Manoj Pradhan - Ideas Lab Series - July 20th, 2022

[00:00:00] Manoj

To look at the United States, if you look at the Congressional Budget Office’s estimates for debt to GDP, debt to GDP is going to go like a straight line up from the pandemic, to nearly 40% to 50% higher in terms of debt to GDP over the next 20, 30, 40 years. By the time we get to the year 2050, U.S. debt to GDP is going to be around 200%. So, this debt around the pandemic that we’re talking about is a drop in the ocean compared to what aging is going to bring to us.

[00:00:40] Intro

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Here’s your host, veteran hedge fund manager, Niels Kaastrup-Larsen.

[00:01:36] Niels

For me, the best part of my podcasting journey has been the opportunity to speak to a huge range of extraordinary people from all around the world. In this series, I have invited one of them, namely Kevin Coldiron, to host a series of in depth conversations, to help uncover and explain new ideas to make you a better investor.

In this series, Kevin will be speaking to authors of new books and research papers to better understand the global economy and the dynamics that shape it. So that we can all successfully navigate the challenges within it.

And with that, please welcome Kevin Coldiron.

[00:02:13] Kevin

All right, thank you, Niels. Welcome, everyone.

We’re really fortunate today to have with us, Manoj Pradhan, who is the co-author of a very important book called “The Great Demographic Reversal: Aging Societies Waning Inequality and an Inflation Revival”.

Why is this an important book? It’s an important book because it deals with the structural forces that are going to drive markets over the next 5 years, 10 years, 15 years. And, to me, structural forces are something that we as investors, can actually do something about.

So we’re going to talk a lot about inflation. We’re going to talk a lot about interest rates, and why both those things are likely to be much higher in the future, than we’ve seen in the past.

So with that, somewhat long winded introduction and sales pitch, Manoj, welcome to the show.

[00:03:08] Manoj

Kevin, thanks very much for having me here now. That was a much better introduction than I could have done myself. So thanks. I really appreciate it.

I’m glad you found the book useful. It’s really been a pleasure. All of the conversations we’ve had in the wake of the controversies that we’ve seen over the last couple of years have been fantastic as well.
Thanks for having me.

[00:03:29] Kevin

Yeah, I’m really excited about it. Maybe if you don’t mind, just tell us a little bit about your story. Your professional background. How you met Charles Goodhart, who’s a very well known economist and why you two decided to write this book.

[00:03:46] Manoj

Oh, with pleasure. So, Charles and I met when we were both at Morgan Stanley. Charles was an advisor over there for a while, and I was in the economics department. Where I lead the global economics team.

I think we were very much in the minority during the time of ‘lower for longer, and this is never going to change, and we’re all doomed’ in Japan. This was a time when both Charles and I thought that some of the longest structural stories (which we both had a tendency to pay more attention to), simply did not reflect glacial changes that nevertheless had very, very large impacts.

The conversation moved from obviously, what are the lessons from Japan? What can we learn from there? When the turn of demography comes and China turns, what will the impact on the global economy be? And where central banks would find it reasonable to respond and where not. Out of that came a paper at Morgan Stanley. Out of that came a presentation at the BIS annual conference, and we decided to extend the thesis to a book by doing a lot more work to make it a lot more rounded.

During all those points in time we really did not know when inflation would show up. In fact, most of the book was written in 2019. By the time the pandemic hit us, we still did not know when inflation would show up. But when it did hit, we were fairly confident that an acceleration of the things that we thought would happen over a 5 to 10 year period would occur because of the pandemic.

One of the things that we’ve liked about our prognosis, which was that post pandemic we’d see inflation between 5% and 10% is how tight labor markets are. In the early days there was a huge discussion about scarring in the labor markets that would keep wage growth subdued. But we feel fairly vindicated by looking at the tightness of labor markets, looking at the shortages of labor. That’s been the story that we’ve tried to talk about, an acceleration about. So it’s been a fantastic ride.

Sitting with Charles is like being in a classroom every day and learning. (laughing) I sometimes tell him that, actually, he’s exactly the wrong person to write this book because everyone, at his age, works half as hard as he does, we would have no demographic shortage.

[00:06:13] Kevin

A counter argument to your thesis….

[00:06:16] Manoj

But thankfully, for our thesis, not everyone is Charles.

[00:06:22] Kevin

I’m definitely not going to be Charles. I’m going to be spending much more time on the tennis court and a golf course when I get to his age.

So your book came out, I think summer of 2021. It really got a lot of attention, so much so that I actually wrote an article in Forbes and I said, “Hey, you know, looks like 2021 is turning into the summer of demography”. I was kind of bitter about that; like, hey, the baby boomers get the ‘Summer of Love’, and we’re stuck with the ‘summer of demographics’.

But were you surprised at how sexy demographics is now; how interested people were in your arguments?

[00:07:00] Manoj

Um, I really was a little bit taken aback, I have to say. We have seen interest in demography. It’s very difficult to get away from it, because there are phrases like ‘demography is destiny’. People have seen the impact, mistaken as we though it is, on Japan.

But really, I think what was lacking in the marketplace or in the academic literature, first of all, in the textbooks, there’s very, very little about the supply side, shaping the future of growth. Certainly there’s almost nothing about supply side shaping the future of inflation where most textbooks will still tell you that the central bank controls the rate of inflation almost perfectly, even though in real life and in the medium term, that’s hard to do. So yes, I think we were surprised.

