Tag Archives: Central Banks

Yeah…But

Yeah… Barry Bonds, a Major League Baseball (MLB) player, put up some amazing stats in his career. What sets him apart from other players is that he got better in the later years of his career, a time when most players see their production rapidly decline.

Before the age of 30, Bonds hit a home run every 5.9% of the time he was at bat. After his 30th birthday, that rate almost doubled to over 10%. From age 36 to 39, he hit an astounding .351, well above his lifetime .298 batting average. Of all Major League baseball players over the age of 35, Bonds leads in home runs, slugging percentage, runs created, extra-base hits, and home runs per at bat. We would be remiss if we neglected to mention that Barry Bonds hit a record 762 homeruns in his MLB career and he also holds the MLB record for most home runs in a season with 73.

But… as we found out after those records were broken, Bond’s extraordinary statistics were not because of practice, a new batting stance, maturity, or other organic factors. It was his use of steroids. The same steroids that allowed Bonds to get stronger, heal quicker, and produce Hall of Fame statistics will also take a toll on his health in the years ahead.  

Turn on CNBC or Bloomberg News, and you will inevitably hear the hosts and interviewees rave on and on about the booming markets, low unemployment, and the record economic expansion. To that, we say Yeah… As in the Barry Bonds story, there is also a “But…” that tells the whole story.

As we will discuss, the economy is not all roses when one considers the massive amount of monetary steroids stimulating growth. Further, as Bonds too will likely find out at some point in his future, there will be consequences for these performance-enhancing policies.

Wicksell’s Wisdom

Before a discussion of the abnormal fiscal and monetary policies responsible for surging financial asset prices and the record-long economic expansion, it is important to impart the wisdom of Knut Wicksell and a few paragraphs from a prior article we published entitled Wicksell’s Elegant Model.

“According to Wicksell, when the market rate (of interest) is below the natural rate, there is an incentive to borrow and reinvest in an economy at the higher natural rate. This normally leads to an economic boom until demand drives up the market rate and eventually chokes off demand. When the market rate exceeds the natural rate, borrowing slows along with economic activity eventually leading to a recession, and the market rate again falls back below the natural rate. Wicksell viewed the divergences between the natural rate and the market rate as the mechanism by which the economic cycle is determined. If a divergence between the natural rate and the market rate is abnormally sustained, it causes a severe misallocation of capital.

Per Wicksell, optimal policy should aim at keeping the natural rate and the market rate as closely aligned as possible to prevent misallocation. But when short-term market rates are below the natural rate, intelligent investors respond appropriately. They borrow heavily at the low rate and buy existing assets with somewhat predictable returns and shorter time horizons. Financial assets skyrocket in value while long-term, cash-flow driven investments with riskier prospects languish. The bottom line: existing assets rise in value but few new assets are added to the capital stock, which is decidedly bad for productivity and the structural growth of the economy.

Essentially, Wicksell warns that when interest rates are lower than they should be, speculation in financial assets is spurred and investment into the real economy suffers. The result is a boom in financial asset prices at the expense of future economic activity. Sound familiar? 

But… Monetary Policy

The Fed’s primary tool to manage economic growth and inflation is the Fed Funds rate. Fed Funds is the rate of interest that banks charge each other to borrow on an overnight basis. As the graph below shows, the Fed Funds rate has been pinned at least 2% below the rate of economic growth since the financial crisis. Such a low relative rate spanning such a long period is simply unprecedented, and in the words of Wicksell not “optimal policy.” 

Until the financial crisis, managing the Fed Funds rate was the sole tool for setting monetary policy. As such, it was easy to assess how much, if any, stimulus the Fed was providing at any point in time. The advent of Quantitative Easing (QE) made this task less transparent at the same time the Fed was telling us they wanted to be more transparent.  

Between 2008 and 2014, through three installations of QE, the Fed bought nearly $3.2 trillion of government, mortgage-backed, and agency securities in exchange for excess banking reserves. These excess reserves allowed banks to extend more loans than would be otherwise possible. In doing so, not only was economic activity generated, but the money supply rose which had a positive effect on the economy and financial markets.

Trying to quantifying the amount of stimulus offered by QE is not easy. However, in 2011, Fed Chairman Bernanke provided a simple rule in Congressional testimony to allow us to transform a dollar amount of QE into an interest rate equivalent. Bernanke suggested that every additional $6.6 to $10 billion of excess reserves, the byproduct of QE, has the effect of lowering interest rates by 0.01%. Therefore, every trillion dollars’ worth of new excess reserves is equivalent to lowering interest rates by 1.00% to 1.50% in Bernanke’s opinion. In the ensuing discussion, we use Bernanke’s more conservative estimate of $10 billion to produce a .01% decline in interest rates.

The graph below aggregates the two forms of monetary stimulus (Fed Funds and QE) to gauge how much effective interest rates are below the rate of economic growth. The blue area uses the Fed Funds – GDP data from the first graph. The orange area representing QE is based on Bernanke’s formula. 

Since the financial crisis, the Fed has effectively kept interest rates 5.11% below the rate of economic growth on average. Looking back in time, one can see that the current policy prescription is vastly different from the prior three recessions and ensuing expansions. Following the three recessions before the financial crisis, the Fed kept interest rates lower than the GDP rate to help foster recovery. The stimulus was limited in duration and removed entirely during the expansion. Before comparing these periods to the current expansion, it is worth noting that the amount of stimulus increased during each expansion. This is a function of the growth of debt in the economy beyond the economy’s growth rate and the increasing reliance on debt to generate economic growth. 

The current expansion is being promoted by significantly more stimulus and at much more consistent levels. Effectively the Fed is keeping rates 5.11% below normal, which is about five times the stimulus applied to the average of the prior three recessions. 

Simply the Fed has gone from periodic use of stimulus to heal the economy following recessions to a constant intravenous drip of stimulus to support the economy.

Moar

Starting in late 2015, the Fed tried to wean the economy from the stimulus. Between December of 2015 and December of 2018, the Fed increased the Fed Funds rates by 2.50%. They stepped up those efforts in 2018 as they also reduced the size of their balance sheet (via Quantitative Tightening, “QT”) from $4.4 trillion to $3.7 trillion.

The Fed hoped the economic patient was finally healing from the crisis and they could remove the exorbitant amount of stimulus applied to the economy and the markets. What they discovered is their imprudent policies of the post-crisis era made the patient hopelessly addicted to monetary drugs.

Beginning in July 2019, the Fed cut the target for the Fed Funds rate three times by a cumulative 0.75%. A month after the first rate cut they abruptly halted QT and started increasing their balance sheet through a series of repo operations and QE. Since then, the Fed’s balance sheet has reversed much of the QT related decrease and is growing at a pace that rivals what we saw immediately following the crisis. It is now up almost a half a trillion dollars from the lows and only $200 billion from the high watermark. The Fed is scheduled to add $60 billion more per month to its balance sheet through April. Even more may be added if repo operations expand.

The economy was slowing, and markets were turbulent in late 2018. Despite the massive stimulus still in place, the removal of a relatively small amount of stimulus proved too volatility-inducing for the Fed and the markets to bear.

Summary

Wicksell warned that lower than normal rates lead to speculation in financial assets and less investment into the real economy. Is it any wonder that risk assets have zoomed higher over the last five years despite tepid economic growth and flat corporate earnings (NIPA data Bureau of Economic Analysis -BEA)? 

When someone tells you the economy is doing fine, remind them that Barry Bonds was a very good player but the statistics don’t tell the whole story.

To provide further context on the extremity of monetary policy in America and around the world, we present an incredible graph courtesy of Bianco Research. The graph shows the Bank of England’s balance sheet as a percentage of GDP since 1700. If we focus on the past 100 years, notice the only period comparable to today was during World War II. England was in a life or death battle at the time. What is the rationalization today? Central banker inconvenience?

While most major countries cannot produce similar data going back that far, they have all experienced the same unprecedented surge in their central bank’s balance sheet.

Assuming today’s environment is normal without considering the but…. is a big mistake. And like Barry Bonds, who will never know when the consequences of his actions will bring regret, neither do the central bankers or the markets. 

QE – Then, Now, & Why It May Not Work

Since the beginning of the year, the market has rallied sharply. That rally has been fueled by commentary from both the Trump Administration and the Federal Reserve of the removal of obstacles which plagued stocks in 2018. The chart below is an abbreviated, and a bit sarcastic, version of events.

While the resolution of the trade war is certainly beneficial to the economy, as it removes an additional tax on consumers, the biggest support for the market has been the assumption the Fed will return to a much more accommodative stance.

As we summed up previously for our RIA PRO subscribers (try it FREE for 30-days)

  • The Fed will be “patient” with future rate hikes, meaning they are now likely on hold as opposed to their forecasts which still call for two to three more rate hikes in 2019 and more in 2020.
  • The pace of QT, or balance sheet reduction, will not be on “autopilot” but instead driven by the current economic situation and tone of the financial markets. It is expected the Fed will announce in March that QT will end and the balance sheet will stabilize at a much higher level.
  • QE is a tool that WILL BE employed when rate reductions are not enough to stimulate growth and calm jittery financial markets.

In mid-2018, the Federal Reserve was adamant a strong economy, and rising inflationary pressures, required tighter monetary conditions. At that time they were discussing additional rate hikes and a continued reduction of their $4 Trillion balance sheet.

All it took was a rough December, pressure from Wall Street’s member banks, and a disgruntled White House to completely flip their thinking.

The Fed isn’t alone.

China has launched its version of “Quantitative Easing” to help prop up its slowing economy.

Lastly, the ECB downgraded Eurozone growth, and as announced today, not only will they not raise rates in 2019, they also extended the TLTRO program, which is the Targeted Longer-Term Refinancing Operations scheme which gives cheap loans to struggling Eurozone banks, into 2021.

But there is nothing to worry about, right?

Think about this for a moment.

For a decade the global economy has been growing. Market participants are crowing about the massive surge in asset prices as clear evidence of the strength of the economy.

However, such hasn’t been the case. As I discussed previously for the Fed, China, and the ECB, are signaling their concerns about “economic reality,” which as the data through the end of December shows, the U.S. economy is beginning to slow.

“As shown, over the last six months, the decline in the LEI has been sharper than originally anticipated. Importantly, there is a strong historical correlation between the 6-month rate of change in the LEI and the EOCI index. As shown, the downturn in the LEI predicted the current economic weakness and suggests the data is likely to continue to weaken in the months ahead.”

