"So How Did You Lose Money Buying Risk-Free Bonds?"

The title of this article is deliberately silly, but there are times where I just need to be deliberately silly. I am not going to discuss why people (like myself, sigh) decided to not cut their bond allocations to zero ahead of the recent Bond Catastrophe, but rather how to judge or even calculate returns based on the most common bond market data — constant maturity yield series.

(This article is a bit rushed, since I yet again have family visiting from out of town…)

Primer: The Cantillon Effect

The Cantillon Effect is the label applied to a process described in Richard Cantillon’s , «Essai sur la nature du commerce en général», published in 1755. (One English translation of the title is “An Essay on Economic Theory.”) The basic premise is that an initial inflow of money will raise prices as the original recipients of the money spend it, which will then raise other prices as the “new money” enters others’ hands.

Primer: American Bank Insolvency Losses

In this article, I am going to give a basic introduction to insolvency (bankruptcy), as well as a discussion of the principles of how losses are apportioned to the various classes of creditors of American banks. I will only attempt to look at American banks since bankruptcy procedures are specific to each legal jurisdiction. Although I was not a credit analyst, I worked with them and had some training on the topic. The article “U.S. Corporate and Bank Insolvency Regimes: An Economic Comparison and Evaluation” by Robert R. Bliss and George G. Kaufman (URL: https://www.chicagofed.org/-/media/publications/working-papers/2006/wp2006-01-pdf.pdf) covers this topic, and I will use it to justify some assertions about the procedures. I will then discuss some of the issues of the resolution of Silicon Valley Bank, which is underway at the time of writing.

Inflation Index Calculation Basics

My upcoming inflation book continuously refers to price indices, such as the Consumer Price Index (CPI). A price index is meant to stand in for all the prices covered by the index. That is, if the index rises by 1% (e.g., going from 100 to 101), the “average” price change for the covered goods and services is 1%.

Note: This is an unedited draft from my inflation primer manuscript.

Basis Point Usage

There has been a strange debate on Twitter about the usage of the term “basis points.” The argument is that it is deliberately obscure jargon. In this article, I will discuss its usage, and the contexts where it is useful.

The usual definition of basis point is that a basis point is 0.01%, or alternatively, 100 basis points equals 1%. (Note: Canadian and British usage prefers writing “per cent,” whereas Americans prefer “percent.” Although I usually stick with Canadian spelling, this is one case where I bow to American cultural imperialism.)

Primer: Bank Capital

Bank capital is the buffer on a bank’s balance sheet that allows it to absorb losses, particularly credit losses. Although there is a great deal of excitement about bank liquidity — bank runs, just like in “It’s a Wonderful Life”! — but the main danger is the capital buffer being wiped out (insolvency). A bank run might feature at the end of the bank’s lifetime (quite often, regulators just step in), but the trigger is the insolvency. This article discusses bank capital at a high level, from a macroeconomic viewpoint.

Primer: Basics Of A Swap Meltdown

I am now seeing more attempts to dig into what exactly happened in the United Kingdom interest rate market. In this article, I am not attempting to do that. Instead, I am just giving a primer on how interest rate swaps are used to hedge liabilities, and what can go wrong when interest rates rise. The mechanisms I describe were likely part of the issue, but I am not saying that this is “the” explanation. Since most people are unsure what liability-driven investment and swaps are, so I am hoping to cover big picture issues for those readers.

Primer: Bank Treasury Operations

I have been looking at The Moorad Choudry Anthology: Past, Present and Future Principles of Banking and Finance (Amazon affiliate link, and as the title suggests, by Moorad Choudhry) as a source for my banking primer. Professor Choudhry teaches in the M.Sc. Finance at the University of Kent Business school, and previously worked in a bank treasury department. The book is impressive, clocking in at 1252 pages (not counting end matter). As an academic text, it is not cheap, but is a good source for getting a handle on banking.