By the time the labor shortages became a lot more persistent, I could understand why the interest in demography was as strong as it was.

[00:07:58] Kevin

Okay, well, so let’s get into that then. Let’s talk about the structural forces that I mentioned at the beginning. And if we can take a step back and introduce the listeners to how those forces, in your view, have affected the world in the last 30 years.

Let’s start with demography. You start the book by talking about demography and China as the two key structural forces. So maybe start with demography. Explain how that’s impacted inflation and interest rates in the last couple of decades.

[00:08:32] Manoj

Okay, let’s take history first. I think that’s a very, very good place to start. As you mentioned, in our book, there are only two national chapters, and none of them on the US, the Euro area, or the UK or any of the advanced economies. One is in China, and as I hope we’ll discuss later on, the other zone is Japan. China, we thought, was a game changer.

So the introduction of China, and its massive labor force really took place in stages. The real opening up of the economy started in 1979. If you look at China’s share of global trade, the role of emerging markets and the global economy, the disinflationary measures that have been witnessed in the advanced economies, all of them seem to center around that area. But the real thrust of it was when China started entering the global manufacturing system. That really happened, in the biggest way possible, in the year 2000, when the US Congress gave China the equivalent of most favored nation status.

In fact, there’s a lovely paper, by two Federal Reserve economists, which correlates with that story very well. It’s called (fantastic title as well), “The Surprisingly Swift Decline of US Manufacturing Employment”, I mean, it says it all. What they show you, on an item by item basis using a database, is that all of the products that were manufactured in the United States under a threat of tarrif (which were relatively low productivity stories, labor intensive stories), as soon as China was given most favored nation status, the production of all of those things moved into China. Later on the same products were re-exported back into the United States.

That’s how we got a lot of this disinflation was China’s setting the equilibrium wage. But effectively, the bottom line is (if you want to think about it) that the introduction of China’s labor force into the global economy, along with the baby boomers, reflected a 120% increase in the effective supply of labor. It’s an astonishing labor supply shock. The only equivalent that we could think of was the black death, which went the other way and, sadly, killed 25% of the labor supply that was available. We’ve never seen anything like it before, you’re very unlikely to see anything like it again.

So it was no surprise that the cost of labor globally started falling. The middle segment of the advanced economies, and particularly the United States found it a great struggle to keep their incomes intact. So US inequality went up. And global inequality fell, because the emerging market economies started catching up much faster with the advanced economies. The result was disinflation.

[00:11:16] Kevin

Okay. So there’s a lot to unpack there, but if I could try to summarize: So basically, what you’re saying with China is it almost suddenly integrated into the global labor force. You had a huge increase in the supply of labor, and that put downward pressure on wage rates, and then on the price of manufactured goods.

Talk a little bit more…. You hinted at demographic changes influencing that as well. Can you talk a little bit more about how the demographic influences impacted the supply of labor and inflation as well?

In the book, you talk about the relative ratio of (I think of them as) cost centers to workers. So you talk about kids and retired parents as being inflationary, and workers as being deflationary. Can you explain that concept a little bit?

[00:12:16] Manoj

Absolutely. With great pleasure. In fact, that’s one of the most intuitive explanations of demography and inflation. So broadly speaking, I think the force is just to peek a little bit further into history and bring it into the future.

Economists and demographers refer to, what we call, the dependency ratio. And the dependency ratio is the ratio of the people who don’t work, very young people, and very old people, to the number of workers we have in the economy. But there’s a critical difference between the young dependency ratio and the old dependency ratio.

Anytime we have more spending on the young we can almost justify it by saying, “Look, these guys are going to join the labor force a little later on, they will be able to pay for whatever they’ve consumed”. That’s not true for the elderly.

Now, with that in mind, what changes is that the increase in the dependency ratio, that we’re going to see in the next 30 years, is going to be a succession to the decline in the dependency ratio that we saw for the last 30 years. So 30 years was a massive increase in workers not only from China, but also from the baby boomers. Now, as these guys retire, and as China’s labor force becomes smaller, the delta of demography in the global economy is going to be dictated by older people. So the old dependency ratio is going to rise very, very, very rapidly.

Now, what does that mean? Dependents and workers have a very different effect on inflation. So let’s think of a dependence. Dependents don’t work, they consume. And therefore for a given set of goods and services you’re creating an inflationary impulse. But no ability to change the supply of goods. So the net effect is inflation.

If I look at workers, workers are disinflationary for two reasons. Number one, almost every worker in a company, probably with a few small exceptions, are paid less than their marginal product. They would have to be otherwise, what’s the point of employing them. The firm would make no profits, and out of the wages that they receive they have to save for the future.

So any worker, broadly speaking, has a net disinflationary effect on the economy because you’re producing much more than you’re consuming. So while the last 30 years saw a decline in dependency ratio; that means workers were outstripping the increase in dependence, the net disinflationary impact was higher than the net inflationary impact. Over the next 30 or 35 years that is simply going to reverse. The only way we can stop it is what people point to as technology is productivity, but there are limits to that.

[00:15:00] Kevin

So I want to ask you a couple of questions about that. One is, when we look at global trends and population, we can see that China, (because of the one child policy), its demographics are going to change very, very quickly. But there are other economies, particularly in Africa, and also in Southeast Asia, that aren’t aging as rapidly where the dependency ratio isn’t going to change.

