Postcards from the florida republic: An independent and profitable state of mind.
I respect your time - I wouldn’t send you two daily emails unless the second one is urgent.
Technically… we could wait until tomorrow for this message. But, if I’d held off, by the time it reached you, the damage would have already been done.
This morning, the ADP jobs report showed that private companies added nearly 500,000 positions in June. The White House may take a victory lap, but as investors, we know the problem here.
The problem is this: The Federal Reserve can’t get the job market under control. This could spur more inflation, higher interest rates, and wealth destruction down the line.
But if you’re an adult who’s been in the markets longer than a year, you know that headline already.
This is what you really need to know right now…
More People Should Listen to This Rockstar Economist
This morning, I had a conversation with a friend in Europe.
He directed me to a recent speech by Gita Gopinath, a former assistant professor at the University of Chicago. My friend and I sat in on two of her brilliant lectures when we visited from our college down the road in 2003.
Gopinath is now the first deputy managing director of the International Monetary Fund (IMF). On June 26, Gopinath delivered a speech to the IMF on the structural problems in the global economy and inflation.
Consider this a new warning… and pay close attention.
My thesis in graduate school centered on “warnings” of the 2008 financial crash. I studied that crisis back and forth. I read every book and every article that I could get my hands on. I wrote about Peter Schiff’s warning to CNBC in 2006 on the state of the housing market. He predicted a crash. The interviewers laughed at him. I went back further… looking for other warnings.
I wrote about the warnings in 2002 on Freddie Mac and Fannie Mae. Barney Frank ignored those warnings.
But the biggest warning of the 2008 crisis came in the late 1990s. At the time, Brooksley Born warned about the impact of over-the-counter derivatives, the “weapons of mass financial destruction” that would, come 2008, crush the financial markets. From 1996 to 1999, Born was chairwoman of the Commodity Futures Trading Commission (CFTC).
Born warned men like Alan Greenspan, Larry Summers, Robert Rubin, and even President Clinton of the dangers of not regulating over-the-counter (OTC) credit default swaps. The Wall Street Journal wrote that “the nation’s top financial regulators wish Brooksley Born would just shut up.”
Rubin, then the Treasury Secretary, told her that she’d face lawsuits and that she lacked authority to regulate derivatives. But Born had plenty of evidence to warn of the dangers ahead. In 1995, Orange County, California, had gone bankrupt due to unregulated “shadow markets” linked to a then $25 trillion derivatives market.
At one point, Born just wanted to write a concept paper that explored the risks of no regulation on derivatives. They told her no. She couldn’t even conduct research.
Even after Long Term Capital Management LP collapsed in 1998 – due to the very forces Born was warning of – Congress passed a moratorium that stripped her of power to regulate the industry. Born left her office in 1999, and Congress soon passed the industry-friendly Commodity Futures Modernization Act (CFMA) in 2000.
Well, we all know how that turned out.
Born was correct, of course. Rubin left the Treasury Department to run Citigroup. That bank lost trillions of dollars and nearly sank the entire U.S. economy within a decade.
And so the early warning of the events of 2008 fell on willfully, stupidly deaf ears.
Now I think we’re hearing the early warning of a new 2023 crisis.
We’d Better Listen to Gopinath
I believe that Gopinath’s speech constitutes the next major early warning for the global economy.
After reckless levels of debt and spending over the last three years, Gopinath suggested last week that central banks may not be able to get interest rates high enough to tame inflation.
This is a horrifying warning to places like the United Kingdom, where inflation is running rampant due to supply challenges and reckless monetary and fiscal policy.
She offered three specific warnings (or “uncomfortable truths” about the state of inflation. Here are Gopinath’s verbatim warnings.
- The first uncomfortable truth is that inflation is taking too long to get back to target. This means that central banks, including the European Central Bank, must remain committed to fighting inflation despite risks of weaker economic growth.
- The second uncomfortable truth is that financial stresses could generate tensions between central banks’ price and financial stability objectives. Achieving “separation” through additional tools is possible but not a fait accompli.
- The third uncomfortable truth is that, going forward, central banks are likely to experience more upside inflation risks than before the pandemic. Monetary policy strategies and the use of tools like forward guidance and quantitative easing must be refined accordingly.
Let’s unpack these.
Inflation: Over the past 18 months, we’ve seen the fastest pace of rate increases in modern times. Yet, inflation remains entrenched, according to Gopinath. She’s quite correct. We’ve noted that the big challenge for central banks isn’t to bring inflation from 8% to 4%; rather, it’s getting inflation from 4% down to 2%.
