The Claw Machine

Posted on by Finster Posted in Economics, Finance, Markets

Inflation & FOMO

Ever see one of these? It’s a game with a bin full of prizes, over which you work a crane with a claw on it. If you successfully pick up a prize with the claw you win the prize.

It happens to an excellent visual aid for understanding global asset markets. Financology readers are familiar with the conclusions. One for example being my insistence that inflation happens well before it is obvious in the CPI. The Claw Machine helps illustrate why.

All the world’s assets are claims on all the world’s goods and services. Imagine the claims as the claws, and the body of goods and services available at any given time as the bin full of goodies below.

The following illustration schematically shows three asset classes, though the number is really arbitrary since you can define the classes as broadly or finely as you like. For the moment, you can imagine them as cash, stocks and bonds, in green, red and blue, with the goods and services in purple. The equal length of the upper and lower bars represents the tautological equality of the purchasing power of the claims on goods and services with the body of goods and services available for purchase.

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A key fact to bear in mind is that the relative values of these asset classes can fluctuate wildly over the course of a day or week, but the body of goods and services available to buy with them does not. Suppose for example that the purchasing power of stocks rises over some relatively short time frame. What happens to the purchasing power of the remaining asset classes?

This is schematically illustrated by the two graphics. Now, I could have drawn the second one so that the body of goods and services expands to accommodate the increase in value of the stocks, leaving the purchasing power of the other two asset classes unaffected.  And this is roughly how it is portrayed in the financial media. If stocks “went up” a lot, it’s a Good Thing. The world is richer for it. (Conversely, when stocks were down a couple years back media repeated references to trillions of lost wealth.)

But if you’ve been following along, you realize it can’t work that way. The real stuff out there, the number of houses to buy, groceries, hours of plumbers’ labor, etcetera, is unaffected by the price of stocks. If stocks gained in purchasing power, something else must have lost.

In our simplified three-class claw machine, it must have been either cash, bonds, or both. If bonds rallied along with stocks, or even just held their own, then it must have been cash.

What do we call it when cash loses value?

Inflation.

Notice that there’s nothing about consumer prices here. No CPI, no PCE, or other government statistics are necessary. In fact, if stocks gained, say, 5% over the past week, or even 20% over the past year, there need be no immediate change in consumer prices to reflect the diminished value of cash, and even if there were, how would we know it? Most of these statistics are reported only monthly.

Another point to be kept firmly in mind is that assets are not all immediately exchanged for goods and services on a daily basis. Most of the purchasing power represented is being stored for later use. Some maybe for days, others for weeks or months, others for years. For this reason, changes in actual realized purchasing power are not immediately evident, but are distributed over time. Further, non-cash assets like stocks and bonds are typically exchanged for cash before being exercised as claims on goods and services.

But changes in purchasing power that are ultimately reflected in consumer prices occur in asset markets first. If the prices of non-cash assets surge and are not reversed, cash has lost purchasing power and it’s only a matter of time before that loss is reflected in consumer prices.

It is therefore egregious error to equate rising consumer prices with inflation. By the time you see it there, inflation has already happened. Inflation is evident in rising asset prices first. It is like this because it must be.

And this, dear readers, is why the Fed is perpetually behind the curve. It is following lagging indicators. It dismisses asset prices as irrelevant to inflation. It repeatedly attempts to inflate asset prices – drive up stock prices and suppress bond yields – only to be later frustrated when consumer prices start to reflect its inflationary policies.

This occurs across time scales, from weeks to years to decades. The most recent examples are the asset price inflation that occurred in 2020-2021 being followed by the consumer price inflation of 2021-2022, and the asset price disinflation of 2022 being followed by the consumer price disinflation in 2023. The asset price inflation of 2023-2024 will either be reversed or followed by resurgent consumer price inflation. Or some messy combination of both.

But in any case, my argument is not statistical, it is from first principles. It is because it must. Bear in mind that our three class asset model is a simplified illustration. Commodities for example can play a dual role, sometimes as goods themselves and sometimes as assets representing claims on goods; gold is a case in point. Fine art, wines and other collectibles can too. It’s fair to say though that if you want know what is happening to inflation, you need to look at stocks, bonds, currencies and commodities. Consumer goods and services are the last place to look. Literally.

The Claw Machine also helps illustrate the significance of the Global Market Portfolio to investing. In particular, why it represents the portfolio of lowest risk due to asset selection. Owners of this portfolio cannot lose their share of claims on the body of goods and services available for purchase. This is not to say investors must emulate it, but that comparing it with how they are invested clarifies exactly what risks they are taking.