Why can’t one of those economies become the China of the next 30 years? Why can’t the global labor force be increased by the integration of a big African economy, or Pakistan, or a Southeast Asian economy with a growing population?

[00:15:48] Manoj

It’s a very valid question. India often has some claim on that. Pakistan is another place that has a population that will get young for a much longer time. Sub-Saharan Africa has fantastic demography on its balance sheet. And a lot of these countries are going to sustain that story for a while.

There are a few problems here. If you go to New Delhi or if you look at the Arab Spring, one of the issues that makes policymakers sweat is how to get a young population jobs on a persistent basis. So in fact, we’re looking at two extreme problems. On the one hand, we’re saying, well, these countries should be a massive boon to the global economy, which is aging, and we should be able to utilize the labor supply very well. And policymakers, on the local side, are sweating to say how are we going to get all these young people jobs?

As Mark Knopfler says, “Two men say they’re Jesus / One of them must be wrong!” There must be something in between. I think what bridges the gap between the two is that a lot of the economies in Africa or in Southeast Asia don’t have the ability to transform capital into output as effectively.

So there are three things to keep in mind. Number one, mathematically, and economically the problem would be solved if we could take some of the excess labor that policymakers locally are worried about and bring it over to the west. And we could deploy them according to the human capital; all different parts. Politically, that seems very difficult especially given the debates that we’ve had. I think Ukraine’s refugee story has been handled in a very, very, very different way for a variety of reasons than any immigration story that we’ve seen in the last decade. I don’t think that’s going to change very soon.

So why not take capital there, you could. But, just to give you a flavor of the problems at hand, Africa and India actually have the same size population. Close to a few 100,000, which is peanuts for blisters. The problem is, Africa is not a nation, as we know, it’s a collection of 50 countries. And India, as a country by itself, has so many problems coordinating a national strategy. It’s very difficult to think that you will avoid the wasted replication of infrastructure of basic things in Africa and come with a coordinated strategy which you would need to become the next China.

The last point I’d make is that China was incredibly lucky. In the last 30 years, China rose rapidly, globalization was a good word. Everyone wanted to shift offshore. Now, we think Africa will do very well. We think India will do very well. They will receive a lot of capital inflows. But the willingness to offshore your production, your supply chains, it’s just not as enthusiastic as it’s been.

So in fact, if you take the fact that all these countries that have a young population are not really manufacturing superpowers yet that we’re hoping they’ll become, the role they have to play is almost out of three China’s, not one, in order to offset the demographic headwinds that we’re seeing. So we are optimistic about them. but we’re not very optimistic that they will become the salvation of an aging society.

[00:19:02] Kevin

Right. So you’re, in some sense, optimistic on their growth profiles but not on their ability to offset the inflationary forces in more developed economies. So, would that be right?

[00:19:16] Manoj

I think that’s perfectly said.

[00:19:18] Kevin

One thing that I took from your book was that, if we look at where the growth in demand for labor is going to be in the developed economies, it’s going to be in the healthcare sector, and that is much more difficult to automate away. Of course, we can apply technology. We’re not going to have robots looking after our parents. At least that’s what my parents are emphasizing to me anyway. (laughing) I think what you’re saying is, hey, if you could take people from Africa and have them work as healthcare workers in the developed economy that might help, but that seems politically, really challenging. So the developed economies are going to have to pay more for people to work in those sectors. Is that right?

[00:20:14] Manoj

I think that’s spot on again. In fact, I think what we should do is that we should get you to paraphrase every answer. And I’m going to collect those into a small set of and publish them just so that people get the right message. I think that’s absolutely right.

But your parents are either pressured or they have been reading economic articles slyly without telling you. There is a study out of Japan, no less, that confirms what they’re talking about. So the Japanese government is far more involved in looking after the older part of the population than any other country as we all know. Some time ago, they had provided nursing homes an incentive for a pilot program in which they gave every nursing home that used a robot $1,000 (approximately), for a certain period of time, to find out what that experiment would look like. And the robot was very simple. It wasn’t one of those office clerks, or any of those kind of human drawn robots. It was basically simple things that help patients in and out of wheelchairs and onto beds, or simple sensors that looked at whether beds were wet and they needed to be changed. Simple things like that.

The study was actually really interesting. The first thing that it did provide was a pretty significant decline in overtime. Because probably all the nurses who need to go every night and check 4 times whether beds were wet, or if anyone needed any help, those sensors obviated the need for that. However, not a single nursing home in the study was able to reduce the number of nurses that they had on their payroll. There was no decline in unemployment.

There are two reasons for that. Number one: these machines don’t have empathy. Anyone who’s in a nursing home, particularly for a neurodegenerative disease (which, unfortunately, both Charles and I have first hand experience about), what they want is empathy. If you can’t provide that to them, that kind of service is no good. The second thing is: what those machines did allow was for the human staff, to focus a lot more on improving the quality of service that you provided the elderly, or whoever was in firm in those institutions. But it did not really replace human beings at all. I think that’s what the future holds for us.

