What are the markets smoking?
The other day I was at a cafe and I overheard some smokers talking about the cost of cigarettes. In Australia at the moment you could easily pay $50 AUD for a packet of cigarettes. Because I don't smoke I had no idea what any of this costs, but I figured "why not look it up?" since it's another interesting data point in figuring out if we are seeing inflation or deflation. Given that technology and improved methodology has greatly decreased the costs of manufacturing many goods there's a definite case of "cost gravity" that would tend to be pretty strongly deflationary all other things being equal. But all other things are not equal and $50 for a packet of cigarettes is indeed what some now cost here as confirmed by 1 minute of research on a grocery company site:
And this is in line with a lot of other groceries, a lot of groceries have gone up in price lately. But cigarettes are a lot more expensive in Australia compared to other places in the world, it's not like the market is being distorted by people hoarding cigarettes like they did with toilet paper, so what's going on?
Cigarettes, capital controls and monetary policy
When I was travelling frequently for work I remember on the customs declaration form when returning to Australia that there was a limit of 25 cigarettes you could bring back from overseas. The reason for this limit is that cigarettes are absurdly expensive here so they have to impose controls on the movement of these goods because the difference in price is just so large that people would be incentivized to bring back the items from overseas to sell them locally at a profit.
Now this brings me to another interesting point about monetary policy. Say cigarettes are like a currency and you wanted to fix the price of them, say peg the value of the $CIG/whatever to some fixed ratio. Then you would have to effectively stop people from being able to freely move them across the border otherwise people could effectively buy the foreign currency to buy the goods them move the goods to sell them in local currency to then buy more foreign currency. This loop would put pressure on the exchange rate.
Cigarettes end up being a good example of what's known as the "Impossible trinity" of monetary policy which is basically that it's impossible to have all of the following 3 at the same time:
- a fixed
cigaretteforeign exchange rate
cigarettecapital movement (absence of capital controls)
- an independent
In the case of cigarettes there's effectively cigarette controls at the border, you can't move as much as you'd like, you are limited to a very small amount. This is very much like the situation with currencies in some countries, there are limits on how much money you can move from some places. It's interesting to note that given a differential a strong game-theoretic incentive starts to be put in place for people to break the rules, since breaking the rules gets more and more lucrative the more the prices get out of balance compared to the exchange rates with overseas. With cigarettes there's been cases of criminal enterprises running smuggling rings from other countries to import illegal cigarettes into the country since they figure they can make a lot of money from committing such a crime.
One of the major casinos here is under extreme scrutiny and had its operating licence revoked for doing the equivalent of illegally moving cigarettes across borders, something that we sometimes call money laundering or various other things. Circumventing capital controls was simply just too lucrative for them to pass up on, despite it being entirely illegal and because they were getting a lot of money moving into the country they got away with it for a long time.
If you've been following the markets the last year you'll know that there's been some crazy stuff going on. Like really unprecedentedly crazy stuff.
One thing you'll have possibly seen is that for quite some time government bond yields were dropping which has some pressures on interest rates as its effectively a measure of how cheap government debt is. Going back to this cigarettes analogy a government bond is like loaning the government 100 cigarettes and in a few years at maturity the government gives you back the original 100 cigarettes plus a few extra in interest. Here's a graph of the USA 10 year treasury yields:
Effectively if the yield is 1% you have the equivalent of loaning 100 cigarettes to someone in return for getting paid back 101 cigarettes in ten years time. In recent years there has been absurdly cheap debt available in the markets but only to some people. When interest rates go lower fewer people are willing to offer loans without assurances that they will get their money back. Let's say you are loaning someone 100 cigarettes and they are agreeing to pay you back 101 cigarettes tomorrow that might be a deal you may do, but if you are getting the 101 cigarettes back in ten years then you might not want to do this. The duration of the loan matters a lot, there's a lot more risk associated with the loan if you are getting paid back in 10 years time, you may have quit smoking by then or the other person might default on their loan and not be able to pay you back because of some unforeseen event that say happens 6 years into the 10 year loan.
