation, rising prices will only worsen the wealth gap as more and more Americans will live paycheck to paycheck.

I will take a moment here to make another semantic argument. By definition, prices coming down is deflation. I think it is safe to say, even without data (I am too lazy to look it up), that most Americans would like prices to come down. Therefore, I feel comfortable in asserting that a recession is necessary to help the lives of millions of Americans.

The Case for a Recession 

The problem is that even though deflation would be a good thing in today’s day and age, there are very few ways that it can occur. In fact, essentially the only way that a country can induce deflation is by drastically increasing domestic production (increasing supply). Just like the value of a dollar, supply and demand tells us that more supply should lead to lower prices, all else being equal. 

As a side note, theoretically all we need is more supply to cause deflation, not necessarily domestic production. However, importing foreign goods comes with its own set of issues including tariffs, quotas, sanctions, etc., all of which increase cost and makes the importer (us) more reliant on the exporter, who then gains control over price. Therefore the only way that we as a country can control both the supply and the cost, is through domestic production.

While almost everyone would agree that bringing manufacturing jobs back to America is a good thing (politicians love to say this but rarely do anything about it), it tends to have the opposite effect as intended. In general producing products in the United States tends to cause inflation rather than deflation. 

The problem is that in the United States we have these (often ignored) annoyances called labor laws. Unions, politicians, and workers alike continually lobby for increased wages, which themselves are not a bad thing, but makes American made products more expensive, sometimes to the point of making them completely uncompetitive with foreign products. China, Vietnam, Mexico and many other countries with different (or no) labor laws and minimum wages are able to produce products much cheaper. Again, cheaper products are good, that is the whole point of this newsletter, but buying everything from foreign countries makes us reliant on their good graces. If every trade partner with the United States decided to stop exporting to us, what would we do? Would we be able to survive?

Since it is unrealistic to assume that we can control our own supply, we have to look at the other side of the supply-demand equation, and this is where things get more uncomfortable. The other way to influence prices to go down is to lower demand. If demand goes down and supply stays the same, prices will go down. The real question is how do we influence demand?

We have seen the Federal Reserve take steps already to curb demand over the past couple of years by raising interest rates. The mechanism that allows interest rates to have such a significant effect on inflation is a little convoluted, but I will try to make it simple. 

When you raise interest rates, it becomes more expensive to borrow money and fewer people will be willing to borrow. You are less likely to buy a home because the house will become more expensive since you have to pay more money in interest. In the same way businesses will put off building a new factory because it will be more expensive to build. This means fewer new jobs and fewer raises and less spending, and so on. The fact of the matter is that raising interest rates has a direct impact on lowering overall spending in the economy. And what is consumer spending if not a quantifiable measure of demand.

However, I argue that the Fed is not going far enough. They have caused inflation to come down but prices are still rising. The only way to curb demand enough that it causes prices to fall is for Americans to be unwilling to spend. This has not yet happened.

Since the United States left the gold standard, there have only been two instances of deflation and they were both caused by the financial crisis of 2008. Even then the deflation was so minor (-0.1%) that it hardly impacted prices at all. If we look back at the history of deflation since the Civil War the picture becomes even more clear: the only way to curb demand enough to cause prices to fall is through a recession. In our consumption driven culture the only reason that we stop consuming is when we lose our jobs or we are scared to lose them. 

All we hear about in the news whenever Jerome Powell (the head of Federal Reserve) speaks, is how he is trying to induce a “soft landing” for the economy. By this he means that he wants to curb demand enough to lower inflation without causing a recession. It is clear why he wants this, it is his job. The Fed has a dual mandate: to control inflation and also to minimize unemployment. If the economy goes into a recession he will achieve one of these mandates but fail in the other (and will probably lose his job as well).

My close friends know that I have been in favor of raising interest rates since at least 2018 when the discount rate was essentially zero. My view has not changed. The economy is on a knife's edge right now, we can all feel it. It almost feels like a recession without actually being one. All it would take is a signal of continued rate increases to push the economy over the brink and into a recession. Jerome wouldn't even have to raise rates, the threat would likely be enough.

I don’t want you to think that I am unsympathetic. I have already been laid off once (see newsletter #1) and know the fear and pain it causes first hand. A recession is never fun and the point of this newsletter is not to discuss the pros and cons of a recession, but to highlight a single (highly beneficial) silver lining. 

As I mentioned above, the Fed is fighting very hard to avoid a recession and so far they are succeeding (a shocker for a government agency). All I, and anyone else who is struggling to afford the basics of living, can hope for is that the Fed fails at their job. I do not relish the fact that I am rooting for millions of people to lose their jobs and trust me, it is always hard to go against popular sentiment (as a “Don’t Pass” bettor in craps I know). But I truly believe that it is a necessary evil that will result in a better life for tens of millions of Americans. In the same way that a blister has to be lanced, it will have to hurt before it feels better.

Non Sequitur

Because I don’t want to leave you with that gross picture in your head (I need to come up with better analogies), I will end this with a side note about one of my biggest pet peeves when people are discussing inflation.

I’m not sure if people genuinely don’t know this or if they are intentionally being dishonest, but the overwhelming majority of inflation is not caused by “corporate greed”. Companies have been touting in recent years that they keep generating record profits. I can see why this leads people to think they are being greedy but hear me out.

Companies report profits in nominal dollars, that means dollars unadjusted for inflation. This means that if their costs go up 10% due to inflation, they price their products 10% higher and voila! their profits have increased 10%! Even though they report that profits rose, their margins (the more important metric when valuing a company) either stayed the same or shrank. Of course companies’ PR teams publicize record profits, they want their stock to go up.

Are there some true cases of corporate greed? Sure. Capitalism is a system built on greed. But as a contributor to inflation, greedy companies are barely a rounding error compared to the increase in the money supply that we have seen through record government borrowing over the last couple of years.

Finally, I would like to point out that my overall arguments and explanations of inflation, its causes and Keynsian economics more broadly, are extremely simplified in this newsletter. It's already been at least a 15 minute read and barely scratches the surface of these topics. There are entire books that are written explaining nuances of all of this. My goal is not to teach you economics but to make a single point and hope that you learned something new. If you disagree with any of my arguments or assertions, I would love to hear them in the comments.

All data is pulled from the Federal Reserve Economic Data website (fred.stlouisfed.org) or from various articles in the Wall Street Journal.