[00:22:31] Kevin

Yeah, there was that movie where the guy falls in love with a robot with the voice of Scarlett Johansson. So I think, if that could be rolled out more aggressively. It might help. (Laughing)…

So that’s a point, I think, that you make in the book that I wanted to highlight, because I think we’re all a little bit scared of automation. You really say, hey, actually, we need all the automation we can get. And I think what you just said is a really good example. Sure, automation can help with routine jobs and that’s good. That leaves the humans to focus on (I don’t want to say higher value added – that sounds like an Atlanta economist would approach it) things like empathy, things that humans are capable of doing that robots aren’t. Could you elaborate a little bit more on this notion that actually, automation is going to be something that we’re going to want to lean into?

[00:23:35] Manoj

Oh, with pleasure. So let’s start in a slightly different place. Let’s start with the UN Population Statistics. It sounds incredibly boring, but there’s a very important point to this. Most of the charts that you’ll see almost anywhere, including our book, are based on these human population statistics. They tell you how demography is going to change under different tendencies (we take the central one), and they are those statistics that show you how compelling the aging in our societies is going to be. However, what they do not do is explain the economic lower availability of labor, the way we think about it.

Okay, let’s think about a worker who has two tasks or two workers who have a choice of things to do. There’s a worker who is involved in a manufacturing sector, and there is a worker who was involved primarily in looking after the elderly. Let’s call it the most basic functions, not very high value added if you wanted to use that phrase and feel free to do so. The worker who is part of the manufacturing sector is actually part of the production of capital goods. Which would mean a good that is used to produce other goods, or he could be used to produce a good that is going to be consumed and paid for. And the people who are paying for that good could either have incomes that have been earned in the past, or incomes that are going to be earned in the future.

When you look after the elderly, you cannot produce a capital good. You can only produce a consumption good that has a one time use. The reason you say that is because the elderly person is not going to be able to generate an income to pay for it in the future. That service that you provide is going to be very unique, it is going to be incredibly idiosyncratic, and it is the reason that health care costs in the United States are mistakenly called inefficient.

They’re not inefficient in a classic sense, where we’re doing something terribly wrong, and if we just changed the way we did things efficiency would go through the roof. No, the simple point is that if I take two older people to a hospital the way they need to be treated is completely different. And that difference is something that robots cannot deal with.

So I’ll give you another cute example from Japan, which always tickles me. It’s about five years ago or so in Japan. I don’t know if you have it in the book but it’s really funny. Japan came out with a fully roboticized hotel. I mean, complete with a velociraptor as a receptionist. Okay, completely roboticized there was no human working in there. However, over the next two years, what started happening was that the robots were trying to give directions to people living in there. Could not give them simple directions about how to go about different routes to get to the subway station, where they could buy a sandwich. Things like that became very difficult. So in two years…

[00:26:31] Kevin

And I must say most concierges at hotels can’t do that very well, either.

[00:26:38] Manoj

They give you the map with the pen and ink it down. But whatever the result was, with no labor unions to protect them. Within two years 50% of the robot staff was fired, and have now been replaced by humans. So there is a coexisting middle ground where some paths can be automated; delivery to room, so on and so forth. But there are some idiosyncratic human specific paths that, I don’t think, are possible for robots to do that. That may change.

[00:27:07] Kevin

But not right now.

On that topic, as you were talking about automation and technology, I remember that if we go back to the basic theme of your book which is that we’ve got these structural forces that are going to drive inflation, higher demography; the one time China bonus kind of disappearing. What one of the counter arguments to that (it’s not so much an argument against your book specifically, but just the general notion that we’re going to see higher inflation) relates to technology. And it’s the idea that, hey, technology, in general, has lowered costs; has put a downward pressure on inflation.

When my first son was born, 25 years ago, I splurged on a $1,000 video camera. Now that same functionality is just a tiny part of my $300 smartphone. So that’s not going to change, technology is going to continue to evolve, improve. Therefore, inflation is going to keep falling because we’re going to be able to do things much cheaper.

What’s your response to that? I know you’ve kind of addressed that to some extent but I want to (since that’s an argument we hear) just get your general sense as to the extent to which that’s correct.

[00:28:25] Manoj

I mean the argument, the way you put it, is perfectly sound. There’s absolutely nothing wrong with it. There are some parts of our consumption basket which are going to get ever cheaper.

In fact, I was at a central bank (I won’t name which one, because it was a difficult question to ask them). I just proposed to someone who was actually running the statistics department, I asked them, “How do you assess the contribution of something like WhatsApp to the consumption basket?” It started with the price of zero. If anything, its usefulness has increased because of network effects. It’s gotten much better, the glitches have gone down, and the price has still remained zero.

So it’s not even as sympathetic sounding as your argument. It’s is a lot more aggressive. There are services that we just don’t pay for that I used to pay a ton for. Just to give you an idea, when I started grad school (it’s so far back now but I still remember it clearly), AT&T used to come to campuses, and one of the big things that they did for international students, which I was at that time, was they would let you speak to your family for five minutes. Normally that call would have cost you about $20. And it was a huge deal. I mean, right now, I’m busy telling my family members, no, I can’t speak now. No, I can’t speak now. So it’s a lot more dramatic than that.

However, the problem is, not everything that we’ve got is subject to the same technological progress. And so many people might say, look, it’s a relative price argument. It’s not an absolute price argument. But there is an old trade theory called Stolper Samuelson and Stolper Samuelson, just to whittle it down, basically says, look, if I hit one part of the economy with a positive or a negative shock, what happens? It starts absorbing resources from the other part of the economy until the whole economy either gets lifted up or lifted down.