More importantly, monetary policy never really impacted the economy as prolifically as was anticipated following the financial crisis. The two 4-panel charts below show the percentage change in the Fed’s balance sheet from 2009-present (309%) versus the total percentage change in various economic components. I have also included the amount of stimulus required to create those changes.

First, it is interesting to note that despite headlines of strong employment growth, the percentage of people considered “Not In Labor Force or NILF” has grown more than full-time employment. Of course, and not surprisingly, the biggest beneficiary of monetary policy was…corporate profits.

Secondly, where monetary policy did work was lifting asset prices as shown in the chart and table below.

The table above shows that QE1 came immediately following the financial crisis and had an effective ratio of about 1.6:1. In other words, it took a 1.6% increase in the balance sheet to create a 1% advance in the S&P 500. However, once market participants figured out the transmission system, QE2 and QE3 had an almost perfect 1:1 ratio of effectiveness. The ECB’s QE program, which was implemented in 2015 to support concerns of an unruly “Brexit,” had an effective ratio of 1.5:1.

Clearly, QE worked well in lifting asset prices, but not so much for the economy as shown above. In other words, QE was ultimately a massive “wealth transfer” from the middle class to the rich which has created one of the greatest wealth gaps in the history of the U.S., not to mention an asset bubble of historic proportions.

But Will It Work Next Time?

This is the single most important question for investors.

The current belief is that QE4 will be implemented at the first hint of a more protracted downturn in the market. However, as we noted above, QE will likely only be employed when rate reductions aren’t enough. Such was noted in 2016 by David Reifschneider, deputy director of the division of research and statistics for the Federal Reserve Board in Washington, D.C., released a staff working paper entitled “Gauging The Ability Of The FOMC To Respond To Future Recessions.” 

The conclusion was simply this:

“Simulations of the FRB/US model of a severe recession suggest that large-scale asset purchases and forward guidance about the future path of the federal funds rate should be able to provide enough additional accommodation to fully compensate for a more limited [ability] to cut short-term interest rates in most, but probably not all, circumstances.”

In other words, the Federal Reserve is rapidly becoming aware they have become caught in a liquidity trap keeping them unable to raise interest rates sufficiently to reload that particular policy tool. There are certainly growing indications, as discussed recently, the U.S. economy maybe be heading towards the next recession. 

Interestingly, David compared three policy approaches to offset the next recession.

  1. Fed funds goes into negative territory but there is no breakdown in the structure of economic relationships.
  2. Fed funds returns to zero and keeps it there long enough for unemployment to return to baseline.
  3. Fed funds returns to zero and the FOMC augments it with additional $2-4 Trillion of QE and forward guidance. 

In other words, the Fed is already factoring in a scenario in which a shock to the economy leads to additional QE of either $2 trillion, or in a worst case scenario, $4 trillion, effectively doubling the current size of the Fed’s balance sheet.

Here is what is interesting, as reported by Jennifer Ablan:

So, 2-years ago David lays out the plan and yesterday Williams reiterates that plan.

Does the Fed see a recession on the horizon? Is this the reason for the sudden change in views by Powell in recent weeks?

Maybe.

But there is a problem with the entire analysis. The effectiveness of QE, and zero interest rates, is based on the point at which you apply these measures. This was something I pointed out previously:

“In 2008, when the Fed launched into their “accommodative policy” emergency strategy to bail out the financial markets, the Fed’s balance sheet was only about $915 Billion. The Fed Funds rate was at 4.2%.

If the market fell into a recession tomorrow, the Fed would be starting with roughly a $4 Trillion balance sheet with interest rates 2% lower than they were in 2009. In other words, the ability of the Fed to ‘bail out’ the markets today, is much more limited than it was in 2008.”

But there is more to the story than just the Fed’s balance sheet and funds rate. The entire backdrop is completely reversed. The table below compares a variety of financial and economic factors from 2009 to present.

The critical point here is that QE and rate reductions have the MOST effect when the economy, markets, and investors have been “blown out,” deviations from the “norm” are negatively extended, confidence is hugely negative.

In other words, there is nowhere to go but up.

Such was the case in 2009. Even without Federal Reserve interventions, it is highly probable that the economy would have begun a recovery as the normal economic cycle took hold. No, the recovery would not have been as strong, and asset prices would be about half of where they are today, but an improvement would have happened nonetheless.

The extremely negative environment that existed, particularly in the asset markets, provided a fertile starting point for monetary interventions. Today, as shown in the table above, the economic and fundamental backdrop could not be more diametrically opposed.

This suggests that the Fed’s ability to stem the decline of the next recession, or offset a financial shock to the economy from falling asset prices, may be much more limited than the Fed, and most investors, currently believe.

The Fed’s hope has always been that at some point they would be able to wean the economy off of life support and it would operate under its own strength. This would allow the Fed to raise interest rates back to more normalized levels and provide a policy tool to offset the next recession. However, given the Fed has never been able to get rates higher than the last crisis, it has only led to bigger “booms and busts” in recent decades.

Summary

It has taken a massive amount of interventions by Central Banks to keep economies afloat globally over the last decade and there is rising evidence that growth is beginning to decelerate.

While another $2-4 Trillion in QE might indeed be successful in further inflating the third bubble in asset prices since the turn of the century, there is a finite ability to continue to pull forward future consumption to stimulate economic activity. In other words, there are only so many autos, houses, etc., which can be purchased within a given cycle. There is evidence the cycle peak has been reached.

If I am correct, and the effectiveness of rate reductions and QE are diminished due to the reasons detailed herein, the subsequent destruction to the “wealth effect” will be far larger than currently imagined. There is a limit to just how many bonds the Federal Reserve can buy and a deep recession will likely find the Fed powerless to offset much of the negative effects. 

If more “QE” works, great. But as investors, with our retirement savings at risk, what if it doesn’t.

The Fed Doesn’t Target The Market?

Earlier this month, I penned an article asking if we “really shouldn’t worry about the Fed’s balance sheet?” The question arose from a specific statement made by previous New York Federal Reserve President Bill Dudley:

“Financial types have long had a preoccupation: What will the Federal Reserve do with all the fixed income securities it purchased to help the U.S. economy recover from the last recession? The Fed’s efforts to shrink its holdings have been blamed for various ills, including December’s stock-market swoon. And any new nuance of policy — such as last week’s statement on “balance sheet normalization” — is seen as a really big deal.

I’m amazed and baffled by this. It gets much more attention than it deserves.”

As I noted, there is a specific reason why “financial types” have a preoccupation with the balance sheet.

The preoccupation came to light in 2010 when Ben Bernanke added the “third mandate” to the Fed – the creation of the “wealth effect.”

“This approach eased financial conditions in the past and, so far, looks to be effective again. Stock prices rose and long-term interest rates fell when investors began to anticipate this additional action. Easier financial conditions will promote economic growth. For example, lower mortgage rates will make housing more affordable and allow more homeowners to refinance. Lower corporate bond rates will encourage investment. And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion.”

– Ben Bernanke, Washington Post Op-Ed, November, 2010.

As he noted, the Fed specifically targeted asset prices to boost consumer confidence. Given that consumption makes up roughly 70% of economic growth in the U.S., it makes sense. So, not surprisingly, when the economy begins to show signs of deterioration, the Fed acts to offset that weakness.

This is why the slowdown in global growth became an important factor behind the central bank’s decision to put plans for interest rate increases on hold. That comment was made by Federal Reserve Vice Chairman Richard Clarida during a question-and-answer session last week.

“The reality is that the global economy is slowing. You’ve got negative growth in Italy, Germany may just grow…1% this year, [and] a slowdown in China. These are all things that we need to factor in. 

Slower global growth would crimp U.S. exports and could also negatively influence financial and asset markets, a primary transmission mechanism for monetary policy.”

As we noted previously in “Data or Markets,” the Fed is not truly just “data dependent.” They are, in many ways, co-dependent on each other. A strongly rising market allows the Fed to raise rates and reduce accommodative as higher asset prices support confidence. However, that “leeway” is quickly reduced when asset prices reverse. This has been the Fed cycle for the last 40-years.

The problem for the Fed is they have now become “liquidity trapped.”

What is that? Here is the definition:

“A liquidity trap is a situation described in Keynesian economics in which injections of cash into the private banking system by a central bank fail to lower interest rates and hence fail to stimulate economic growth. A liquidity trap is caused when people hoard cash because they expect an adverse event such as deflation, insufficient aggregate demand, or war. Signature characteristics of a liquidity trap are short-term interest rates that are near zero and fluctuations in the monetary base that fail to translate into fluctuations in general price levels.

The chart below shows the correlation between the decline of GDP and the Fed Funds rate.

There are two important things to notice from the chart above. The first is that prior to 1980, the trend of both economic growth and the Fed Funds rate were rising. Then, post-1980, as then Fed Chairman Paul Volker and President Ronald Reagan set out to break the back of inflation, each successive cycle of rate increases were started from a level lower than the previous cycle.

The difference between the two periods was the amount of debt in the system and the shift from an expansive production and manufacturing based economy to one driven primarily by services which have a substantially lower multiplier effect. Since 1980, it has required increasing levels of debt to manufacture $1 of GDP growth.

In every case, the rate cycle increase ALWAYS led to either a recession, bear market, crisis, or all three. Importantly, those events occurred not when the Fed STARTED hiking rates, but when they recognized that their tightening process was confronted by weakening economic growth. 

The Trap

The problem for the Fed is that while lower interest rates may help spur economic growth in the short-term, the growth has come from an increasing level of debt accumulation. Therefore, the economy cannot withstand a reversal of those rates. As shown above, each successive round of rate increases was never able to achieve a rate higher than the previous peak. For example, in 2007, the Fed Funds rate was roughly 5% when the Fed started lowering rates to combat the financial crisis. Today, if the Fed started lowering rates to combat economic weakness,  they would do so from less than half that previous rate.

As Richard Clarida noted in his speech, one of the potential risks to Central Banks globally is the lack of monetary policy firepower available. We previously pointed out that in 2009, the Fed went to work to rescue the economy with a $915 billion balance sheet and Fed Funds at 4.2%. Today, that balance sheet remains above $4 trillion and rates are at 2.5%.

It isn’t lost on the Fed that if a recession were to occur, their main lever for stimulating economic activity, interest rate reductions, will have little value. Given the amount of debt outstanding and the onerous burden of servicing it, the marginal benefit of lower rates will likely not be enough to lift the country out of a recession. In such a tough situation the next lever at their disposal is increasing their balance sheet and flooding the markets with liquidity via QE.

