The Law of Ignored Consequences

An interview with former Federal Reserve official Lawrence Lindsey... What Washington misses... The law of ignored consequences... Why inflation has sticking power... The Fed's not going to solve anything...

Editor's note: We're taking a break from our normal Digest fare over the next two days to bring you an exclusive, wide-ranging interview with Lawrence Lindsey.

Lindsey is a former member of the Federal Reserve's Board of Governors, was economic adviser to multiple presidents, has a Ph.D. in economics from Harvard University, and is the author of an exciting new novel called Currency War, which postulates an economic war between the United States and China.

Our Stansberry NewsWire editor C. Scott Garliss recently caught up with Lindsey to talk about the book and get his insights on what the Federal Reserve is doing with policy today. As you'll see, Lindsey thinks inflation will be sticking around the economy much longer than some at the Fed today are saying...

Scott Garliss: You earned your master's and Ph.D. in economics from Harvard starting in the late 1970s. What was the prevailing school of economic thought at that time?

Lawrence Lindsey: The prevailing school of thought was what I would call Keynesian. You have to remember, I'm an old geezer. I really went there in the '70s! And believe it or not, back then, we really didn't even separate nominal GDP from real GDP. We only thought in nominal terms. The economy of the '70s changed that and changed economic analysis quite a bit. The idea of inflation was not only brought into the data but so was the concept of inflation expectations and what I call an aggregate supply curve, as well as an aggregate demand curve. It was cutting-edge, at the time.

SG: Some of today's central bank governors learned the same things. You very much understand their way of thinking and the policies they've implemented in the recent past. Right?

LL: Very much so. And to be honest, especially after I got my Ph.D. and went back to Harvard as a professor, I was not a popular dude. We didn't have the same cancel culture that we have today, but it was moderately hostile.

SG: Would you say you prescribe to Keynesian theory?

LL: I am a supply-and-demand sider. I don't know how one can do an economic forecast without using both. Although most models, including the Fed, really only look at the demand side of the economy... I start on the demand side. I say, "How much are people likely to spend?" That will depend, in part, on how much they're likely to earn. Then I think, "Well, how much is it likely that the economy can produce?" which is the supply side. You end up where supply and demand cross. That's at least the first pass.

And then comes the little tricky part: You have to make sure that that equilibrium that you first calculated actually matches into your assumptions of how much money people are going to earn and what the demand side looks like. Sometimes it may take two or three passes to refine down to a forecast.

SG: To summarize for people who may not be as familiar, you feel that these central banks are missing a big part of the picture right now.

LL: Yes, and I would say it's not just central banks. In the case of Washington, it's basically the entire economic establishment. That would include, for example, the Congressional Budget Office... The bias in Washington is purely demand side, because that's what they think they can control. They believe, in their hearts, that if you turn this dial a little bit, push that button, and pull that lever, that they will get the result that they desire...

Now, indirectly, they move the supply side. For example, if you shoot up taxes on entrepreneurs – which they are certainly contemplating – that's going to cause the supply side to shift back. That's going to mean lower growth and higher inflation – it's as simple as that. Policy matters very much. It may not matter as much as, say, fiscal and monetary policy, but it matters quite a bit in determining how things end up.

SG: It sounds like the law of unintended consequences...

LL: "Unintended" is generous. You might say ignored but predictable consequences, in their case. They really don't pay attention, at all, to what the impacts of their policies are.

SG: What are your thoughts on Modern Monetary Theory? It proposes governments that control their own currency can spend freely... It also suggests increased government spending will not generate inflation, as long as there's unused economic capacity like labor...

LL: I started off by saying I'm an old geezer, so "modern" anything immediately gets my suspicion. But I also am a great believer in common sense, so let's deconstruct what you just described as Modern Monetary Theory... There won't be inflation as long as there's spare capacity... That's kind of true. I would say there's not going to be much inflation as long as there's spare capacity. But the real trick is, how do you measure spare capacity? And the Fed and, frankly, most economists, including in the private sector, have a very naïve view of spare capacity.

One thing that differentiated us from them this year is they thought, "Well, we have 8 million fewer people working than we did before COVID hit, and therefore, there must be excess capacity." There's a lot of apples and oranges here. For example, a lot of those people who are still unemployed, or were in January, were in the hospitality business. If you look back over the last few months, roughly half of the additional jobs were in that area. But let's think about that in terms of GDP.

Those workers in hospitality earned 40% less than the average worker. That, their earnings, is roughly a measure of their contribution to GDP. Even if you brought all the hospitality workers back, the boost to GDP would be only 60% as much as if you brought back an equivalent number of typical workers from other sectors. Then there's the question about "coming back." We put a lot of self-inflicted wounds on that process, certainly the top-up in unemployment benefits was one of them. And let's be honest, I'm working from home. Why?

We're working from home because the thought of hanging around all day with a bunch of strangers is a lot less appealing than it used to be. You and I have that luxury – roughly 75% of the American workforce does not. If I'm a server in a restaurant, the thought of going in there and mingling with all those perfect strangers is a lot less appealing.

Here are the statistics on this: We have 10 million vacant jobs, and we have 8 million people who say they're unemployed... Does that mean we have spare capacity? No, there must be some other reason those jobs are not being filled. And in every business survey you look at, the biggest complaint of employers is they can't find qualified workers. That suggests the labor market really isn't clearing. And if the labor market isn't clearing, then that means the supply side of the economy isn't doing very well, and the supply side has shifted back and effectively been reduced.