You'd think that if there were low yields in places that the currencies would start to show some serious weakness as people would move money to other currencies that offered better interest rates. But the craziness of the currency debasement situation is not so obvious in forex trades because everywhere has been having shit yields and countries have this pretty strong incentive to artificially debase their currencies to promote exports if other countries have weakened their currencies too. Going back to the smoking example lets say you have to pay workers a packet of cigarettes a day in various countries to get some work done, for the sake of the example we will assume that the people doing the work do the same quality of work everywhere. If your country has 20 cigarettes in each packet but the other countries sneakily decide to try only put 10 cigarettes in a packet to pay their workers then all of a sudden foreign investment in outsourcing gets cheaper in the countries that only have 10 per packet. The pressure is therefore placed on the countries that pay in packets of 20 real things to drop that to 10 lest they get no exports of their labor. This exact dynamic describes a lot of what's going on in the world of international trade.
This dynamic can create a currency debasement race to the bottom, and there's a lot of pressure for export heavy countries to not defect from the overall trend with their monetary policy.
For the average person though they just care that each hour of their work buys them the same amount of commodities like food and other things needed for day to day life. There's definitely a tension between domestic goals and international goals here. Which is probably why Dani Rodrik comments "democracy, national sovereignty and global economic integration are mutually incompatible: we can combine any two of the three, but never have all three simultaneously and in full." While it might be convenient to debase the currency to promote international trade ends there can be a very large domestic political cost to do this.
The global bond market
If you aren't familiar with it the global bond market is a market for loans. Debt is bought and sold on this market. Interest rates are a crucial aspect for debt in general and therefore the general directions that interest rates are moving have a huge impact on the bond market.
So one of the things that happens in the bond market is that inflation is really bad for bonds. A bond is effectively a loan where one party pays back another party at a future date and there's some interest payments along the way. At the end of the duration of the bond the principle is repaid. There's quite a few things that go into pricing bonds, but generally speaking if the value of the money itself goes down in nominal terms (inflation) this is bad for bonds whereas if the value of money goes up in nominal terms (deflation) this is good for bonds. Lets say you loan 100 cigarettes to someone else with the deal being that you get paid back 110 cigarettes in a year, if in a years time the cigarettes buy you half as much or are worth half as much (due to effects of inflation) then offering the loan is not as good a deal. On the other hand if the value of the cigarettes were to go up over time (deflation) then your loan would be a lot more worthwhile to offer.
On top of this, when interest rates drop existing bonds get more valuable and when interest rates rise existing bonds get less valuable.
As a direct result of a few years (2018-2020) of interest rates steadily declining there was this gigantic bull market in bonds recently, with corporate bonds being one of the biggest bubbles I've seen in a long time. This then spilled over in to the equity markets because cheap debt was directly funding a lot of corporate stock buybacks which pushed the equity markets up a lot without actually generating any value at all (to some people this makes things on the stock market look like they are recovering more than they really are). For a while in there the yields just kept going down, something that the central banks of the world were very happy to see happen. This is because many governments have a lot of debt at the moment so a raise in the interest rates would be extremely uncomfortable for them, if rates are low the burden of this debt is a lot lower. All other things being equal an over indebted society will tend to see deflation because in our current debt based monetary system debt is effectively a type of money and when people start paying back their debts money is destroyed in this system. But of course not all other things have been equal in 2020-2021 since fiscal policy spending has been at absolutely unprecedented levels and unlike in previous times it's not just one country doing it, this is very widespread. We have also had a widespread pandemic to deal with as well, which has led to a lot of changes in a very short amount of time and in very many cases has exacerbated existing longstanding economic issues.
The consequences of the fact that in this current financial system that debt is effectively money are huge. If more debt is issued it means more money is created in the system. How money that's created via things like Quantitative Easing impacts inflation is rather complex, if you are interested I wrote an article about that.