However, even that may not be enough as both Ben Bernanke and Janet Yellen have acknowledged that they were aware that each successive round of QE was somewhat less effective than the last. That certainly must be a concern for Powell if he is called upon to re-engage QE in a recession or another economic crisis.

For the Federal Reserve, they are now caught in the same “liquidity trap” that has been the history of Japan for the last three decades. One only needs to look at Japan for an understanding that QE, low-interest rate policies, and expansion of debt have done little economically. Take a look at the chart below which shows the expansion of the BOJ assets versus the growth of GDP and levels of interest rates.

Notice that since 1998, Japan has not achieved a 2% rate of economic growth. Even with interest rates still near zero, economic growth remains mired below one-percent, providing little evidence to support the idea that inflating asset prices by buying assets leads to stronger economic outcomes.

But yet, the current Administration believes our outcome will be different.

With the current economic recovery already pushing the long end of the economic cycle, the risk is rising that the next economic downturn is closer than not. The danger is that the Federal Reserve is now potentially trapped with an inability to use monetary policy tools to offset the next economic decline when it occurs.

This is the same problem that Japan has wrestled with for the last 30-years. While Japan has entered into an unprecedented stimulus program (on a relative basis twice as large as the U.S. on an economy 1/3 the size) there is no guarantee that such a program will result in the desired effect of pulling the Japanese economy out of its 30-year deflationary cycle. The problems that face Japan are similar to what we are currently witnessing in the U.S.:

  • A decline in savings rates to extremely low levels which depletes productive investments
  • An aging demographic that is top heavy and drawing on social benefits at an advancing rate.
  • A heavily indebted economy with debt/GDP ratios above 100%.
  • A decline in exports due to a weak global economic environment.
  • Slowing domestic economic growth rates.
  • An underemployed younger demographic.
  • An inelastic supply-demand curve
  • Weak industrial production
  • Dependence on productivity increases to offset reduced employment

The real concern for investors, and individuals, is the actual economy. We are likely experiencing more than just a ‘soft patch’ currently despite the mainstream analysts’ rhetoric to the contrary. There is clearly something amiss within the economic landscape and the ongoing decline of inflationary pressures longer term is likely telling us just that. The big question for the Fed is how to get out of the ‘liquidity trap’ they have gotten themselves into without cratering the economy, and the financial markets, in the process.

The One Thing

However, the one statement, which is arguably the most important for investors, is what Bill Dudley stated relative to the size of the balance sheet and it’s use a tool to stem the next decline.

“The balance sheet tool becomes relevant only if the economy falters badly and the Fed needs more ammunition.”

In other words, it will likely require a substantially larger correction than what we have just seen to bring “QE” back into the game. Unfortunately, as I laid out in “Why Another 50% Correction Is Possible,” the ingredients for a “mean-reverting” event are all in place.

“What causes the next correction is always unknown until after the fact. However, there are ample warnings that suggest the current cycle may be closer to its inevitable conclusion than many currently believe. There are many factors that can, and will, contribute to the eventual correction which will ‘feed’ on the unwinding of excessive exuberance, valuations, leverage, and deviations from long-term averages.

The biggest risk to investors currently is the magnitude of the next retracement. As shown below the range of potential reversions runs from 36% to more than 54%.”

“It’s happened twice before in the last 20 years and with less debt, less leverage, and better-funded pension plans.

More importantly, notice all three previous corrections, including the 2015-2016 correction which was stopped short by Central Banks, all started from deviations above the long-term exponential trend line. The current deviation above that long-term trend is the largest in history which suggests that a mean reversion will be large as well.

It is unlikely that a 50-61.8% correction would happen outside of the onset of a recession. But considering we are already pushing the longest economic growth cycle in modern American history, such a risk which should not be ignored.”

While Bill makes the point that “QE” is available as a tool, it won’t likely be used until AFTER the Fed lowers interest rates back to the zero-bound. Which means that by the time “QE” comes to the fore, the damage to investors will likely be much more severe than currently contemplated.

Yes, the Fed absolutely targets the financial markets with their policies. The only question will be what “rabbit” they pull out of their hat if it doesn’t work next time?

I am not sure even they know.

The Fed Conundrum – Data Or Markets?

Following the Fed’s last meeting, we published for our RIA PRO subscribers (use code PRO30 for a 30-day free trial) a simple question:

“What does the Fed know?”

Of course, this meeting followed the stock market plunge at the end of 2018 where their tone that turned from “hawkish” to “dovish” in the span of just a few weeks. Seemingly, despite the previous commentary about concerns over rising inflationary pressures, it was pressure from Wall Street and the White House that quickly “realigned” the Fed’s views.

  • The Fed will be “patient” with future rate hikes, meaning they are now likely on hold as opposed to their forecasts which still call for two to three more rate hikes this year.
  • The pace of QT or balance sheet reduction will not be on “autopilot” but instead driven by the current economic situation and tone of the financial markets.
  • QE is a tool that WILL BE employed when rate reductions are not enough to stimulate growth and calm jittery financial markets.

This change in stance, not surprisingly, buoyed the stock market as the proverbial “Fed Put” was back in place.

But the change view may have also just trapped the Fed in their own “data dependent” decision-making process.

The Fed Should Be Hiking Rates

As we noted in our RIA Pro article:

“During the press conference, the Chairman was asked what has transpired since the last meeting on December 19, 2019, to warrant such an abrupt change in policy given that he recently stated that policy was accommodative, and the economy did not require such policy anymore.

In response, Powell stated:

‘We think our policy stance is appropriate right now. We do. We also know that our policy rate is now in the range of the committee’s estimates of neutral.'”

Powell’s awkward response, and unsatisfactory rationale to a simple and obvious question, the question must be asked if it is possible that economic or credit risks are greater than currently believed which would account for the policy U-turn?

However, given that the Fed’s two primary mandates are supposed to be “full employment” and “price stability,” the conflict between managing inflation and supporting the markets is a conundrum.

For example, there is currently sufficient data which suggests “real inflationary pressures” are mounting in the economy. For example, with a 300,000 job print in January and rising wage pressures, the Fed should raise interest rates. The chart below of labor costs clearly show the problem business owners are facing.

As noted employment remains strong and data suggests there is upward pressure on companies to hire more workers.

That pressure to hire is coming from the reality there are currently more demands on labor than there are people to fill them.

Wage pressures are clearly rising in recent months putting additional upward pressures on pricing as companies pass on higher labor costs.

More importantly, inflationary pressures as measured by both PPI, CPI, and the Fed’s preferred measure of Core PCE, continue to rise as well.

The chart below is the spread between PPI and CPI, historically, when “producer price” inflation rises faster than consumer prices, it has impacted economic growth by suggesting that inflation can’t be passed on to consumers.

The composite inflation index is also screaming higher suggesting that if the Fed pauses they could potentially get well “behind the curve.” 

Even the Federal Reserve’s favorite measure of inflation, PCE, is also suggesting the Fed should be hiking rates rather than pausing.

All of this data clearly suggests that the Fed should be hiking rates currently, rather than pausing. 

The Conundrum

However, all of this data is also consistent with the end of an economic cycle rather than a continued expansion. As we quoted last week from John Mauldin:

I think because unemployment is lowest when the economy is in a mature growth cycle, and stock returns are in the process of flattening and rolling over. Sadly, that is where we seem to be right now. Unemployment is presently in the ‘low’ range which, in the past, often preceded a recession.

That loss of confidence is already beginning to show signs as noted recently by Zerohedge:

“American small-business owners are growing increasingly anxious about a looming economic slowdown.

After a report published last week by Vistage Worldwide suggested that small-business confidence had collapsed with the number of small business owners worried that the economy could worsen in 2019 numbering more than twice those who expected it to improve, the NFIB Small Business Optimism Index – a widely watched sentiment gauge – apparently confirmed that more business owners are growing fearful that economic conditions might begin to work against them in the coming months.”

Furthermore, most of these data points are at levels that typically precede economic slowdowns and recession, so hiking rates further from current levels could exacerbate the recessionary risk.

The problem the Fed faces currently, as we discussed previously, is that when the last recession started the Fed Funds rate was at 4.2% not 2.2% and the Fed balance sheet was $915 billion not $4+ trillion.

“If the market fell into a recession tomorrow, the Fed would be starting with roughly a $4 Trillion dollar balance sheet with interest rates 2% lower than they were in 2009. In other words, the ability of the Fed to ‘bail out’ the markets today, is much more limited than it was in 2008.”

But…what do you do?

The Trap

There are clearly rising inflationary pressures on the market, which are also beginning to impede economic growth. Those pressures, combined with a sharp decline in asset prices, spurred the Fed to react to political and market pressures.

The Fed is most likely aware that if a recession were to occur, their main lever for stimulating economic activity, interest rate reductions, will have little value. Given the amount of debt outstanding and the onerous burden of servicing it, the marginal benefit of lower rates will likely not provide enough benefits to lift the country out of a recession. In such a tough situation the next lever at their disposal is increasing their balance sheet and flooding the markets with liquidity via QE.

Sure, Powell might be taking a dovish tone to placate the markets, the President and his member banks and concurrently buying time to further normalize the balance sheet? But this approach is like pouring liquid out of your cup so you can add more when the time is right. You would do this because it is not clear just how much “the cup” will ultimately hold.

Bernanke and Yellen have both acknowledged that they were aware that each successive round of QE was somewhat less effective than prior rounds. That certainly must be a concern for Powell if he is called upon to re-engage QE in a recession or another economic crisis.

If this is the case, Powell will continue to publicly discuss minimizing reductions to the balance sheet and refrain from further rate hikes. Despite such dovish Fed-speak, he would continue to shrink the balance sheet at the current pace. This tactic may trick investors for a few months but at some point, the market will question his intentions and damage Fed credibility.

So, therein lies the trap. Do you hike rates and reduce the balance sheet anyway to be better prepared for the onset of the next recession, OR reverse policy to try to “kick the recession can” down the road a bit which leaves you under-prepared for the next crisis?

For the Fed, it is a choice between the lesser of two evils. The only question is did they make the right one?

While the Fed has a long history of using economic jargon and, quite frankly, non-truths to help promote their agenda, they also have a long history of making the wrong policy moves which spark either some sort of crisis, recession or both.

As Michael Lebowitz concluded for our RIA PRO subscribers last week:

“The market has largely recovered from the fourth quarter swoon, as such the Fed should be resting more comfortably. Economic data remains strong, and if anything it is slightly better than December when the Fed was ready to raise rates three times and put balance sheet reduction on “autopilot.”

