Tag Archives: Keynes

Jerome Powell & The Fed’s Great Betrayal

“Lenin was certainly right. There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose.”

John Maynard Keynes – The Economic Consequences of Peace 1920

“And when we see that we’ve reached that level we’ll begin to gradually reduce our asset purchases to the level of the underlying trend growth of demand for our liabilities.” –Jerome Powell January 29, 2020.

With that one seemingly innocuous statement, Chairman Powell revealed an alarming admission about the supply of money and your wealth. The current state of monetary policy explains why so many people are falling behind and why wealth inequality is at levels last seen almost 100 years ago. 

REALity

 “Real” is a very important concept in the field of economics. Real generally refers to an amount of something adjusted for the effects of inflation. This allows economists to measure true organic growth or decline.

Real is equally important for the rest of us. The size of our paycheck or bank account balance is meaningless without an understanding of what money can buy. For instance, an annual income of $25,000 in 1920 was about eight times the national average. Today that puts a family of four below the Federal Poverty Guideline. As your grandfather used to say, a dollar doesn’t go as far as it used to.

Real wealth and real wage growth are important for assessing your economic standing and that of the nation.

Here are two facts:

  • Wealth is largely a function of the wages we earn
  • The wages we earn are predominately a function of the growth rate of the economy

These facts establish that the prosperity and wealth of all citizens in aggregate is meaningfully tied to economic growth or the output of a nation. It makes perfect sense.

Now, let us consider inflation and the role it plays in determining our real wages and real wealth.

If the rate of inflation is less than the rate of wage growth over time, then our real wages are rising and our wealth is increasing. Conversely, if inflation rises at a pace faster than wages, wealth declines despite a larger paycheck and more money in the bank.

With that understanding of “real,” let’s discuss inflation.

What is Inflation?

Borrowing from an upcoming article, we describe inflation in the following way:

“One of the most pernicious of these issues in our “modern and sophisticated” intellectual age is that of inflation. Most people, when asked to define inflation, would say “rising prices” with no appreciation for the fact that price movements are an effect, not a cause. They are a symptom of monetary circumstances. Inflation defined is, in fact, a disequilibrium between the amount of currency entering an economic system relative to the productive output of that same system.”

The price of cars, cheeseburgers, movie tickets, and all the other goods and services we consume are chiefly based on supply and demand. Demand is a function of both our need and desire to own a good and, equally importantly, how much money we have. The amount of money we have in aggregate, known as money supply, is governed by the Federal Reserve. Therefore, the supply of money is a key component of demand and therefore a significant factor affecting prices.

With the linkage between the supply of money and inflation defined, let us revisit Powell’s recent revelation.

“And when we see that we’ve reached that level we’ll begin to gradually reduce our asset purchases to the level of the underlying trend growth of demand for our liabilities.”

In plain English, Powell states that the supply of money is based on the demand for money and not the economic growth rate.  To clarify, one of the Fed’s largest liabilities currently are bank reserves. Banks are required to hold reserves for every loan they make. Therefore, they need reserves to create money to lend. Ergo, “demand for our liabilities,” as Powell states, actually means bank demand for the seed funding to create money and make loans.

The relationship between money supply and the demand for money may, in fact, be aligned with economic growth. If so, then the supply of money should rise with the economy. This occurs when debt is predominately employed to facilitate productive investments.

The problem occurs when money is demanded for consumption or speculation. For example:

  • When hedge funds demand billions to leverage their trading activity
  • When Apple, which has over $200 billion in cash, borrows money to buy back their stock  
  • When you borrow money to buy a car, the size of the economy increases but not permanently as you are not likely to buy another car tomorrow and the next day

Now ask, should the supply of money increase because of those instances?

The relationship between the demand for money and economic activity boils down to what percentage of the debt taken on is productive and helps the economy and the populace grow versus what percentage is for speculation and consumption.

While there is no way to quantify how debt is used, we do know that speculative and consumptive debt has risen sharply and takes up a much larger percentage of all debt than in prior eras.  The glaring evidence is the sharp rise of debt to GDP.

Data Courtesy St. Louis Federal Reserve

If most of the debt were used productively, then the level of debt would drop relative to GDP. In other words, the debt would not only produce more economic growth but would also pay for itself.  The exact opposite is occurring as growth languishes despite record levels of debt accumulation.

