500 Words — Day Thirty-Three: Inflation
Economics has always had a bit of an expertise crisis. Economics is essentially the study of human behavior through the lenses of money and more generally resources. Unfortunately, that is very dependent on how we as individuals and as a society as a whole value stuff. And the way we value that stuff changes a lot from day to day and is very hard to predict and even harder to attempt to control via the use of monetary policies that different institutions and governments may try out.
Take the prediction by economics that inflation would be transitory and resolve itself within a few months (this was referencing the fall of 2021). Today, we’ve reached a new high in the inflation number (7.5% YoY). Inflation may still be transitory and it could start to come back in the coming months, however, the initial prediction was incorrect. However, economic decisions are being made based on these decisions. Unfortunately, when you make monetary decisions on bad data that can lead to mal-investment. And there are tools and positions that aggregate risk based on assumptions that economic policy will always be used as a tool to save mal-investors from being punished. If you never got punished for misbehaving, why would you ever behave when misbehaving is more profitable? Some investors have been using this mindset as a strategy since the financial crisis in 2008 after institutions were bailed out of their responsibility. So, there’s potentially a lot of locked-in risk associated with investors building on assumptions and predictions that don’t appear to be true.
One way to tame inflation assuming it is still going up is to increase interest rates which makes borrowing less desirable. This is because you essentially have to pay more money in return to borrow. But we’re coming off extremely low rates. Which essentially tells borrowers who were basically borrowing for free that they have to pay to keep borrowing. While this reduces the demand for borrowing and relieves buying pressure on stuff, it also puts pressure on investors who bet that rates wouldn’t go up on the basis that inflation was only temporary and would come back down allowing rates to stay low.
There could be people that need to borrow to continue operating the way they currently do. They can either reduce their position which has side effects depending on how many bets and investments were made in line or on top of them in the chain. Or they could sell other assets in order to maintain their current position, but again that has similar consequences. If you have a lot of distressed borrowers, you have a problem. Subprime mortgages were an example in the 2008 crisis aggravated by the increase in mortgage rates in adjustable rate mortgages.
The thing is if aggressively borrowing is a winning strategy (which it normally is when inflation is low and everything goes up), then you tend to have a lot of aggressive borrowers. Now maybe people learned their lesson in 2008 and institutions are less leveraged than they were then, but risk can accumulate all over the place. And it’s really hard to predict when it will unleash its wrath. Human behavior is difficult to predict and harder to control. Especially when folks get desperate. Let’s hope it doesn’t come to that.