Today the Fed has all but put the kibosh on further rate hikes and, per Mester’s comments, will end balance sheet reduction (QT) in the months ahead.

It is becoming more suspect that the Fed knows something the market does not.”

But, exactly what is it?

Recession Risks Are Likely Higher Than You Think

It is often said that one should never discuss religion or politics as you are going to wind up offending someone. In the financial world it is mentioning the “R” word.

The reason, of course, is that it is the onset of a recession that typically ends the “bull market” party. As the legendary Bob Farrell once stated:

“Bull markets are more fun than bear markets.”

Yet, recessions are part of a normal and healthy economy that purges the excesses built up during the first half of the cycle.

economic_cycle-2

Since “recessions” are painful, as investors, we would rather not think about the “good times” coming to an end. However, by ignoring the risk of a recession, investors have historically been repeatedly crushed by the inevitable completion of the full market and economic cycle.

But after more than a decade of an economic growth cycle, investors have become complacent in the idea that recessions may have been mostly mitigated by monetary policy.

While monetary policy can certainly extend cycles, they cannot be repealed.

Given that monetary policy has consistently inflated asset prices historically, the reversions of those excesses have been just as dramatic. The table below shows every economic recovery and recessionary cycle going back to 1873.

Importantly, note that the average recessionary drawdown historically is about 30%. While there were certainly some recessionary drawdowns which were very small, the majority of the reversions, particularly from more extreme overvaluation levels as we are currently experiencing, have not been kind to investors.

So, why bring this up?

“In the starkest warning yet about the upcoming global recession, which some believe will hit in late 2019 or 2020 at the latest, the IMF warned that the leaders of the world’s largest countries are ‘dangerously unprepared’ for the consequences of a serious global slowdown. The IMF’s chief concern: much of the ammunition to fight a slowdown has been exhausted and governments will find it hard to use fiscal or monetary measures to offset the next recession, while the system of cross-border support mechanisms — such as central bank swap lines — has been undermined.” – David Lipton, first deputy managing director of the IMF.

Despite recent comments that “recession risk” is non-existent, there are various indications which suggest that risk is much higher than currently appreciated.  The New York Federal Reserve recession indicator is now at the highest level since 2008.

Also, as noted by George Vrba recently, the unemployment rate may also be warning of a recession as well.

“For what is considered to be a lagging indicator of the economy, the unemployment rate provides surprisingly good signals for the beginning and end of recessions. This model, backtested to 1948, reliably provided recession signals.

The model, updated with the January 2019 rate of 4.0%, does not signal a recession. However, if the unemployment rate should rise to 4.1% in the coming months the model would then signal a recession.”

John Mauldin also recently noted the same:

“This next chart needs a little explaining. It comes from Ned Davis Research via my friend and business partner Steve Blumenthal. It turns out there is significant correlation between the unemployment rate and stock returns… but not the way you might expect.

Intuitively, you would think low unemployment means a strong economy and thus a strong stock market. The opposite is true, in fact. Going back to 1948, the US unemployment rate was below 4.3% for 20.5% of the time. In those years, the S&P 500 gained an annualized 1.7%.”

“Now, 1.7% is meager but still positive. It could be worse. But why is it not stronger? I think because unemployment is lowest when the economy is in a mature growth cycle, and stock returns are in the process of flattening and rolling over. Sadly, that is where we seem to be right now. Unemployment is presently in the ‘low’ range which, in the past, often preceded a recession.

The yield spread between the 10-year and the 2-year Treasury yields is also suggesting there is a rising risk of a recession in the economy.

As I noted previously:

“The yield curve is clearly sending a message that shouldn’t be ignored and it is a good bet that ‘risk-based’ investors will likely act sooner rather than later. Of course, it is simply the contraction in liquidity that causes the decline which will eventually exacerbate the economic contraction. Importantly, since recessions are only identified in hindsight when current data is negatively revised in the future, it won’t become ‘obvious’ the yield curve was sending the correct message until far too late to be useful.

While it is unwise to use the ‘yield curve’ as a ‘market timing’ tool, it is just as unwise to completely dismiss the message it is currently sending.”

We can also see the slowdown in economic activity more clearly we can look at our RIA Economic Output Composite Index (EOCI). (The index is comprised of the CFNAI, Chicago PMI, ISM Composite, All Fed Manufacturing Surveys, Markit Composite, PMI Composite, NFIB, and LEI)

As shown, over the last six months, the decline in the LEI has actually been sharper than originally anticipated. Importantly, there is a strong historical correlation between the 6-month rate of change in the LEI and the EOCI index. As shown, the downturn in the LEI predicted the current economic weakness and suggests the data is likely to continue to weaken in the months ahead.”

With the exception of the yield curve, which is “real time,” the rest of the data is based on economic data which has a multitude of problems.

There are many suggesting currently that based on current economic data, there is “no recession” in sight. This is based on looking at levels of economic data versus where “recessions” started in the past.

But therein lies the biggest flaw.

“The problem with making an assessment about the state of the economy today, based on current data points, is that these numbers are ‘best guesses’ about the economy currently. However, economic data is subject to substantive negative revisions in the future as actual data is collected and adjusted over the next 12-months and 3-years. Consider for a minute that in January 2008 Chairman Bernanke stated:

‘The Federal Reserve is not currently forecasting a recession.’

In hindsight, the NBER called an official recession that began in December of 2007.”

The issue with a statement of “there is no recession in sight,” is that it is based on the “best guesses” about the economy currently. However, economic data is subject to substantive negative revisions in the future as actual data is collected and adjusted over the next 12-months and 3-years. Consider for a minute that in January 2008 Chairman Bernanke stated:

“The Federal Reserve is not currently forecasting a recession.”

In hindsight, the NBER called an official recession that began in December of 2007.

But this is almost always the case. Take a look at the data below of real (inflation-adjusted)economic growth rates:

  • September 1957:     3.07%
  • May 1960:                 2.06%
  • January 1970:        0.32%
  • December 1973:     4.02%
  • January 1980:        1.42%
  • July 1981:                 4.33%
  • July 1990:                1.73%
  • March 2001:           2.31%
  • December 2007:    1.97%

Each of the dates above shows the growth rate of the economy immediately prior to the onset of a recession.  In 1957, 1973, 1981, 2001, 2007 there was “no sign of a recession.” 

The next month a recession started.

So, what about now?

“The recent decline from the peak in the market, is just that, a simple correction. With the economy growing at 3.0% on an inflation-adjusted basis, there is no recession in sight.” 

Is that really the case or is the market telling us something?

The chart below is the S&P 500 two data points noted.

The green dots are the peak of the market PRIOR to the onset of a recession. In 8 of 9 instances, the S&P 500 peaked and turned lower prior to the recognition of a recession. The yellow dots are the official recessions as dated by the National Bureau of Economic Research (NBER) and the dates at which those proclamations were made.

At the time, the decline from the peak was only considered a “correction” as economic growth was still strong.

In reality, however, the market was signaling a coming recession in the months ahead. The economic data just didn’t reflect it as of yet. (The only exception was 1980 where they coincided in the same month.) The chart below shows the date of the market peak and real GDP versus the start of the recession and GDP growth at that time.

The problem is in waiting for the data to catch up.

Today, we are once again seeing many of the same early warnings. If you have been paying attention to the trend of the economic data, the stock market, and the yield curve, the warnings are becoming more pronounced. In 2007, the market warned of a recession 14-months in advance of the recognition. 

So, therein lies THE question:

Is the market currently signaling a “recession warning?”

Everybody wants a specific answer. “Yes” or “No.

Unfortunately, making absolute predictions can be extremely costly when it comes to portfolio management.

There are three lessons to be learned from this analysis:

  1. The economic “number” reported today will not be the same when it is revised in the future.
  2. The trend and deviation of the data are far more important than the number itself.
  3. “Record” highs and lows are records for a reason as they denote historical turning points in the data.

As Doug Kass noted on Tuesday there are certainly plenty of risks to be aware of:

  1. Domestic economic growth weakens, Chinese growth fails to stabilize and Europe enters a recession
  2. U.S./China fail to agree on a trade deal
  3. Trump institutes an attack on European Union trade by raising auto tariffs
  4. U.S. Treasury yields fail to ratify an improvement in economic growth
  5. The market leadership of FANG and Apple (AAPL) subsidies
  6. Earnings decline in 2019 and valuations fail to expand
  7. The Mueller Report jeopardizes the president
  8. A hard and disruptive Brexit
  9. Crude oil supplies spike and oil prices collapse, taking down the high-yield market
  10. Draghi is replaced by a hawk

While the call of a “recession” may seem far-fetched based on today’s economic data points, no one was calling for a recession in early 2000, or 2007, either. By the time the data is adjusted, and the eventual recession is revealed, it won’t matter as the damage will have already been done.

Pay attention to the message markets are sending. It may just be saying something very important.

Dalio’s Fear Of The Next Downturn Is Likely Understated

“What scares me the most longer term is that we have limitations to monetary policy — which is our most valuable tool — at the same time we have greater political and social antagonism.” – Ray Dalio, Bridgewater Associates

Dalio made the remarks in a panel discussion at the World Economic Forum’s annual meeting in Davos on Tuesday where he reiterated that a limited monetary policy toolbox, rising populist pressures and other issues, including rising global trade tensions, are similar to the backdrop present in the latter part of the Great Depression in the late 1930s.

Before you dismiss Dalio’s view Bridgewater’s Pure Alpha Strategy Fund posted a gain of 14.6% in 2018, while the average hedge fund dropped 6.7% in 2018 and the S&P 500 lost 4.4%.

The comments come at a time when a brief market correction has turned monetary and fiscal policy concerns on a dime. As noted by Michael Lebowitz yesterday afternoon at RIA PRO

“In our opinion, the Fed’s new warm and cuddly tone is all about supporting the stock market. The market fell nearly 20% from record highs in the fourth quarter and fear set in. There is no doubt President Trump’s tweets along with strong advisement from the shareholders of the Fed, the large banks, certainly played an influential role in persuading Powell to pivot.

Speaking on CNBC shortly after the Powell press conference, James Grant stated the current situation well.

“Jerome Powell is a prisoner of the institutions and the history that he has inherited. Among this inheritance is a $4 trillion balance sheet under which the Fed has $39 billon of capital representing 100-to-1 leverage. That’s a symptom of the overstretched state of our debts and the dollar as an institution.”