My primer is aimed more at the macroeconomic aspects of banking, and would be a lot shorter (and cheaper). However, my plan is to lean on the Anthology for more complex topics.

Bank Reserves Demystified

Bank reserves feature prominently in Economics 101 discussions of banking. As is entirely typical for Economics 101 macroeconomics, the topic is either taught incorrectly or in a misleading fashion. Bank reserves — better referred to as “settlement balances” — are just private sector bank deposits at the central bank. If you know what a bank deposit is, you know what a “bank reserve” is.

Primer: Leveraged Financial Firms

This article discusses the basic concepts around leveraged financial firms (entities). This is expected to turn into an early section in my banking primer. The key take away from this discussion is that the distinction between bank and non-bank finance is somewhat smaller than is popularly suggested. The difference lies in the infrastructure needed to gather and service deposits, but the balance sheet structure can be largely replicated by non-bank financial firms. This explains why banks and non-banks blend into each other in the absence of regulations to the contrary.

"What Is A Recession?" Primer

I published an excerpt from my book Recessions: Volume I on my Substack. Since I believe I published the content already here in draft form, I am just putting a link to the other site.

Since it is a straight excerpt of the book, obviously not aimed at the current debate, but I believe it covers the main points that are coming up in conversation.

Banking Debate Woes: Part III

This article finishes off a sequence of articles on an ancient debate in economics: what limits bank lending? (Links to Part I, Part II.) My argument is that the usual ways of looking at this question are highly misleading. The mainstream Economics 101 description of banking is hopeless — and then heterodox critics got bogged down in attacking a hopeless description of banking. The key to understanding banking is that they are a financial firm that borrows to invest in assets (a “levered financial entity”) — and they have some similarities to other financial firms, albeit that they have some special privileges.

Where Are Supply/Demand Curves?

The reduction of the Fed’s balance sheet is coming, and so we are likely to be involved in debates about how much this will affect bond yields. I am in the camp that the quantities involved do not really matter (which some qualifications). I just want to explain my logic, which involves discussions about “supply and demand” curves for bonds, which vary based on time frame. Although this discussion might appear obvious, my feeling is that there are some hidden assumptions that people make about market price determination.

Understanding Long End Inversion

I have seen a certain amount of chatter about inversions of the long end (or ultra-long end) of the Treasury curve. I do not have enough information to offer definitive conclusions on recent market action, but in the article I explain why I view a 20-/30-year inversion is not comparable to a 2-/10-year inversion.

Inflation History Overview (For Some Selected Countries)

Note: This is a preliminary draft of a section from my inflation primer. It is an overview of the “modern” inflation experience for a few developed countries. I expect to add data and comments for a few continental European and Antipodean countries later. This content will be familiar to anyone who has pored over historical inflation charts, but not everyone is in that boat. As for the readers interested in my modelling work, I put up a post on my Patreon about the latest additions to my agent-based modelling package. Although it did not add new content to the model, this work will now make it easier to add new complex agents to the mix.

Hyperinflation! (Primer)

Hyperinflation is a phenomenon that has caused a significant amount of hyperventilation within economic and market commentary. The pictures of people using wheelbarrows of money to go shopping are certainly memorable.

NOTE: This is an unedited draft of a section that will make its way into my inflation primer. I have kept this section minimal, but may add more later during editing.

Primer: Quantity Theory Of Money

Note: This is an unedited excerpt from my inflation primer manuscript.

Even if we put aside the atypical argument that an increase in the money supply is how to define inflation, there is a widespread belief that increasing the money supply causes inflation (as normally defined). These beliefs can be traced back to what is termed the Quantity Theory of Money, which has a long history in economic thinking.

Wage Inflation

Note: This is an unedited excerpt section from my latest manuscript, which is an inflation primer. Unlike my previous writings, this planned book largely stays clear of theoretical disputes, and mainly discusses what we know for sure about inflation. This section dips a bit into theories — mainly to say to read about them elsewhere.