It also highlights that FOMO is not just a feeling. If a major asset class is beating the others and you’re not in it, you’re not merely missing out … you’re losing purchasing power.

37 thoughts on “The Claw Machine”

    1. Reply
      jk says:

      sir keir has decided to follow the enlightened lead of germany on energy policy. you can look forward to penury: de-insdustrialization, power outages, and perhaps a re-opening of the uk’s coal mines. but you can claim the moral high ground, nonetheless.

  6. Reply
    Mega says:

    Already ruled out COAL……………..”They” want to turn Blight into some sort of Hippy commune/Re education camp………they might even only allow 2 overseas flights a year…………trouble is people will only require one ..ONE WAY!

    Rumour tonight is Elon is about to give the new “Reform” party $100 million!
    Given that Trump was not too pleased with Blighty, from everything from the Steel dossier to almost getting his he blown off i think this government will fall quickly.

    indeed the PM himself has gone very quite on Ukraine & even said some bad things about the mass immigration legal or otherwise. I think the penny has dropped that “Team america” is about to trash european economy &take its skilled/semi skilled workforce.

    1. Reply
      Finster says:

      Trump seems pretty favorably disposed towards Britain … the current government maybe not so much…

    1. Reply
      jk says:

      u.s. citizens are taxed on the income irrespective of their residence. so the dutch “exit tax” doesn’t look like a big deal from here.

    1. Reply
      Finster says:

      Apparently the president declared martial law and parliament quickly and thoroughly undeclared it.

      High political drama to be sure, but without enduring significance. Barring some unlikely development like the military deciding to side with the president, it will be pretty much forgotten by the next news cycle.

      Yesterday you’d have thought the Biden pardon shook the foundations of American democracy; today it’s like “Hunter who?”.

  14. Reply
    Mega says:

    China bans some rare earth stuff…………….keep an eye on this because elon gets a lot of his ev stuff from China.

    1. Reply
      Finster says:

      You bet … otoh Elon et al have to have thought of that.
      Most of this is a reaction to going too far on the globalism binge. The next risk is the pendulum swings too far the other way.

      2. Reply
        sunpearl71 says:

        Thanks for the original reference to Martin Hutchinson that you made a while back. I’m subscribed since then and learnt a lot from his writings.

    1. Reply
      Mega says:

      PM May, i had dealings with her when she was Home Sec……..i offended her greatly when she came to visit using a TV remote control……

  18. Reply
    Mega says:

    British PM & Labour leader has had a “Reset” today to relaunch his disaster Labour government back on track…………..it failed. What was interesting was he spoke of his determination to fight on, for growth………….he spoke of how the civil service (british establishment) had advised him to allow Blighty to have a “Managed decline”….but he wont do that….

    In other words the game is up but like Hell will he allow the ship to go down on his watch….
    Tosser

  19. Reply
    Mega says:

    The empire strikes back!
    I watched in almost total disbelief at Israel’s insane mishandling after the Hamas attack. Bibi was a total fool……..i little doubt that Hamas was given “a GREEN light” by Iran who got an email from Putin.

    Just after the attack a VERY large number of Israel INTEL decamped from a Nato base just outside Athens where they been rather unhelpful to russia war efforts. Thus Putin got the break he needed……
    BiBi war on Hes-bul-lar was one of the biggest F**k ups in history. From what i can tell he didn’t take one Bloody Village ……this was somewhat at odds with 1982 where they Rolled up the PLO (+ Syria) in short order.

    Given just how bad things are Israel need a new plan……& it looks like they got one. If it all goes to plan Israel (+Turkey) will clear out Iran+ Russia in short order……..frankly i think Putin been caught napping on this one.

    The “Alex Jones” with in me sez it just window dressing & a eal has been done behind close doors, a trade…..Syria for Ukraine…………..but am not sure.
    Either way the next week will be very interesting……….

    1. Reply
      Finster says:

      It’s boiling a frog in moral hazard. Sure it might help prevent a failure from spreading into a wider crisis, but it’s also ex post facto enablement. The cure isn’t sweeping it under the rug, it’s reforming the behavior that led to it in the first place. Part of that is letting the chips fall on the decision makers. Embarrassment and shame are part of that.

      Here in the US we’re still paying the price from the GFC era bailouts. One of the biggest rarely even gets mentioned. GSE (Fannie, Freddie…) bond holders bought agency paper to reap yields over and above Treasury debt knowing that it wasn’t guaranteed by the “full faith and credit” of the US Treasury. That was the tradeoff. The bailouts retroactively turned their paper into the equivalent of Treasuries. So they got the extra yield for free. They should have taken at least some haircut.

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