As Mike correctly notes, all it took for Jerome Powell to completely abandon any facsimile of “independence” was a rough December, pressure from Wall Street’s member banks, and a disgruntled White House to completely flip their thinking.

In other words, the Federal Reserve is now the “market’s bitch.”

However, while the markets are celebrating the very clear confirmation that the “Fed Put” is alive and well, it should be remembered these “emergency measures” are coming at a time when we are told the economy is booming.

“We’re the hottest economy in the world. Trillions of dollars are flowing here and building new plants and equipment. Almost every other data point suggests, that the economy is very strong. We will beat 3% economic growth in the fourth quarter when the Commerce Department reopens. 

We are seeing very strong chain sales. We don’t get the retail sales report right now and we see very strong manufacturing production. And in particular, this is my favorite with our corporate tax cuts and deregulation, we’re seeing a seven-month run-up of the production of business equipment, which is, you know, one way of saying business investment, which is another way of saying the kind of competitive business boom we expected to happen is happening.” – Larry Kudlow, Jan 24, 2019.

Of course, the reality is that while he is certainly “spinning the yarn” for the media, the Fed is likely more concerned about “reality” which, as the data through the end of December shows, the U.S. economy is beginning to slow.

“As shown, over the last six months, the decline in the LEI has actually been sharper than originally anticipated. Importantly, there is a strong historical correlation between the 6-month rate of change in the LEI and the EOCI index. As shown, the downturn in the LEI predicted the current economic weakness and suggests the data is likely to continue to weaken in the months ahead.”

Limited Monetary Tool Box

As Dalio noted, one of the biggest issues facing global Central Banks is the ongoing effectiveness of “Quantitative Easing” programs. As previously discussed:

“Of course, after a decade of Central Bank interventions, it has become a commonly held belief the Fed will quickly jump in to forestall a market decline at every turn. While such may have indeed been the case previously, the problem for the Fed is their ability to ‘bail out’ markets in the event of a ‘credit-related’ crisis.”

“In 2008, when the Fed launched into their “accommodative policy” emergency strategy to bail out the financial markets, the Fed’s balance sheet was only about $915 Billion. The Fed Funds rate was at 4.2%.

If the market fell into a recession tomorrow, the Fed would be starting with roughly a $4 Trillion dollar balance sheet with interest rates 2% lower than they were in 2009. In other words, the ability of the Fed to ‘bail out’ the markets today, is much more limited than it was in 2008.”

But it isn’t just the issue of the Fed’s limited toolbox, but the combination of other issues, outside of those noted by Dalio, which have the ability to spur a much larger

The nonprofit National Institute on Retirement Security released a study in March stating that nearly 40 million working-age households (about 45 percent of the U.S. total) have no retirement savings at all. And those that do have retirement savings don’t have enough. As I discussed recently, the Federal Reserve’s 2016 Survey of consumer finances found that the mean holdings for the bottom 80% of families with holdings was only $199,750.

Such levels of financial “savings” are hardly sufficient to support individuals through retirement. This is particularly the case as life expectancy has grown, and healthcare costs skyrocket in the latter stages of life due historically high levels of obesity and poor physical health. The lack of financial stability will ultimately shift almost entirely onto the already grossly underfunded welfare system.

However, that is for those with financial assets heading into retirement. After two major bear markets since the turn of the century, weak employment and wage growth, and an inability to expand debt levels, the majority of American families are financially barren. Here are some recent statistics:

  1. 78 million Americans are participating in the “gig economy” because full-time jobs just don’t pay enough to make ends meet these days.
  2. In 2011, the average home price was 3.56 times the average yearly salary in the United States. But by the time 2017 was finished, the average home price was 4.73 times the average yearly salary in the United States.
  3. In 1980, the average American worker’s debt was 1.96 times larger than his or her monthly salary. Today, that number has ballooned to 5.00.
  4. In the United States today, 66 percent of all jobs pay less than 20 dollars an hour.
  5. 102 million working age Americans do not have a job right now.  That number is higher than it was at any point during the last recession.
  6. Earnings for low-skill jobs have stayed very flat for the last 40 years.
  7. Americans have been spending more money than they make for 28 months in a row.
  8. In the United States today, the average young adult with student loan debt has a negative net worth.
  9. At this point, the average American household is nearly $140,000 in debt.
  10. Poverty rates in U.S. suburbs “have increased by 50 percent since 1990”.
  11. Almost 51 million U.S. households “can’t afford basics like rent and food”.
  12. The bottom 40 percent of all U.S. households bring home just 11.4 percent of all income.
  13. According to the Federal Reserve, 4 out of 10 Americans do not have enough money to cover an unexpected $400 expense without borrowing the money or selling something they own. 
  14. 22 percent of all Americans cannot pay all of their bills in a typical month.
  15. Today, U.S. households are collectively 13.15 trillion dollars in debt.  That is a new all-time record.

Here is the problem with all of this.

Despite Central Bank’s best efforts globally to stoke economic growth by pushing asset prices higher, the effect is nearly entirely mitigated when only a very small percentage of the population actually benefit from rising asset prices. The problem for the Federal Reserve is in an economy that is roughly 70% based on consumption, when the vast majority of American’s are living paycheck-to-paycheck, the aggregate end demand is not sufficient to push economic growth higher.

While monetary policies increased the wealth of those that already have wealth, the Fed has been misguided in believing that the “trickle down” effect would be enough to stimulate the entire economy. It hasn’t. The sad reality is that these policies have only acted as a transfer of wealth from the middle class to the wealthy and created one of the largest “wealth gaps” in human history.

The real problem for the economy, wage growth and the future of the economy is clearly seen in the employment-to-population ratio of 16-54-year-olds. This is the group that SHOULD be working and saving for their retirement years.

The current economic expansion is already set to become the longest post-WWII expansion on record. Of course, that expansion was supported by repeated artificial interventions rather than stable organic economic growth. As noted, while the financial markets have soared higher in recent years, it has bypassed a large portion of Americans NOT because they were afraid to invest, but because they have NO CAPITAL to invest with.

To Dalio’s point, the real crisis will come during the next economic recession.

While the decline in asset prices, which are normally associated with recessions, will have the majority of its impact at the upper end of the income scale, it will be the job losses through the economy that will further damage and already ill-equipped population in their prime saving and retirement years.

Furthermore, the already grossly underfunded pension system will implode.

An April 2016 Moody’s analysis pegged the total 75-year unfunded liability for all state and local pension plans at $3.5 trillion. That’s the amount not covered by current fund assets, future expected contributions, and investment returns at assumed rates ranging from 3.7% to 4.1%. Another calculation from the American Enterprise Institute comes up with $5.2 trillion, presuming that long-term bond yields average 2.6%.

The massive amount of corporate debt, when it begins to default, will trigger further strains on the financial and credit systems of the economy.

Dalio’s View Is Likely Understated. 

The real crisis comes when there is a “run on pensions.” With a large number of pensioners already eligible for their pension, the next decline in the markets will likely spur the “fear” that benefits will be lost entirely. The combined run on the system, which is grossly underfunded, at a time when asset prices are dropping will cause a debacle of mass proportions. It will require a massive government bailout to resolve it.

But it doesn’t end there. Consumers are once again heavily leveraged with sub-prime auto loans, mortgages, and student debt. When the recession hits, the reduction in employment will further damage what remains of personal savings and consumption ability. The downturn will increase the strain on an already burdened government welfare system as an insufficient number of individuals paying into the scheme is being absorbed by a swelling pool of aging baby-boomers now forced to draw on it. Yes, more Government funding will be required to solve that problem as well. 

As debts and deficits swell in the coming years, the negative impact to economic growth will continue. At some point, there will be a realization of the real crisis. It isn’t a crash in the financial markets that is the real problem, but the ongoing structural shift in the economy that is depressing the living standards of the average American family. There has indeed been a redistribution of wealth in America since the turn of the century. Unfortunately, it has been in the wrong direction as the U.S. has created its own class of royalty and serfdom.

The issue for future politicians won’t be the “breadlines” of the 30’s, but rather the number of individuals collecting benefit checks and the dilemma of how to pay for it all.

The good news, if you want to call it that, is that the next “crisis,” will be the “great reset” which will also make it the “last crisis.”

Will Gold Help a 60/40 Portfolio?

I noted recently that the classic balanced or 60/40 portfolio has a difficult time in periods of inflation. Bonds deliver fixed dollar interest, so they obviously fare poorly during inflation. Stocks should do better theoretically because companies can push prices up in response to higher input costs. But it doesn’t always work that way. Stocks did poorly in the 1970s, for example.

This leads to the question of whether gold can help a classic balanced portfolio in an inflationary environment. Gold is a tricky asset. It has no utility and delivers no cash flow. Its owners can’t point to any intrinsic value and depend on other market participants to set the price. If you buy gold, you have to hope that someone else will buy it from you at the same price or a higher price in the future. While that seems obvious and can be said in some sense for every asset, other assets that deliver cash flow, such as an occupied apartment building, have a much more obvious value.

Sure, real estate prices can somehow become wildly dislocated from the cash flows the properties are delivering because investors and markets can become irrational at times. But the point is that you can compare price to some underlying cash flow with a property. You can’t do that with gold. The market can come to any conclusion about the price of a building it wants. As the owner, you can collect the cash flow the building delivers and wait until the market comes to its senses. Not so with gold.

Now a proponent of gold will say that the problem with an asset that delivers cash is that the cash’s value or purchasing power can erode. But the owner of the apartment building can raise the rent if cash’s purchasing power is declining.

Gold’s lack of utility also makes it difficult to compare to other commodities. Observes have noted that gold production has decreased in recent years, and such a decrease in, say, oil would lead to price spikes. But gold isn’t like oil precisely because it’s useless. People need and use oil everyday. That’s not the case with gold. Gold mining can drop off considerably with the price remaining stable because of lack of demand. If nobody wants something, it doesn’t matter if it’s not being produced.

Brett Arends has argued that gold and silver aren’t what they once were since the U.S. Government “has. . . . broken its legal connection to the dollar.” But Arends notes that Charles de Vaulx of the IVA funds still keeps a slug of the metal in his portfolios. Also gold has delivered a 7.5% annualized return, measured in dollar terms since 1970. The entire period is marked by long stretches of price stagnation and then two great price surges. Nobody should expect to time entries and exits adroitly.