So, if the shock is big enough (and this one certainly is), aging will be an absolutely gigantic shock when we think about all the caring costs that go along with it, that’s going to raise the demand for labor in a way that whatever labor is released from sectors that use fewer and fewer people will be absorbed very easily in looking after the elderly. The overall cost of caring is going to go up.

And most importantly, Kevin, something we haven’t talked about yet, is these are costs that the governments cannot say no thank you to. These are costs that every government that is going to be elected, is going to have to incorporate in the debt to GDP ratios. Inflation is the one way that they can make that debt sustainable. Every other way is fraught with some problem or the other.

[00:31:17] Kevin

You’re talking about inflation is the one way that governments can deal with rising debt. Is that what you’re saying?

[00:31:28] Manoj

It is, and central banks too. I mean, in a classic economic model, what you would say is, the central bank controls the long term rate of inflation. Okay, let’s say that’s true. Then does the central bank have the incentive to allow inflation to be higher?

Well, look at the United States, if you look at the Congressional Budget Office’s estimates for debt to GDP, debt to GDP is going to go like a straight line up from the pandemic, to nearly 40% to 50% higher, in terms of debt to GDP, over the next 20, 30, 40 years. By the time we get to the year 2050 US debt to GDP, according to their projections (not ours), is going to be around 200%.

So this debt around the pandemic that we’re talking about is a drop in the ocean compared to what aging is going to bring to us. Now, how do we deal with it? Well, if you’re ever stuck on an exam in economics, the one answer you give us productivity, and you’re always going to get at least half the points.

[00:32:35] Kevin

Take note of that anyone who’s studying economics.

[00:32:37] Manoj

That’s right. So that’s what we’ve devoted a lot of this conversation to. What will technology do to productivity, and so on, and so forth. But barring a miraculous increase in productivity, let’s say the best case scenario is we hit a Japan kind of number, Japan has outstripped every economy, in terms of output per worker, over the last 20 to 30 years. Let’s say we hit that 2%. What happens is growth slows down because of demography, because you’ve got fewer workers.

So the net effect of growth and productivity isn’t actually tremendous. Okay, you could increase taxes, which is incredibly unpopular, and that’s what populates governments. You could try and aggressively fight inflation but, with debt levels rising, we’re under a concept of financial dominance, which means financial markets can disrupt it. So inflation then turns out to be the one thing that central banks and governments and societies will need to agree on because how else do you make debt sustainable while the debt to GDP is rising so quickly? How do you convince people that the government is going to generate enough revenues to pay back that debt? If you don’t, then the default risks crisis and interest rates are going to go through the moon?

[00:33:49] Kevin

Yeah, let’s talk about that. Because as you were giving that explanation, I’m a complete believer in that. And I think the historical record also shows that, right? There are very few episodes where economies grow their way out of debt. It’s usually some combination of taxation, but more like inflation and financial repression, basically forcing people to invest their money at rates below the rate of inflation.

So it sounds like what you’re suggesting is interest rates… Well, in the book you talk about the yield curve is going to steepen a lot. I found that really interesting, because if we look at where the yield curve sits now, it’s pretty flat. Certainly from the difference between, say a 2-year interest rate and a 10-year interest rate is almost zero. Now there’s a bigger difference between the long-term interest rate and the current short rate. But if the Fed follows through on what it says it’s going to do, and raises rates to what the market expects, around 3% by the end of the year, then we’re looking at a flat yield curve across the board.

You were saying that long-term, we’re going to see a much steeper yield curve. So I’m guessing that you’re thinking, long rates are going to have to potentially go up by quite a bit. Is that right? Again, you’re not making a prediction about next year or the year after, but if we’re sitting here 5 to 10 years down the road.

[00:35:23] Manoj

Well, let’s talk about the current juncture and where we’ve been wrong, because the curves are incredibly flat. So actually, we turned out to be wrong for really interesting reasons.

Our argument in the book was, what would happen initially is that the central banks would say (and this was actually in the PostScript and written very clearly, and we wrote a few articles on VoxEU about this), initially, this is all temporary, it’s not going to go away, then they would switch to saying, even if…

[00:35:52] Kevin

That inflation was temporary?

[00:35:54] Manoj

Yes, inflation was temporary, and the use of were transitory and sort of temporary. The second thing they would then say is, well, even if inflation has gone up, inflation expectations are anchored. It would be quite a while until they actually came to realize this thing isn’t a short term blip. It’s a longer one.

What we didn’t get and what we didn’t take into account, and that’s where we got the short term story wrong on the yield curve, was that markets would not believe them. We have not seen markets treating the Federal Reserve, the European Central Bank, the Reserve Bank of Australia, the Riksbank as if they were emerging markets, to be honest with you.

In September, when the Federal Reserve indicated that it will have to accelerate quantitative easing at a more rapid pace than the past, the trigger that something had changed led at one-year yields to go up so fast that it was almost in disbelief that markets saw the Federal Reserve not capitulate to rising inflation until December. The same thing happened in Sweden, Australia, Canada, UK, Euro area. Wherever you looked, it was as if the market said well, you are falling behind the curve every day that you don’t hike interest rates. And if you can’t change things, I will. So the difference that you’re talking about is between….

[00:37:18] Kevin

James Carville is back right? The bond market vigilantes, at least, are kind of starting to re-emerge from their slumbers. Is that what you’re saying?