How do we solve that? If you have more demand for anything than you have supply, the price is going to go up. And so we now have to see a significant rise in real wages, after inflation, in order for the labor market to clear. If we're going to induce all those people to come back to work, we're going to have to pay them to do so. The president has even said, "Yes, that's what I want." The problem is, in every single month of his administration, inflation has gone up faster than average hourly earnings.

The situation has actually been getting worse, this year, in terms of labor market clearing, and this is a huge, huge long-term problem. In my mind, the thought that inflation is transitory verges on laughable. Everything we know about economics says you're going to have a bout of wage inflation, and that's going to feed through into price inflation.

SG: You served as part of three different presidential administrations, and you served as a member of the Federal Reserve Board of Governors during another. Did the economic policies of any one of those presidents stand out above the rest?

LL: Ronald Reagan. When you're in an administration, you're part of a policy process. Everyone gets together – these people all come from different points of view and different life experiences – and you try and hammer out something sensible. The only constraint is you have to have it consistent with what the boss wants. The great thing about working for Ronald Reagan is you knew exactly what the boss wanted.

So our job was largely technical: How do you get what the boss wants, in the simplest kind of way? His administration was an unquestioned economic success – we brought inflation down. Yes, there was a sharp recession, but you can go back and look at anybody's forecast: That recession ended much quicker, and the recovery was much greater, as well as the decline in inflation, than anyone expected. Even then-Fed Chair Paul Volcker said as much. And that's because the supply-side policies of the Reagan administration were the right thing to do as Volcker's tightening demand-side policy took hold.

Picture a demand and a supply curve in your head... The demand curve is falling back to cut inflation, but it also cuts jobs, then output. But if you have the supply curve increase at the same time, it pulls the inflation down even faster, and it helps mitigate how much the loss in output was. Inflation dropped from double digits to 4% very quickly. We actually had negative inflation in the second half of 1982. But we were down from 12% to 4% in 18 months, and no one thought that was possible. The reason was sensible supply-side policy.

SG: During President Carter's term, interest rates got up to as high as 20%. Paul Volcker came in and started hiking interest rates, to offset. Do you see us in a similar situation today? And if you do, what's our way out?

LL: The thing about history is it never repeats itself, but it does tend to rhyme. And we have had 10 prior episodes, since 1957 and not including 2021, where the first half of the year had core inflation of 3% or higher. In nine of those 10 previous years, the full year ended up above 6%, meaning there was no reduction in inflation. It was generally a small acceleration of inflation. Once you get to 3% over six months, inflation's pretty well imbedded – so nine out of 10. What was the tenth? The tenth was 1982, when Volcker slammed on the brakes.

So you say to yourself, "OK, I guess we can stop inflation by slamming on the brakes, and a very sharp hike in interest rates." And then you say to yourself, "Is the current crowd, Jay Powell and company, anything like Paul Volcker?" And the answer is no. They view their incentive structure as keeping the music playing as long as possible, so they are going to delay tightening as long as possible. That's their judgment. Volcker had a different mandate, shall we say. So, no. History says we're stuck with inflation, and these guys are not going to be solving it.

SG: So what can we expect from your book, Currency War?

LL: This is my first work of fiction. I have six nonfiction books out there. People don't think of an egghead like me as a fiction writer, but I found it therapeutic. You can say things in a work of fiction – and I remind everyone that this is a work of fiction, and any resemblance of characters in the book to real people is purely coincidental. I have to stress that. But with that caveat, you can do things in a work of fiction that you can't do in a work of nonfiction. And I found that very liberating.

Editor's note: Check back tomorrow for Part II of Scott's interview with Lawrence Lindsey. He will talk in detail about the threats that he believes China poses to the United States and how they might manifest themselves in the years ahead... and how investors can protect themselves today.

He'll also share some more details about his novel, Currency War. In the meantime, if you are interested in learning more about the book, you can find more information about it and how to order it right here.

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Longtime Digest readers know that Stansberry Research partnered with professional golfer Kevin Kisner back in 2018. This past weekend, Kisner won the Wyndham Championship in a six-man playoff... And judging from our mailbag, at least a few subscribers noticed. Plus, we've heard from a lot of folks in regard to our colleague Dan Ferris' latest Friday Digest about hedging against inflation. As always, you can tell us what's on your mind at feedback@stansberryresearch.com.

"I see the winner of the PGA golf today had on a shirt with Stansberry Research over the left pocket. Way to go." – Paid-up subscriber John W.

"Excited to see Stansberry Research on Kevin's shirt. Way to go, you guys." – Paid-up subscriber Mick

"The first time the FED used the term 'transitory' to describe inflation last year, my immediate thought was, 'Sounds like denial kicking the can down the road again.'" – Paid-up subscriber David W.

"I enjoyed your Friday Digest on inflation.

"I recall when I was in high school, gas was 32.9 cents a gallon and a hamburger was 15 cents. Now gas is $3.29 (or more!) a gallon and a hamburger is $1.50 – up 10 times.

"I was telling my grandkids, when they are my age, they will go to the drive-in and pay $30 for two hamburgers, and then fill up the car for 'just' $493.50 (15 gallons at $32.90 a gallon)!

"Hard to believe, but it's the same scale – 10 times." – Paid-up subscriber Dave O.

"Excellent explanation of the danger of inflation.

"My parents grew up in the Great Depression, and their whole outlook on life was affected by it as long as they lived.

"For me, now in my mid-70s, I started my business life in the '70s and I saw the impact of inflation up close. I have always had inflation in the back of my mind as a risk that must be taken into account. For those in the audience who are younger, inflation is an abstract concept that is not a big deal.

"Those who ignore history do so at great peril." – Paid-up subscriber Lloyd V.

Regards,

C. Scott Garliss
Baltimore, Maryland
August 16, 2021