Gold’s two big spikes over the past half century have been in the 1970s and after the “dot.com” crash and accelerated by the “Financial Crisis.” The great newsletter editor and value investor, James Grant, often argues that gold is the reciprocal of faith in central banks. At some point, if people become dissatisfied with fiat currency, gold could rise again.

Investors adding gold to portfolios should understand that its price movement is difficult to predict. They should treat a gold holding as an insurance policy against central bank money printing, but realize that it’s difficult to know if and when all the money central banks have printed in recent years will lead to fiat currency problems. Investors should treat gold as an insurance policy that can sometimes take a very long time to pay off.

Danielle DiMartino-Booth: What Powell Really Said

Yesterday, on the “Real Investment Hour” I spoke with my dear friend Danielle DiMartino-Booth, best selling author of Fed Up, about the recent Federal Reserve policy announcement. Danielle takes a dive into what J. Powell really said in his concise 43-minute statement that most people overlooked.

The question remains as to whether the Fed understands what they are doing? Or, are they simply hoping to raise rates far enough away from zero to have room to operate when the next recession comes.

Danielle has the answers.

Mike “Mish” Shedlock: Trade Wars & Economic Outcomes

Last week, on the “Real Investment Hour” I spent some time with world renowned blogger and writer, Mike “Mish” Shedlock discussing the recent moves by the Trump Administration to engage in a trade war with China.

Is the idea of engaging in a “trade war” a good one?

Even if we win the “battle,” do we lose the “war?”

Mike and I cover all of this and more…

For all of our videos subscribe to our “RIA Pro” YouTube channel


Nomi Prins: The Fed & The Global “Collusion”

Yesterday, on the “Real Investment Hour” we were privileged to visit with Nomi Prins to discuss the Fed’s rate hike decision yesterday and the end result of the ongoing surge in debt combined with continued Central Bank interventions.

Spoiler Alert: “It Ain’t Good.” 

Nomi, is also graciously giving our readers an “exclusive 40% discount” on her upcoming book “Collu$ion”  just by clicking the link below:

Pre-Order “COLLU$ION” Now – 40% OFF

Enjoy the interview and order the book.

Financialization & The Erosion Of Growth

Real Investment Advice welcomes Ben Masters to our growing list of contributors. Benjamin Masters is the creator, designer, and writer for Third Wave Finance, With over ten years of experience working as a lead Portfolio Analyst, Ben brings additional insights into the discussion of economics, markets and portfolio management.


One of the common side effects of debt-fueled speculation/spending is financialization, and one should immediately look to the growth and prominence of the financial industry (since the 1980s) with alarm, hesitation and concern; how and why is it that an industry that produces no physical product has grown to its current size?  After all, the financial industry exists as a non-production-utility — its very purpose is to properly allocate capital and resources to desirable (in-demand) industries; it’s an industry whose very existence relies on the success of other industries. If the financial industry is able to properly allocate capital/resources to desirable industries, it’s rewarded and is able to grow along with those other fundamental industries; and if a misallocation occurs, capital/resources are allocated to (and used up by) unsuccessful industries — those industries then shrink, along with the finance industry and economic growth.

The concern then is that if a general “hollowing out” of production occurs in a country — something that is rarely disputed these days when addressing U.S. industry — this would typically result in a smaller financial industry, not a larger one; yet the explosion of growth in the finance industry since the 1980s has been in stark contrast.  Why is this?  Put simply, debt-fueled investment speculation and debt-based spending has exploded since the 1980s.

Debt-fueled investment speculation can be seen in this visual of the three instances of the 21st century where long-term returns for stocks have been reduced — each peak fueled by different forms of speculation that ensure low future returns:

Tradable securities far outpacing economic growth…

The three speculative episodes of the 21st century, and dangerous transition periods…

Each of these speculative episodes have been addressed in The Orchestration of Debt-Based Expansions; and the topic of debt-based spending (pursued since the 1980s) has been written about as well, and includes government debt and consumer debt (mortgages, credit cards, student loans, car loans, borrowing to supplement falling incomes, etc.): see Debt LevelsWhy does college cost so much?Why doesn’t anyone earn anything in a bank account anymore?, and Income Stagnation.

The dilemma is that debt temporarily inflates the price of desirable assets (until the point in time where that debt needs to be paid back), and if a majority of the economy has debt that needs to be paid back economic growth is constrained — at some point in time those individuals are paying back loans instead of boosting economic growth through spending.  And if the majority of the economy has unproductive debt (debt that has not created an income stream to repay the principal amount borrowed and interest on the debt) then defaults, write-downs, etc. have a punishing affect on the economy and financial system.

For many, that punishing affect is a destruction of investments (which are not the same as wealth… see Fundamental Wealth).  Their “assets” evaporate, prices plunge, and they don’t know why…  The reason that assets vanish in a market crisis is because debt is always considered an asset by the issuer, yet in reality debt isn’t always an asset for the issuer; there are improper claims of assets — assets that don’t exist (loans that won’t be able to be paid back).  In effect, there are claims of assets (and securities issued on those “assets”) that outnumber the actual underlying assets.

It’s the financialization due to debt/leverage/speculation — the adding of layers and complexities — that can lead to a weakening of the market structure; one need only look to Charles Kindleberger’s work Manias, Panics, and Crashes to see how this process has unfolded over and over throughout history.

“Speculative manias gather speed through expansion of money and credit. . .there are many more economic expansions than there are manias.  But every mania has been associated with the expansion of credit.  In the last hundred or so years the expansion of credit has been almost exclusively through the banks and the financial system.

In boom, entropy in regulation and supervision builds up danger spots that burst into view when the boom levels off.” – Charles Kindleberger

And so financialization — the prominence of the finance industry and the growing dominance of obscure types of investments (many of which are simply more expensive packages of existing investments) — is made plain and clear: since the 1980s, it has grown due to temporary debt-based investment speculation and debt-based spending.  And although financialization is temporary (debt constraints eventually cause a readjustment), the real danger is that the temporary misallocation-of-wealth that occurs rewards the financial industry in a boom/bust cycle; wealth and capital that would have been used in other in-demand industries (had productive debt been pursued) is instead concentrated and used up in the financial industry, and when coupled with the ability to influence politics this temporary reward/misallocation can cause a further entrenchment of the undeservedly rewarded industry — a further misallocation of wealth.

Said in 2009 by Jeremy Grantham, co-founder and chief investment strategist of Grantham, Mayo, & Van Otterloo — one of the largest investment companies in the world…

“I’d like to challenge the usefulness — not just of new instruments — but of large tracts of the whole financial industry, much of which is a net drag.  Let’s start with the investment management business, because I think intuitively, obviously, you can see that we collectively add nothing.  We produce no “widgets”, we shuffle the existing value of all corporations and bonds around, in a cosmic poker game.  At the end of each year, the investment community is down by one percent (cough)…the individual is down by two, and aggregate fees have steadily grown.  As we grew by ten times from ’89 to ’99 huge economies of scale were existing, but the fees-per-dollar-managed grows — no fee competition at all, contrary to theory.  Why?  Agency problems, asymmetry of information, the client can’t tell talent from luck or risk taking, and as we add new products (options, futures, CDOs, hedge funds, private equity) aggregate fees rise as a percentage of assets; there becomes a layer of fees and another layer of agents and fees — the more complicated and opaque, the more the client need us. . .

As fees go up by half-a-percent, we reach into the client’s balance sheet, snatch the half-a-percent, and turn it into income; it’s almost magic — capital into income… but we lower the savings rate of our clients (savings and investment rate) by half-a-percent as our fees go up, so we get short term GDP kick from our income, at the expense of lower long-term growth on the part of the system.  Similarly with the whole financial system… let us say by 1965 (the best decade we ever had, the ’60s) there was a very financial financial-service arrangement — enough banking, enough letters of credit, to get the job done.  

Adequate tools are vital — that’s not the issue.  We’re talking the razzmatazz of the last ten or fifteen years…  The financial system was 3% of GDP in 1965 — it’s now 7 1/2; this is an extra 4% load that the real economy carries.  The financial system overfeeds and slows down the real economy.  The first hundred years, up to 1965, the economy was like a battleship, growing at 3.5% a year.  Even the great depression bounced off it.  After 1965 the GDP (ex-financials) grew at 3.2; after 1982, at 3.1; after 2000, at 2.3; all of these to the end of ’07 (not including the current problems).  From society’s point of view this 4% works like looting, or an earthquake — both increase GDP short term, but chew up capital.  They might as well be retirees or children — all these extra people in the financial business— but they are much, much more, expensive.  

Economists have not studied the optimal size for finance — indeed, a learned journal recently rejected a paper on the grounds that finance does not comment on social utility; that is perhaps why the risks are little.  

The underlying problem recently has been touching faith in capitalism, this faith was based on 50 years of a dominant economic theory that was shockingly not based on facts but on unestablished, unprovable, assumptions: “rational expectations” — this has given us efficient markets. So why regulate new instruments, if capitalism and markets are efficient?  Or why regulate anything?  So Greenspan, Rubens, Summers, and the SEC, happily beat back Brooksley Borne trying to regulate new instruments. But as Keynes knew in 1934, markets are behavioral jungles, racked by changing animal spirits, and by agency problems.  Efficient markets assume symmetry of data on all sides.  In real life, agents have all the data and the principal clients know little. It’s like taking candy from babies, the more opaque and complicated the new instruments, the easier the ripoff.  There is now — at LSE [London School of Economics] — a Centre for the Study of Capital Market Dysfunctionality, started by my former colleague, Paul Woolley, that is even now, attempting an academese, to establish that in the real world condition, agents in finance tend towards getting everything.” — Jeremy Grantham, 5:33 mark of 2009 Buttonwood Gathering

The Questionable State & Abusive Use Of Economics – Part 3

Real Investment Advice welcomes Ben Masters to our growing list of contributors. Benjamin Masters is the creator, designer, and writer for Third Wave Finance, With over ten years of experience working as a lead Portfolio Analyst, Ben brings additional insights into the discussion of economics, markets and portfolio management.


Part 1 Of The Series

Part 2 Of The Series


Currency Devaluation

 

After addressing the dire condition of economics and monetary policy in Part 1, and highlighting some of their more-damaging effects in Part 2, it’s now time to address one of the fundamental pillars of current policy — a hazard so deeply rooted yet one so easily accepted due to its illusory nature: namely, the process of currency devaluation and inflation targeting.