Coming back to the smokers, I had to wonder if the people who were coming up with these "there's no inflation" types of comments were high or something because any look at any number of commodity charts or money aggregates shows a different picture (I mean sure there could be a tremendous deflationary bust in the future, it might even be likely, but at the moment everything points towards more inflation in the meantime, more about this later). But clearly not high on weed in Australia since the smokers were complaining about how marijuana in Australia is going for 280-360 AUD 1 per ounce. This just struck me as absolutely crazy, how could one ounce of silver in Australia be $40 or so but yet an ounce of marijuana be 7-9 times more expensive than silver? This is just crazy to me, agriculture can be done at scale and unlike elemental metals you can sustainably grow more things if there's demand but you can't grow more silver. That said capital controls (and making it illegal to have marijuana in Australia) are the reason why this huge price spread can exist, I asked a friend what it cost in Canada since it's entirely legal there and you can buy entirely legal marijuana for $100/oz there and get it delivered I'm told that a cheaper black market exists there too. Currently 100 CAD is equal to 100.35 AUD on the mid market forex rate. Clearly the purchasing power of the currencies are not quite the same thing as the forex rates, a concept I wish more people could internalize. I don't want to get too sidetracked with the questions of morality and ethics of drugs, there's some pretty complex questions there but I do want to use this example to show how differences in laws impact capital flows. Any form of capital controls, of which controlling movements of commodities is a form, will start to create incentives for people to smuggle and otherwise break the restrictions on movements. We see this in entirely mundane categories of goods that are legal in all places like the people who were smuggling cheese across the USA and Canada border around 2014. This cheese smuggling was highly lucrative because the prices on either side of the border were sufficiently different for the same sorts of products.
The issue is basically that if "Money printer goes brrrr" meaning that huge amounts of currency are created, real commodities and assets will have enormous pressure to be priced higher in nominal terms or be moved to the places where the prices are higher. This doesn't happen instantly though, the prices of any commodity is determined by the completed trades of cash for that commodity. So it takes a while for newly created extra money to impact prices (see the Cantillon effect for an interesting discussion of something that happens as a result of these unequal delays in inflation impacting prices). But if "money printers go brrrrr" everywhere then you won't so clearly see the inflation by looking only at forex, events like what we saw in Weimar Germany, Zimbabwe and recently in Venezuela have mostly been obvious to the public because the change in forex was rapid and brutal.
Why commodities matter
The smokers before in this anecdote certainly seemed more interested in their ability to keep smoking than any particular interest they had in the specifics of currencies. People tend to want money mainly for two reasons, to buy commodities (or other items) and to pay taxes. If a specific currency can't buy many commodities then that currency just isn't so strong. If there's one thing to take away from this it's that commodities are directly related to exchange rates in a rather deep way. After all money has value because it allows us to exchange goods but the very act of exchanging goods can be somewhat overlooked these days.
At the end of the day money is valuable only in as much as it gets you access to goods and the ability to expend energy towards goals.
But everything is getting more expensive here, lockdown is over in Australia and you can really tell that - at least for now - the monetary velocity has got faster3. For comparison it's winter in Canada and the virus situation has been far more problematic so people are moving less and have fewer chances to spend money, meaning lower monetary velocity there. Sure there might be an overall deflationary shock to the system if the asset price bubble bursts. But I'm far more worried that "the big one" will be some form of an economic "crash" that really should be deflationary to asset bubbles that gets hidden in nominal terms by egregious monetary and fiscal policy aimed at keeping the asset price bubble going at any costs. And the costs of keeping this asset bubble going will be tremendously high4, in such a scenario I could see people taking up smoking to deal with the stress from the rampant societal issues that such a monetary and fiscal policy would create.
This is February 2021 Australia dollar prices, something I feel obliged to explicitly point out in the footnotes since this is an article that claims widespread inflation and currency debasement is something to watch out for. ↩
To see why this is true in the broader banking system imagine you are a bank, if there's a drop in the interest rate you have to have a higher likelihood of getting the loan repaid to make it worth your while to offer the loan. At something like a 1% interest rate you have to be extremely confident that the full principle of the loan will be repaid otherwise it's just not in your favor to loan the money out. At a higher interest rate you have more ability to deal with defaults and therefore you can loan money out to more dubious prospects. This is part of the reason that loan sharks and various payday loans places have such high interest rates, it allows them to deal with a lot of defaults on debt. There's a lot of questions about if this is ethical as the whole concept of usury is an important one, but that's perhaps a discussion for another time. ↩
Might be worth watching the Australian yields, especially the long end, closely if this higher monetary velocity keeps up. ↩
Monetary policy and the actions of central banks lately has done a lot to damage the way in which price discovery works. When price discovery is damaged huge amounts of effort start to be misallocated into less valuable things, which is a large part of the reason behind the huge rise in "bullshit jobs". The cost of this is tremendous in the longer term. ↩