[00:37:29] Manoj

They are but it wasn’t just the bond market, because usually what would happen is the yield curve would play the role of being a vigilante. What we’re seeing over here is, it didn’t even have to come to that.

The reason that I said they were being treated like emerging markets is because the one-year and two-year yields went up. That was a direct challenge to the Central Bank saying, you may control the two year rate, but you don’t know what you’re doing. That was something that we have seen only for places like Brazil, for South Africa, for Turkey, and sometimes for India and Indonesia. But this being applied to the advanced economies is something we have never seen before, to this extent. That’s what changed, really.

[00:38:11] Kevin

That’s a fascinating way to put it. Suggesting that the market has maybe lost faith in central banks more quickly than one might expect. Does that change your conclusion in the book that the yield curve eventually is going to steepen?

[00:38:30] Manoj

We think there is an opportunity here for the yield curve to still steepen, but it will depend tremendously on what Central Banks do.

If we go back to original thinking (and honestly, we’ve had no reason to change it) that Central Banks finally understand that they have to learn to live with inflation, the way we’ve learned to live with COVID. The parallels are there that, unlike COVID, which is perhaps some might argue a net positive because it gives us immunity. But inflation is actually a net positive having inflation 1%, 2%, 2.5%, 3% (well, let’s stop there) higher than your target is something that can help erode the real burden of debt over a period of time.

If you had to choose between slightly higher inflation, and attacking inflation, which would crush growth, I think most Central Banks would eventually come to hold policy relatively steady. And under those conditions, you would need a premium out of the bond market. That’s where we think the story might still have some relevance.

[00:39:33] Kevin

I just want to circle back. So, as you said, it’s quite important. So when you said, “Hey, Central Banks have to learn to live with inflation,” my first thought was, well, markets might not like that. So therefore they’re going to impose, or Central Banks can live with inflation in the sense that they can keep short term interest rates below inflation. But if the markets are controlling long term interest rates, then we’re back to your world where the yield curve does steepen. Is that what you’re saying?

[00:40:05] Manoj

It’s a fair point. But I don’t want to overextend that point either, because I think there is a way that gets around the story. So if you look, in the last two years of the recovery they have been somewhat unique in a very clear sense. For people who are listening out there who are not technical, I’m going to spend a minute just explaining a couple of things.

So we’ve got the bonds that the government sells in markets called the nominal bonds. The reason they call them nominal bonds, is because there is also another kind of bond that is sold, which protects you from inflation. The coupon payments are linked to CPI. The difference between the two, the yields of the two bonds, is what markets called breakeven inflation. So markets see that as a way of expressing the inflation expectations as a way of protecting themselves from inflation. What has been unique in this recovery is this is the first recovery we’ve seen, (at least in the data), where breakeven inflation, the inflation that the market expects, has been higher than the yield on the nominal bond.

Think about what that saying means in some senses. You mentioned repression in the beginning, this repression in a fantastic form. The interest rate on a bond, all inclusive, does not compensate you for the inflation that the market expects. And to a large extent that has happened because QE and financial repression on bonds (what you’re required to buy in terms of financial securities) has plowed funds into the bond market and kept nominal yields from rising.

If that policy were to be deployed, and I see no way out of it, Central Bank balance sheets would double, triple, maybe even quadruple over the next 20 or 30 years. That might be a way in which you can repress economies at both ends: at the short end, and at the long end of the yield curve.

[00:42:01] Kevin

That’s fascinating, because Central Banks, right now, are talking about the opposite. They’re talking about getting out of QE, quantitative tightening, and you’re saying, be on the lookout. We might see the other. Is that what you’re saying? Or you’re saying if that happened?

[00:42:21] Manoj

Oh, it is exactly what I’m saying. There is no, I mean….let me put it as bluntly as possible. The US government is going to be the biggest issuer of bonds in the US market and in the global market for the next 30 years. There’s no doubt about that, unless the CBO projections are way off target, and they’re a very responsible institution, it’s unlikely that they are. So let’s just take that as something that is a very high probability case.

If the Central Bank reduces its balance sheet, the Federal Reserve reduces its balance sheet, while the issuance and supply of those bonds is increasing, the gap has to be absorbed by the private sector. There is no chance that the debt to GDP in the US rises to 200%, the Central Bank’s balance sheet remains where it is, and the rest is absorbed by the private sector with no effect on interest rates.

If we leave it to that, interest rates will go through the roof and crush the global economy just in the US. The Federal Reserve is going to have to increase its balance sheet in a way that keeps the gap between issuance and purchases reasonable so that the private sector can actually absorb that supply. There’s no way out.

[00:43:33] Kevin

So we’ve got one of two choices. The first choice, which you think is unlikely, is that the Central Bank does not buy the bonds the US government issues, in which case, we get much higher interest rates. We get the steep yield curve that you’re talking about in the book.

The other choice is that the Fed restarts quantitative easing and absorbs that. That, to me, suggests much higher inflation, potentially a loss of faith in the dollar or do we just muddle along in the same way that we have post 2008 where the Central Bank balance sheet increased a lot?

[00:44:11] Manoj

Well, things have changed a little bit in the following sense, that we’ve got a lot more data that tells us things could go one of two ways.