Yet another adjustment/manipulation scheme used to temporarily boost growth, currency devaluation (via currency creation) is not a new policy — it’s one that has been used throughout history by many countries and empires, including the Roman Empire.  And while the process of currency devaluation can evolve so slowly (potentially over a lifetime or more in a major economy/empire) that an unawareness develops and the instinct to question it subsides, its temporary benefits are often merely offset by a reduction in economic prosperity in the future; depending on the extent to which the policy is used, the economic strains may even lead to social disruption.

For an extreme example one need only look to the social disruptions and anger that developed in 1920s Weimar Germany; currency devaluations were so extreme that they yielded bizarre cases of zero stroke, and created an environment where it was cheaper to burn currency than use firewood. 

This example is not highlighted to imply that inflation or deflation should be the desired target, but merely to point out that economic policy can often be over-influenced by recent history — the economic and social strain of hyperinflation in the 1920s led to a German tendency to fear inflation, while the U.S. Great Depression of the 1930s has led to an American tendency to fear deflation.

The important point to make here is that deflationary and inflationary economic forces can often be occurring at the same time in different areas of the economy — they may simply be indicating a transition (cost and/or popularity of one time falls as the cost and/or popularity of another item rises).  The more-dangerous situation is when extremes in deflation or inflation develop throughout the economy indicating an imbalance, or when that imbalance is specifically targeted.

Inflation Targeting

As discussed, following the Great Depression, modern economic policies have reversed course so drastically that they have merely unbalanced the ship to the other side.  The fear of inflation has given rise to a tendency for central banks to “lean on inflation” (i.e. actively target inflation) via a process of currency-creation/currency-devaluation.

However, actively targeting positive inflation to avoid its counterpoint, deflation, may simply result in a storing of deflationary energy to be released later, as a misallocation of wealth builds.  Here again the wildfire suppression scenario highlighted in Part 2 is at play: just as fires are restricted (the kindling builds, the ecosystem changes storing potential energy for larger fires), so too does inflation-targeting work in the same way; it inhibits deflationary forces, allowing the potential energy of deflation to be stored and released later.  A further visualization of this concept — the storage-and-release of energy — can be seen in introductory physics…

A roller coaster that momentarily stops on the top of its very last large ramp has a high potential energy (energy that is not currently being used, as the coaster is motionless and high above the ground), but a low kinetic energy (energy of movement).  Then as the coaster begins to descend, the potential energy transitions to kinetic energy (motion).

“So inflation turns out to be merely one more example of our central lesson.  It may indeed bring benefits for a short time to favored groups, but only at the expense of others.  And in the long run it brings ruinous consequences to the whole community.  Even a relatively mild inflation distorts the structure of production.  It leads to the overexpansion of some industries at the expense of others.  This involves a misapplication and waste of capital.  When the inflation collapses, or is brought to a halt, the misdirected capital investment — whether in the form of machines, factories or office buildings — cannot yield an adequate return and loses the greater part of its value…

…Yet the ardor for inflation never dies.  It would almost seem as if no country is capable of profiting from the experience of another and no generation of learning from the sufferings of its forebears.  Each generation and country follows the same mirage.  Each grasps for the same Dead Sea fruit that turns to dust and ashes in its mouth.  For it is the nature of inflation to give birth to a thousand illusions.” 

– Henry Hazlitt (H.H.)

The difficulty in “leaning on inflation” (i.e. creating currency above the natural state) is that creating more currency to distribute does not increase real purchasing power — the country has more currency, but that currency buys less items than it could before (a currency is only a tool used to exchange real wealth items, it is not fundamental wealth).

Yet, regardless, inflation continues to be targeted — arguably due to ease, and its illusory nature — to “paper over” the restrictive reality of deflation; and in that respect, inflation can be considered a clandestine redistribution of wealth — one that is similar to an unpredictable, unbalanced, and spontaneous tax.  The redistribution of wealth occurs as the created currency disproportionately benefits those who receive it first; they have the first bid (vote) on assets, goods, and services.  As the newly created currency reaches other individuals, the more desirable assets, goods, and services will have already been bid up (higher prices) by those that received the currency first.  In effect, those that receive the currency last are punished at the expense of those that receive it first; and knowing who will be affected — and to what extent — will be difficult (What will the desirable assets be when the currency makes its way through the economy?).  By its very nature inflation indicates that some individuals benefited before others, yet it typically rests heavier on those least able to pay.

“…inflation does not and cannot affect everyone evenly.  Some suffer more than others.  The poor are usually more heavily taxed by inflation, in percentage terms, than the rich, for they do not have the same means of protecting themselves by speculative purchases of real equities.  Inflation is a kind of tax that is out of control of the tax authorities.  It strikes wantonly in all directions.” – H.H.

So although it’s possible that inflation targeting can be used to temporarily offset deflation, its risk is that it’s illusory and more easily abused.  In our current environment the tendency to question deflation is more commonplace than the inclination to challenge inflation (maybe merely due to a lack of education and awareness).  In deflation, the imbalance is visible; in inflation, the problems are for another day.

A more direct illustration, case 1:  If your income rises but inflation is greater than the change in your income, you’re actually poorer than you were before even though you have more money.  How can this be?  It’s because the total currency in circulation has increased, thus your currency — simply a medium of exchange — buys less real items; you’re poorer even though you have more dollars because each dollar now buys fewer real items.

In a countering example, case 2:  If your income goes down but deflation is more significant than the change in your income, you’re actually wealthier than you were before even though you have less money — each dollar can now buy more real items.

This is the illusory and deceptive nature of inflation: if the amount of currency has increased, your wealth is less — and although it is openly targeted, inflation is infrequently questioned, because, in our current environment, there is less of an inclination to question the state of things when you have more currency (even though your real wealth has gone down).  The inclination to question the state of things — even though it’s misplaced — seems more natural in case 2 because you have less money.  The education and awareness are not present to raise the flag of warning.  For these reasons, inflation is politically favorable, leading us to the questionable state — and abusive use — of economics.

“And this is precisely its political function.  It is because inflation confuses everything that it is so consistently resorted to by our modern ‘planned economy’ governments.” – H.H.


Get Part 1 Here

Get Part 2 Here

The Questionable State & Abusive Use Of Economics – Part 2

Real Investment Advice welcomes Ben Masters to our growing list of contributors. Benjamin Masters is the creator, designer, and writer for Third Wave Finance, With over ten years of experience working as a lead Portfolio Analyst, Ben brings additional insights into the discussion of economics, markets and portfolio management.


Part 1 Of The Series


The Continuous and Immediate Democracy of the Price System

So often the devastating social and economic events of our past have occurred due to a misplaced desire to “fix” a problem.  For an illustration of the mechanism just look to the disastrous implications of forest fire suppression (also addressed by author and hedge fund manager Mark Spitznagel) — an attempt to prevent damage to ecosystems by only allowing small fires to occur has allowed more kindling to be built up to stoke even larger more disastrous fires.

In a similar fashion, current economic policies have — in an attempt to “fix” a problem — moved the economy away from the continuous and immediate democracy of the price system; a system that can be thought of as a constantly adjusting balance.  Every minute, of every hour, of every day individuals are voting on whether more or less of a product should be produced.  Every time they purchase an item they encourage its continued production at the expense of another item, and every time they decide not to buy they discourage its production, to the encouragement of another.

If more individuals want a particular item, it is difficult to keep it in stock, and the retailer is pushed to move the price up (if they don’t then they will underperform the competition who will move the price up).  But the price moves up because the majority of individuals agree that it should be higher; they desire the product more, which draws individuals into the industry (seeking profits) and increases production to meet demand.  By voting the price higher they are signaling desirability; when the price moves up, the profits of the company selling the product move up, more individuals enter the industry to follow profit potential, and the price then moves down when more have entered the industry than are necessary to meet demand.  It’s a cycle of adjustment based on the continuous and immediate voting of the individual — the voter decides whether the price is reasonable.

The shrinking or expansion of an industry depends on the desires of the majority.  If more people think that industry’s product or service is reasonable, the price transitions up, encouraging individuals to leave less desirable industries behind to pursue the industry with more profits — accommodating the desire of the majority.  If more people think the price is unreasonable, they refuse to buy, the price transitions down, and the industry shrinks as individuals move to pursue other industries that the majority does desire.

So, in this fashion, the decisions of individuals — on a moment-to-moment basis — cause the change in prices and production.  If more people desire computers rather than typewriters, the price of typewriters falls until it reaches the point where they are desirable again, and the typewriter industry is forced to lower prices based on the desire of the majority — the industry shrinks based on the majority’s preference for other items and services.

The continuous and immediate democracy of the price system is what calls into question the results of artificial adjustment schemes — those results being that any adjustment to this voting system would, in effect, benefit a small group of individuals at the expense of the larger group; yet this is the nature of the adjustment schemes championed by all sorts of different groups and governments.  The adjustments pursued include “parity” pricing, tariffs, “stabilizing” commodities, and price “fixing”, among many others; their commonality is that they disrupt the democratic price system, allow a smaller group to inhibit the desires of the larger group, and are still being used.

Leaving a much lengthier discussion to other sources, a few examples may be of use here.  Of the many examples of adjustment (or manipulation) previously listed, one would be the attempt to keep a price level artificially high.  In an attempt to save a dying industry the price for the product is held above the price voted on by the majority.  In this case the industry benefits (a minority of the population) at the expense of the majority who now have to pay more than they would otherwise deem reasonable.  The money above what they were willing to pay will now flow toward the “adjusted” industry and away from a different, more desirable one.

The effect of this attempt to manipulate the democratic price system is a temporary (short-term) benefit to the supported industry (the small group) at the expense of the larger group; yet since the majority is negatively affected, and the smaller group is not isolated (they are also dependent on others), the smaller group will eventually be negatively affected as well as the cycle continues.  This is, in essence, the wildfire suppression scenario — prevent fires (prevent the death of an undesirable industry) only to have to deal with larger fires (the majority is negatively affected and in turn negatively affects the smaller group).

The significance is that the manipulation of the equilibrium moves the majority to a lesser-desired state, encouraging a waste of raw materials and a squandering of time, both of which are used up on industries that are not as desirable as others — a misallocation of capital and an aggregate hindrance to the economy.

Technological Progress: Cessation of Industries = Progress for Others

Unfortunately, due to the custom of “specialization” (a person typically works in one industry), the individual effects of technological progress and invention can often be disastrous for some (those working in the industry with reduced demand), even though the change provides an aggregate benefit to the majority.  By its very nature that reduced demand for the failing industry is due to a demand for other more-desirable items.  This is not a new process.  It has occurred throughout history.  The mechanical revolution displaced so many that people that some thought work would become obsolete.