Core inflation – the things not linked to food and energy – is what keeps central bankers up at night. This hasn’t come down in a meaningful way. And as we move into the second half of the year, inflation may remain elevated or increase depending on the month-over-month trajectory heading into 2024.
Banks: In March, banking failures were larger in dollar terms than what we witnessed in 2008. And we haven’t even seen an official recession yet (although that is clearly coming.) But Gopinath warns that business and customer defaults could accelerate these problems in the next year (Is this why Janet Yellen is warning about more banking weakness?) The question is whether the government will bail banks out once again. If so, will that create new upward pressure on inflation once again?
The March 2023 crisis – fueled by ownership of conservative Treasury bonds at low-interest rates – was something that an intern at the Fed could have caught just by looking at publicly available data and balance sheets.
For banks to implode the way they did suggests that this industry isn’t as healthy as regulators would have hoped coming out of the 2008 and 2020 crises. Of course, it was the regulators who forced these institutions to own Treasury bills not just in the United States but also in other nations. Central banks have been looking for other buyers of last resort.
The banks made sense. Gopinath warns another inflationary shoe will drop: More bailouts create more inflation. Gopinath notes that higher interest rates will just increase the odds of such a situation. Raise rates, fuel bankruptcies, inject bailouts, fuel inflation… and the process restarts. What a vicious cycle.
But it’s the last problem that should worry any economists.
“Structural changes affecting aggregate supply.”
Here’s What We Should Take from All of This
Economies are weaker - and supply shocks are likely in the future. We’re talking about the very same supply shocks that Ben Bernanke argued to be the primary source of inflation.
But structural changes are directly tied to policy.
Gopinath warns about the ongoing trend of de-globalization and the restricting of supply chains after COVID. She warns that there have always been disruptions to the transition to clean energy.
Here is where my view diverges from hers. I’d argue that the transition has struggled – largely because of the sheer scale, size, and difficulty of this transition. In addition, the green transition is highly inflationary by its basic nature.
But let me make one additional point on policy.
You can’t print more food. You can’t print more oil. You can’t print more metals. In the wake of COVID, the world economy has experienced dramatic shocks caused by bad policymakers.
Now, Gopinath isn’t going to explicitly say this - she works for the IMF, and her bosses are all-in on green energy and global health initiatives.
But I will. Because I have no problem calling out the problem.
We have regulators in charge – usually Yale lawyers – with no understanding of how business works. Whether it’s COVID or climate change, or pick any pet issue – the walls of regulation are increasing, and costs increase as a result.
Eventually, companies throw up their hands (and throw in the towel), or they produce less.
We have zero supply-side support in this country aside from massive subsidization of businesses.
But when you subsidize something, you make it more expensive. Look at U.S. education, food, energy, and housing costs since the 1970s, and you’ll find these are the categories with the biggest increases in price compared to the Consumer Price Index.
The same goes for medicines.
Now, we have the government injecting tons of money into the green energy movement and semiconductors. Subsidies won’t make these things cheaper – what they will do is drive up the underlying supply inputs like metals, industrial gases, and more because they juice demand. But they don’t increase supply.
The way to increase supply is to cut red tape and make it easier to operate. But that doesn’t happen. In fact, regulatory red tape is a business model for certain think tanks, consultancies, and lawyers who get paid big bucks to hold up mining projects or try to take energy projects offline. It’s largely a grift.
As I noted yesterday, the economist Casey Mulligan determined that new regulatory costs since 2021 on the average American have increased by $5,019 a year.
Take note, kids - there’s money in regulation.
Permanent – structural decline on the supply side combined with governments providing more bailouts and chasing more expensive energy sources – could make 4% inflation look tame.
Since surging debt and misallocation of resources already hurt the real economy, higher interest rates will negatively impact consumers and businesses, all while governments keep doing the same frustrating things and producing more debt. The solution is to cut spending, cut regulations, increase domestic production, balance the budget, and get the fiscal house in order.
But that would mean the death of dirigisme. And we all know that isn’t going to happen – with an ever-expanding government. The only hope – for now - is for the Supreme Court to keep chipping away at the regulatory state. And for investors to understand Gopinath‘s warning and adjust their portfolios accordingly.
To your wealth,
Garrett Baldwin
Florida Republic Capital (Available on Substack)
About the Author
Garrett Baldwin is a globally recognized research economist, financial writer, consultant, and political risk analyst with decades of trading experience and degrees in economics, cybersecurity, and business from Johns Hopkins, Purdue, Indiana University, and Northwestern.