I view this text as very preliminary. I will take a long look at it again once I have the rest of the book put into place. My plan is that the book was supposed to be a short report, and it may be that I am near the end of overall text structure. I then need to fill in more details - data from other countries, more references - but I will do that once all the sections are assembled. There is no point tracking down data and references for a section that ends up getting deleted completely.

The usual convention is for inflation to refer to the cost of goods and services – things people buy. From a macroeconomic standpoint, a good deal of “inflation” discussions are about another phenomenon – wage growth.

From the perspective of most individuals, getting a pay increase is a good thing. An increase in the price of goods and services means you can buy less stuff, and that is viewed as a bad thing. This fits the framing that inflation is bad.

Once we start looking at the macroeconomy, the emphasis starts to shift. The labour market is watched intensely.

Wages are Domestic, Prices Often International

The bond market reacts to the interest rate policy decisions of the central bank, and modern central banks are generally mandated to control inflation. That said, they have very little control over many key prices, such as oil prices.

Oil prices are set in international markets, driven by both private firms and state actors. If oil prices increase, rate hikes by the Bank of Canada would do very little to tame them. Even rate hikes by the U.S. Federal Reserve might do very little to oil prices if the reason for the price increase is either a supply constriction or a demand increase elsewhere in the world.

Policymakers need to focus on what they can feasibly control, which is the domestic economy. Wages represent one of the most important domestic prices (the price of labour).

(As an aside, one could argue that policymakers could adjust the level of the currency to counter-act rising international prices. Since the developed economies generally let their currencies float, this is not possible. But even if the currency were controlled, it is not necessarily a good idea to let your currency increase in value in response to an oil price spike if you are not a major oil exporter. Rising energy costs displace other spending, and so there is a demand shortfall in the developed countries that import oil. This means that your exporters would face a double whammy – falling external demand, as well as a loss of competitiveness from currency appreciation.)

Relationship Between Wages And CPI

From the perspective of mainstream theory or post-Keynesian theory, we expect to see a relationship between wage growth and inflation. However, there are considerable differences of opinion regarding the exact mechanisms involved. So long as we focus on prices determined by domestic macro factors, we generally see a relationship. In a country where imported goods or non-processed foods represent a large part of the CPI basket, then there can be large divergences between wage growth and CPI inflation.

When we look at the data, we typically see that wage growth and CPI inflation move together. The chart above shows the U.S. experience, comparing average hourly wages to the core CPI. The top panel shows growth rates and see that they tend to rise and fall together – but not at the exact same rate. (The pandemic caused an unusual spike in 2020 – lower-wage workers were disproportionately stopped from working by health directives, and so the mix of workers shifted towards higher-wage workers, raising the average.) I used core inflation to demonstrate how it is smooth, very much like the wage growth series.

The bottom panel shows the ratio of wages to core inflation. Using core inflation in the ratio is admittedly an unusual choice – we normally want to do the ratio to headline. I kept it with core CPI so that it is directly comparable with the previous panel. Since the average hourly wages are in dollars while the CPI index is a number without dimensions, the ratio is arbitrary. I set the scaling of the ratio so that the displayed series equals the original value in January 2020, which is often described as using a January 2020 baseline. We can think of the series as average wages in 2020 dollars (keeping in mind that I used core CPI). We see that there are smooth trends – falling in the 1980s, and then recovering in the mid-1990s until just after the Financial Crisis of 2008.

So long as we lop out oil prices – largely driven by global factors after the 1990s – we can say that there is a relationship between wage growth and CPI inflation.

So long as we keep in mind the domestic/global distinction, we can see that CPI and wages represent different segments of a wider notion of “domestic prices.” I will often refer to this wider concept as the “price level” – a generic notion of prices that includes all the major components of the prices of current goods and services, which includes wage measures and producer prices as well as the CPI. However, I do not include asset prices within this concept, as I discuss further in Chapter 4.