The same progress has continued to occur: the dwindling of the typewriter industry due to the boom of the computer industry and the loss of cashiers to automation, among many, many others.  But there are other jobs created that are not so easily recognized; the machines created to replace cashiers have also created jobs — designers, manufacturers, etc.  Labor moves to the desirable industries and creates new ones.  Technological advancement can even create demand in an industry if it reduces the price of the item to the point where individuals want more.

The cessation of undesirable industries results in progress for desirable ones; the outcome is a social benefit to the majority and an unfortunate, temporary, expense for a smaller group.  The best solution isn’t to prevent progress, but to allow for mobility between industries — to ease the transition, to encourage movement to existing in-demand industries and to those new industries yet to be created.

Unless everyone’s desires are completely satisfied there is still progress to be made.  It’s when individuals are freed from undesirable industries that their faculties are applied to the desires of the majority.  The worse outcome is for groups and governments to manipulate and encourage undesirable industries to use up finite raw materials and time when the actual demand of the majority lies elsewhere.

“If it were indeed true that the introduction of labor-saving machinery is a cause of constantly mounting unemployment and misery, the logical conclusions to be drawn would be revolutionary, not only in the technical field but for our whole concept of civilization.  Not only should we have to regard all further technical progress as a calamity; we should have to regard all past technical progress with equal horror…

…It follows that it is just as essential for the health of a dynamic economy that dying industries should be allowed to die as that growing industries should be allowed to grow.  For the dying industries absorb labor and capital that should be released for the growing industries.” 

– Henry Hazlitt (H.H.)

Returning to the topic of economic policy, one can see the wildfire suppression scenario occurring once again.  The attempt to pull growth forward by reducing interest rates (and using experimental policies, i.e. large-scale asset purchases) is effectively encouraging short-term benefits (fire suppression) at the expense of long-term benefits (a worse outcome, larger fires).  One could argue that the market crises and stock manias of the 21st century have been more severe because risk (kindling) has been allowed to build.

Since the 1980s the Fed has been encouraging debt-based spending to attempt to counter slowing economic growth — they influence interest rates lower (you get paid less interest in your bank account), and by doing so they’re attempting to make debt more attractive due to it being more “affordable” (individuals pay less in interest when they take on debt); individuals may then borrow more and spend more to boost economic growth.

However there is a “catch”: although more debt and more economic growth may occur temporarily due to the reduction of the interest rate target, the productiveness-of-the-debt determines the long-run outcome.  If the debt is productive — i.e. creates an income stream to repay the principal (original amount borrowed) and the interest on the debt — then long-run growth may not flag due to the debt; yet if the debt is unproductive and/or counter-productive then economic growth is constrained in the long run.  One of the most important measures of the productiveness-of-debt is the velocity of money.

The more serious implications of economic policy, however, are for the broad economy and country (the stock market is only a portion of the economy).  A misallocation of capital and investment, due to economic policy, slows growth and results in zombie industries kept alive by the continued attempt to manipulate the democratic price system; it creates an undesirable imbalance — a temporary benefit to a small group at the expense of a larger group, which in turn inhibits growth.

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…Stay Tuned for Part III

The Questionable State & Abusive Use Of Economics – Part 1

Real Investment Advice welcomes Ben Masters to our growing list of contributors. Benjamin Masters is the creator, designer, and writer for Third Wave Finance, With over ten years of experience working as a lead Portfolio Analyst, Ben brings additional insights into the discussion of economics, markets and portfolio management.


As lackluster results from rather experimental central bank policies continue to emerge, it’s time to readdress the seemingly endless nature of the perpetual-motion machine known as central bank stimulus — to stop and be still for moment and question whether the endlessly spinning wheels should be spinning at all, to question whether the maze is leading us back to the beginning. It’s often difficult to do — to question a lifetime’s worth of custom — but it’s so very important, as even the most advanced civilizations have drifted off course at some point in history.

A brief look at the charts below can give us a sense of the misalignment that is occurring:

1. The experimental monetary policies (Large Scale Asset Purchases / Quantitative Easing) that have been used to expand the monetary base have not met the goal of dramatically affecting the money supply.

2. A misallocation of capital has occurred shifting assets away from the broader economy, and toward a portion of the economy — tradable securities. Since the 1980s, the prices of many tradable securities, including stocks, have seen a significant rise, yet the economy as a whole has been unable to reach previously-attainable levels of growth.


And although the results can be damaging (to be addressed in this multi-part series), the outcome should not be surprising:

When faced with near-zero interest rates, it’s not surprising if banks decide against pursing their low-return commercial banking side, and instead favor leveraged asset speculation via their proprietary trading desks. If the trade-off from low-risk/guaranteed-low-return to high-risk/potential-for-return takes place, it may actually deprive the economy of funds while banks temporarily improve earnings through risk-taking — a point that would be consistent with Robert Hall’s comment at the Jackson Hole Monetary Conference in 2013: “An expansion of reserves contracts the economy”. And in a similar fashion, when savings rates are near-zero, there may be an irresistible temptation for companies and investors to take on unsustainable, speculative, investment risk (in an attempt to try to meet performance and savings goals).

Questions then arise: Why is this form of economics being pursued? Are there other options available? Is economics and central bank policy worthless?

A Starting Point

Although economics is typically addressed without a qualifier to distinguish one version from another, it may be worthwhile to begin the custom as there are many schools of economics — each with strongly opposing views of the world. And if there are many schools of economics (see the video Economics is for Everyone), why should we assume that the choice made by many of the world’s economies — which is to eschew all but one version — is the proper decision? Given that the world is constantly changing, and that each version of economics has its own built in assumptions, it may be naïve to assume that economics in its existing state has reached peak perfection; and based on the charts above, the current form of economics may not even be desirable.

The Questionable State — and Abusive Use — of Economics

A necessary and constant desire to explore alternative viewpoints — as a way to broaden the scope of understanding — has brought me to Henry Hazlitt’s Economics in One Lesson. It aligns with the important recognition that an idea, profession, concept, axiom, or story, should not be seen as a static topic to be memorized and repeated, but as one to be challenged in a constantly evolving process of reeducation, to merge established ideas with novel ones; it should constantly be influenced, adjusted, and questioned. Only then, is the fallibility of any one particular idea realized — its transitory nature recognized.

And this brings us to our current economic environment, where one predominant ethos has been perpetuated, saturating the economic landscape — arguably because its benefits are lucid and ramifications clandestine. That idea is a bizarre version of keynesian economics — not even in its originally intended form — a version that pursues debt-based spending to temporarily boost growth, a version that disregards the quality of debt being taken on and the long-term affects on all other parties; this is the version of economics used by central banks and governments throughout the world. It’s a stagnant policy that has favored the short term over the long term, while creating an illusory environment based on inflation, the results of which are a misallocation of wealth, and social disruptions.

In moving away from the study of classical economics — which also suffers its own drawbacks, showing a certain callousness toward the groups immediately hurt by its attempt to focus on the long term — modern economic policies have reversed course so drastically that they have merely unbalanced the ship to the other side.

“There are men regarded today as brilliant economists, who deprecate saving and recommend squandering on a national scale as the way of economic salvation; and when anyone points to what the consequences of these policies will be in the long run, they reply flippantly, as might the prodigal son of a warning father: ‘In the long run we are all dead.’ And such shallow wisecracks pass as devastating epigrams and the ripest wisdom.

But the tragedy is that, on the contrary, we are already suffering the long-run consequences of the policies of the remote or recent past. Today is already the tomorrow which the bad economist yesterday urged us to ignore. The long-run consequences of some economic policies may become evident in a few months. Others may not become evident for several years. Still others may not become evident for decades. But in every case those long-run consequences are contained in the policy as surely as the hen was in the egg, the flower in the seed.

From this aspect, therefore, the whole of economics can be reduced to a single lesson, and that lesson can be reduced to a single sentence. The art of economics consists in looking not merely at the immediate but at the longer effects of any act or policy; it consists in tracing the consequences of that policy not merely for one group but for all groups.”

– Henry Hazlitt (H.H.)

And the oversight suggested in the last line is the reason that economics and central bank policy are becoming questionable endeavors — not because they are worthless but because they have been abused. The immediate effects of a policy are visible, the affects on one (or a few) particular groups are seen, yet the implications for all remaining groups are overlooked; the chain of events that is set into motion — each causing its own further effects — is forgotten.

“Economics is haunted by more fallacies than any other study known to man. This is no accident. The inherent difficulties of the subject would be great enough in any case, but they are multiplied a thousandfold by a factor that is insignificant in, say, physics, mathematics or medicine — the special pleading of selfish interests. While every group has certain economic interests identical with those of all groups, every group has also, as we shall see, interests antagonistic to those of all other groups. While certain public policies would in the long run benefit everybody, other policies would benefit one group only at the expense of all other groups. The group that would benefit by such policies, having such a direct interest in them, will argue for them plausibly and persistently. It will hire the best buyable minds to devote their whole time to presenting its case. And it will finally either convince the general public that its case is sound, or so befuddle it that clear thinking on the subject becomes next to impossible.” – H.H.

One may stop to ponder on why the immediate is preferred to the future (An innate survival instinct? Merely due to a lack-of-awareness of consequence?), but one point is clear and immovable in our current environment: it is easier to choose the “here and now”.

The Fallacy of Deficit Spending

The fallacy in the concept that a country can borrow money to boost growth (i.e. deficit spending) in an economic downturn is that it assumes that politicians will counter the process in the recovery period to actually slow growth down.

When an individual takes a loan they are able to boost their current spending, yet at the same time they’re also reducing their future spending (future payments toward the loan are reducing their income and ability to spend at that time). Just as an individual can only spend from income, a country can only spend from taxes, so a country that uses deficit spending to boost the economy during a downturn will be forced to slow the economy while the loan is being paid back through increased taxes.

Deficit spending is easy to agree to, but its other side is so very difficult to complete — especially when it’s likely that a different politician will be the one that will need to complete the process. Although it’s possible, what politician would campaign to slow the growth of the country? — yet that’s what is necessitated by deficit spending.

Although deficit spending can be used to boost growth in a deflationary / recessionary / depression-type environment, by doing so the country is pulling growth forward — borrowing from future taxes — and if it occurs over a long enough period of time, the taxes will be placed on a different generation; this is the concept of “generational warfare” — the consequences of a spendthrift generation are passed to another.

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