So Oliver Blanchard, who’s probably one of the finest economists in the world, had a comment on monetization, which doesn’t really let you sleep better at night. I think he had it about right, which he says, look, we’ve seen plenty of episodes thus far of monetization of debt that have not led to inflation. It may happen that we may overstep the bounds, and that some of that monetization comes back to bite us. But in my personal opinion, there are episodes in which you don’t get massive amounts of inflation because of debt being purchased by the central banks.

The first one is the bad case. And the bad case is where the debt creates so much excess capacity that it creates disinflation or deflation of its own. We’ve seen that in China. Then if you’re absorbing that debt, all you’re doing is really helping write down the value of those assets. That’s not very good.

The second thing is, if you are financing an activity, which if not financed would have taken inflation through the roof itself. So if you did not….

[00:45:32] Kevin

Give us an example of that.

[00:45:34] Manoj

I mean, we’ve got it right in front of us. The simple example is aging. So aging will have to be financed one way or the other. If, let’s say, the government says, “I’m not touching this, this is all you. You decide how to deal with your own life a little later on.” What would happen, right now, if the government told us, “I’ve got absolutely no health protection for you, or no pension protection for you.” You’d stop consuming almost everything you could because you’d have to save because you’d say, “Look, I don’t know if I’m going to live to be 70, 80, 90 or 100.”

There was a very famous book, a very popular book in Japan called “The 100 Year Life”, which really made people wake up to the fact of, look, how are you going to live if you’re going to turn out to be 100, what should you do now? If the government told you, “I’m walking away,” you would increase your savings so much that consumption will absolutely collapse. This is the paradox of thrift and we would go into a deep depression. You’d buy nothing, you would just stay home where you are. So the government will not allow that. They can walk away to some extent, but they will finance it. They will take some of it, because the government can do the one thing that you can’t, they can tax.

Now, the question is, is taxation the right way to finance its debt? It’s a point we’ve talked about before, so I won’t elaborate much on it. If you tax people, then what the worker will say is, while you’re taxing me to pay for the older people, I need to protect my purchasing power. So increase my wages to the extent that I am protected in my after tax income, and that would be massively inflationary. You can see how a rich price spirals.

So the central bank then has to say, okay, let’s do some of that, but not so much that we get a wage price spiral, because that crushes inflation. You spend on the old, I’ll buy some of those bonds to help you finance it. In effect, what I will do is, I will not let those bonds expire. I’ll just keep buying them. In other words, what the central bank does is it turns a nominal bond with a redemption date into something that we would call a console; a bond that never really expires. It’s an infinitely lived bond.

If the central bank didn’t do that, we would have a massive inflation problem on our hands. But the fact that the central bank allows that kind of spending is something that might keep inflation under greater control through monetization, which is a very, very weird concept.

[00:47:58] Kevin

Well, I’m gonna have to go back and think about that one. It’s a fascinating perspective, the idea that monetization could actually be disinflationary in a certain world. I guess, is Japan an example of that?
Because what would they have done, they have monetized their debt. I know that in the book, you say, Japan is not really a good template for what we’re going to experience. But in that limited sense of the government basically monetizing the debt and inflation not taking off. Is that an example? Or is that not the right analogy to make?

[00:48:44] Manoj

I think partly, yes, partly, yes, because they have financed a lot of government spending. But the reason it’s a yes and no answer is because not all of the government spending has been productive.

When we started looking into Japan, I realized that the phrase that is used so often with China, ‘bridges to nowhere’, actually came from Japan. They spent a lot of money on infrastructure. It simply wasn’t used to the same extent that they thought it would be. So some of Japan’s debt has been spent on things that you really can’t understand.

Without naming any names. I’ll tell you that I spoke to a Japanese economist who I used to work with, and I asked a simple question. I said over the last 30 years, can you tell me where Japanese fiscal spending has gone? And he came back to me with a phone call that said I can’t because no one knows. I don’t know. But you see where we’re going with this is, in the future, actually now, Japan’s spending on the elderly is quite significant. And to the extent that the government has allowed that spending to happen we haven’t gone into a depression, and we haven’t gone into extreme. So, there is some of what you say in that story. I don’t quite know if my thesis is going to work out, but I just don’t see any way out of it for most central banks. They have to finance some of the fiscal spending.

[00:50:14] Kevin

We’re getting toward the end, and I wanted to bring up inequality a little bit because that’s in the title of your book. In some sense the message, I guess, is positive in that you are suggesting that inequality is going to wane. Could you elaborate a little bit on why you think that’s the case?

[00:50:37] Manoj

Oh, yes, I’d be happy too, I mean, the simplest message that comes out of our book is that the bargaining power of labor is set to come back. And it’s so easy to see today. That point was really hard to make two years ago. When the pandemic hit the real discussion around the pandemic was whether there would be wage growth or, according to the opposite camp, whether there would be what people called scarring.

Scarring meant that labor markets would take an incredibly long time to recover and wage growth would be non-existent for the next five years, maybe even more depending on the pandemic. That simply hasn’t panned out. What we’ve seen is not only has labor, in an absolute sense, been scarce, which means that the lower availability of labor has caused wages to grow., but we’ve seen two distributional stories that are absolutely fascinating. If you look at the Atlanta Fed’s wage tracker, the Atlanta Fed’s wage tracker tells you that the lowest income and skill quartile of the labor market, which is where most of the labor deficiencies in terms of supply have been, is growing at two to three times the pace of wages in the top earning quartile.