(As an aside, the bottom panel could be used to discuss the standard of living of workers over time. However, if the (core) CPI systematically deviates from the true “cost of living,” then the readings for the “real wage” are not comparable over the decades. If we accept the common view among economists that the CPI overstates the “cost of living,” then wages should have a rising trend over time that is not apparent in the figure.)

Lots of Theories

There is a long history of arguing that conditions in the labour market determine the inflationary trends in the economy. In economic commentary, you will see many references to concepts like the Phillips Curve, the non-accelerating inflation rate of unemployment – more normally referred to by its acronym NAIRU.

If we ignore the details, we could paraphrase these ideas as: if the labour market gets “tighter” (or “overheated”), wages and then CPI inflation will rise with a delay (“lag” in economist-speak).

If we stick to generalities, this largely represents my beliefs about the causes of inflation (with various exceptions). However, the problem is getting more specific. As soon as we try to come up with a mathematical model that links observed labour market data to inflation, the models sort-of work until they do not. The determination of inflation is complicated.

(Since many of my readers are fans of Modern Monetary Theory, I would note that my comments here largely refer to existing institutional arrangements. The argument is that the introduction of a Job Guarantee programme would help stabilise wages and thus the price level. I discuss this in my book Modern Monetary Theory and the Recovery, such as in Section 4.3. However, we cannot point to historical data to demonstrate this conclusively yet.)

Why There Should be a Link

To what extent workers have cost of living adjustments (COLAs) in their bargaining agreements, a rise in CPI inflation will tend to raise wages. This certainly was a factor in the 1970s, when private sector unions were relatively more powerful than now. Even in their absence, every firm that has employees has wages embedded in their cost of doing business. There are two fighting flavours of theories to link wage costs to output prices.

1.  The mainstream view is that firms set wages based on the value of the output of the “worker at the margin”: if output prices rise, they can pay more.

2. The post-Keynesian view is that firms set prices as a markup over the cost of production. So if worker’s wages go up, the cost of production goes up, and so firms want to raise prices to compensate.

I lean towards the post-Keynesian view, but both views point in the same direction. If wage costs rise, then we should expect the cost of domestically produced goods and services to also rise (sooner or later). This explains why central bankers and bond market participants pay a great deal of attention to labour market data, instead of obsessing about the price increases of Crunchy Cheese Treats in the snack section of your local grocery store. Admittedly, they tended to analyse the data incorrectly, but nobody is perfect.

The relationship between wages and CPI inflation is not the simple case of one being a constant ratio to another (which marginal theories might suggest). Wages are a cost of doing business, and if they go up without output prices rising, profits fall. This leads to the post-Keynesian conflict theory of inflation. Workers and firms each attempt to increase their income share, and wages and output prices increase to accommodate this.

It is a basic accounting fact that the ratio of wages to output prices determines profit margins, and that ratio is not constant. The only real debate is around whether we can make useful predictions using this observation. Since I do not want to get into theoretical disputes within this introductory text, I will just point the reader to Chapter 17 of Macroeconomics by Mitchell, Wray, and Watts for more details.

Output Has to Be Bought

The general demise of cost-of-living adjustments means that the psychological link between CPI inflation and wage growth has faded. To a certain extent, there is a fear that inflation just destroys workers’ standards of living. This is certainly what it feels like from the perspective of an individual.

From a macroeconomic perspective, we see that it is harder to de-link the two. Produced output has to be bought, or else it piles up as unsold inventory.

For example, imagine that the price of goods and services suddenly rose by 10%, while wages did not respond. Unless workers suddenly dip into their savings to make up for this, the implication is that workers can buy 10% less stuff. The most likely outcome is that this would trigger a recession (albeit with an unlikely exception that I will return to). Pricing power of firms normally softens in recessions, counter-acting the previous price jump. Very simply, raising prices of goods and services without rising wages to purchase them is difficult.