[00:51:58] Kevin

It’s fascinating that you say that. I just want to throw in a real world example.

My son works at a resort in Central Oregon, and they just can’t find anyone to clean the houses. So they’ve had to increase wages, increase wages, increase wages. So they did, eventually, start to attract some of the local people to do the cleaning. But they had to raise the wages so much that the cleaners, when you aggregate their wages on an annual basis, were making more than the managers at the resort. The managers when they did the math were like hold on, I should get paid more. Whether they should or not, is another story, but then they bargain their wages to go up. And I think that’s an example of what you’re saying.

[00:52:50] Manoj

Oh, it completely is. I see the same thing happening in the UK. I’ll get to another example that will add to your anecdotal story. But look at what you’re implying. Effectively, it’s a microcosm of that stupid Samuelson story that I told you about, which is basically saying that one segment of the labor force gets a shock, wages go up over there, and another segment says, “well hold on a second, that’s so attractive, I’m going to give up being a manager and start taking lower jobs”. Eventually that pressure pushes up all wages. And naturally, we have to keep in mind that all of this is happening, while the hotel I’m presuming is struggling to keep a full supply of rooms and services intact. Which means for a lower supply, you’ve got a higher input cost which is where the wage price spiral comes from.

But there’s one more anecdotal story, if you don’t mind, I’ll talk about and that actually is best to show through what’s happening at a place like the one my wife works at. She is a distributional manager for online services at a local chain of retail stores. They have struggled to keep good workers with them. Because the compensation that is being offered, exactly in places where your son is working in restaurants and hotels, has gone up so much that leaving a job, where you’ve got three years experience and wages that reflect that, is far easier because the starting wage for completely inexperienced workers is sometimes higher.

So what you see in the United States and other places is that people are saying, “Okay, this sector looks really difficult from a long term perspective. I want to switch to something else that’s better.” Luckily, the wage is so good, that by switching and giving up seniority in the place I was working, I actually lost nothing and actually stand to gain right now.

So a reallocation of labor between sectors has never been easier. That’s what we will see in the demographic future as well.

[00:54:56] Kevin

That’s fascinating. So, that, I guess, is the positive story from the inequality sense. Your wages are going to go up at the lower end. I suppose the negative, at the macro economy, means higher inflation, or at least, maybe you wouldn’t describe it as negative but it’s a contributing force to higher inflation.

[00:55:23] Manoj

Well it is negative in the sense that it destroys our notion that our inflationary future is in our hands. And it is safe in the hands of Central Bankers.

Back in the day when I was teaching at university I used to try and depict Greenspan as being portrayed almost like Luke Skywalker. I was horrified when the economist came up with the same idea.

[00:55:51] Kevin

Surely you hadn’t copyrighted it?

[00:55:53] Manoj

No, no, it was terrible but it was the way people were thinking. That idea has been really blown to smithereens to some extent. That makes us feel unsafe. When we feel unsafe financial markets demand a risk premium for the most basic activities. That makes everything harder. So it is a win-win situation.

If inflation is falling and growth is better, it’s while Mervyn King called the nice years; non-inflationary, continuous expansion.

The problem is, the social side is where we gave up a lot of benefits. We had unhappy societies, which we’re paying the price for, even today. So the trade-off in the future is that we get some of that back. We feel we are more equal over a period of time. The people who have been neglected, the workers that we simply didn’t have to worry about are the ones who are on our radar in a big way.

We give up some of the macro stability and the ease of doing things; the ease of access to credit, the low risk premiums that we had in the past. Some would say it’s not a good trade-off. Some would say it’s an excellent trade-off, and that’s the world we’re in.

[00:57:02] Kevin

Right. Okay. I think that’s a really good place to stop on, maybe a more positive note, certainly a note that the world’s changing. It might seem a little scary, but it’s certainly potentially manageable.

I just wanted to thank you for taking the time to come and talk to us. It’s a book that we’ve really only scratched the surface of. We really wanted to talk more about Japan, and there’s a lot in the book about that. So I really suggest anyone who’s heard this conversation to pick it up and read it.

Thanks for joining us. And I wish you all the best.

[00:57:43] Manoj

Kevin, I really enjoyed that. I’m looking at the recording time. And it’s 56 minutes. I’ve really enjoyed it. Time has really flown by. Thanks for having me. That was great.

[00:57:53] Kevin

Our pleasure. Thank you.

[00:57:58] Niels

Thank you so much, Kevin and Manoj for a very insightful conversation. Clearly the nice years, meaning the non-inflationary continuous expansion years are over. And demographics will drive so much of the global economic agenda for years to come. The consequences of QE or non-QE, that Manoj expects are massive. And it’ll be interesting to see if central banks and policymakers will choose inflation or high interest rates as their worst enemy. The risk of getting both is of course, pretty high as well.

Aging will have to be financed for sure, which will make life very difficult indeed. And that forecast of the US government being the biggest issue of bonds, bar none, in the coming decades will potentially lay the ground for massive dislocations in the financial markets which investors need to be prepared for.

Make sure you go and follow Manoj’s and Kevin’s work as well as getting a copy of both of their books. Because as you can tell from today’s conversation, some of these ideas and topics are not being discussed on mainstream media. From Kevin and me. Thanks so much for listening, and we look forward to being back with you on the next episode. And in the meantime, take care of yourself and take care of each other.

[00:59:18] Ending

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