That said, we can see such outcomes in the real world, which are typically the result of a currency collapse or a supply disruption (e.g., a failed harvest). If the price of a critical import spike in price, a country faces a drop in the standard of living. Such episodes are common, but currently less of an issue for most developed economies. As firms get used to operating in a floating currency regime, they become less sensitive to foreign exchange volatility. Also, developed countries feature less food inflation swings. the industrial food sector has more reliable yields, a diversified set of suppliers all over the globe, and the layers of processing between the raw food inputs and the output “food product” means that large changes to raw food prices only have a limited impact on final prices in the grocery store/

This explains why the phrase “price and wage spiral” is commonly used in the discussion of inflation: wages generally need to rise in order to purchase goods that are rising in price.

As a final theoretical point, we can imagine a possibility where output prices rise but wages are unchanged – the owners of capital spend the increased profits to make up for the loss of purchasing power of workers. Although this happens to a certain extent, the extent of this effect are limited. Very simply, rich people are not going to run out and buy all the Crunchy Cheese Snacks that workers cannot afford to purchase.

Productivity

The conflict theory might suggest that workers and employers are fighting over a fixed size income pie. This is essentially true in the short term, but over the longer term, the pie itself is growing. This means that both wages and profits can grow faster than the rate of inflation.

The reason that the pie is growing is chalked up under the term productivity. The output per hour of workers has tended to increase. This can largely be attributed to technology in its various forms, in particular the ability to harness concentrated energy, and increased agricultural yields. The increase in agricultural output has allowed developed societies to transition from mainly rural to mainly urban. However, the increase in productivity can be the result of more efficient institutional structures (possibly aided by new information processing technology).

Historically, productivity growth has been high, and there is a common assumption that this will continue going forward, because it is somehow an inherent property of industrial capitalism. From the perspective of Peak Oil, this is a dangerous assumption. The harnessing of the concentrated energy in fossil fuel sources went hand-in-hand with the rise of industrial capitalism. That era is coming to an end, either due to environmental concerns or resource depletion. Industrial societies may be able to innovate away from fossil fuel usage, but their ability to do so is still largely untested.

Concluding Remarks

Average wages will not rise at exactly the same pace as goods inflation. Nevertheless, there is a strong linkage between domestic prices and wages if we are looking at what is happening within a business cycle. This has the result that labour market data is the most closely followed set of macro data.

References and Further Reading

• Macroeconomics, by William Mitchell, L. Randall Wray, and Martin Watts. Red Globe Press, 2019. ISBN: 978-1-137-61066-9

Email subscription: Go to https://bondeconomics.substack.com/ 

(c) Brian Romanchuk 2021

Primer: Core And Median CPI Justification

One practice of economists that draws a lot of complaints is the use of subsets of the consumer price indices. Most commonly it is core CPI – excluding food and energy – although there are fancier measures like median CPI (which I describe below). Meanwhile, if a component of the CPI rises a lot in a month, commentary will often state things like “if we exclude {whatever had a price spike}, then CPI increased by only 0.2% on the month, instead of 0.5%.” (As should be expected, complaints are only about excluding items that rose quickly, everybody is happy to throw away the effects of items that fall rapidly in price.)

Note: This is an unedited rough draft of a book section. It is the long form version of a discussion I sketched out last week. Right now, I have done the minimal amount of data analysis, but I expect to add a bit more later.

Cost of Living Versus Inflation

One thing I have discovered when discussing inflation is that discussions very rapidly get derailed into discussions of the “cost of living.” I take a view that is conventional within market and economic discussion: inflation is a macroeconomic concept, and the consumer price index is one way to measure it. However, many people view inflation as rising cost of living.

There is a link between these two ideas, but they are not the same thing. It is entirely possible that the reader might disagree with my views on the distinction, but if they are to get any value from this book at all, they need to understand what I am referring to.