The speculative markets provide further evidence. Without presenting the long list of asset valuations that stand at or near record levels, consider that since the last time the S&P 500 was fairly valued in 2009, it has grown 375%. Meanwhile, total U.S. Treasury debt outstanding is up by 105% from $11 trillion to $22.5 trillion and corporate debt is up 55% from $6.5 trillion to $10.1 trillion. Over that same period, nominal GDP has only grown 46% and Average Hourly Earnings by 29%.

When the money supply is increased for consumptive and speculative purposes, the Fed creates dissonance between our wages, wealth, and the rate of inflation. In other words, they generate excessive inflation and reduce our real wealth.  

If this is the case, why is the stated rate of inflation less than economic growth and wage growth?

The Wealth Scheme

This scheme works like all schemes by keeping the majority of people blind to what is truly occurring. To perpetuate such a scheme, the public must be convinced that inflation is low and their wealth is increasing.

In 2000, a brand new Ford Taurus SE sedan had an original MSRP of $18,935. The 2019 Ford Taurus SE has a starting price of $27,800.  Over the last 19 years, the base price of the Ford Taurus has risen by 2.05% a year or a total of 47%. According to the Bureau of Labor Statics (BLS), since the year 2000, the consumer price index for new vehicles has only risen by 0.08% a year and a total of 1.68% over the same period.

For another instance of how inflation is grossly underreported, we highlighted flaws in the reporting of housing prices in MMT Sounds Great in Theory But…  To wit: 

“Since then, inflation measures have been tortured, mangled, and abused to the point where it scarcely equates to the inflation that consumers deal with in reality. For example, home prices were substituted for “homeowners equivalent rent,” which was falling at the time, and lowered inflationary pressures, despite rising house prices.

Since 1998, homeowners equivalent rent has risen 72% while house prices, as measured by the Shiller U.S. National Home Price Index has almost doubled the rate at 136%. Needless to say, house prices, which currently comprise almost 25% of CPI, have been grossly under-accounted for. In fact, since 1998 CPI has been under-reported by .40% a year on average. Considering that official CPI has run at a 2.20% annual rate since 1998, .40% is a big misrepresentation, especially for just one line item.”

Those two obscene examples highlight that the government reported inflation is not the same inflation experienced by consumers. It is important to note that we are not breaking new ground with the assertion that the government reporting of inflation is low. As we have previously discussed, numerous private assessments quantify that the real inflation rate could easily be well above the average reported 2% rate. For example, Shadow Stats quantifies that inflation is running at 10% when one uses the official BLS formula from 1980.

Despite what we may sense and a multitude of private studies confirming that inflation is running greater than 2%, there are a multitude of other government-sponsored studies that argue inflation is actually over-stated. So, the battle is in the trenches, and the devil is in the details.

As defined earlier, inflation is “a disequilibrium between the amount of currency entering an economic system relative to the productive output of that same system.”

The following graph shows that the supply of money, measured by M2, has grown far more than the rate of economic growth (GDP) over the last 20 years.

Data St. Louis Federal Reserve

Since 2000, M2 has grown 234% while GDP has grown at half of that rate, 117%. Over the same period, the CPI price index has only grown by 53%. M2 implies an annualized inflation rate over the last 20 years of 6.22% which is three times that of CPI. 

Dampening perceived inflation is only part of the cover-up. The scheme is also perpetuated with other help from the government. The government borrows to boost temporary economic growth and help citizens on the margin. This further limits people’s ability to detect a significant decline in their standard of living.

As shown below, when one strips out the change in government debt (the actual increase in U.S. Treasury debt outstanding) from the change in GDP growth, the organic economy has shrunk for the better part of the last 20 years. 

Data St. Louis Federal Reserve

It doesn’t take an economist to know that a 6.22% inflation rate (based on M2) and decade long recession would force changes to our monetary policy and send those responsible to the guillotines. If someone suffering severe headaches is diagnosed with a brain tumor, the problem does not go away because the doctor uses white-out to cover up the tumor on the x-ray film.

Despite crystal clear evidence, the mirages of economic growth and low inflation prevent us from seeing reality.

Summary

Those engaging in speculative ventures with the benefit of cheap borrowing costs are thriving. Those whose livelihood and wealth are dependent on a paycheck are falling behind. For this large percentage of the population, their paychecks may be growing in line with the stated government inflation rate but not the true inflation rate they pay at the counter. They fall further behind day by day as shown below.

While this may be hard to prove using government inflation data, it is the reality. If you think otherwise, you may want to ask why a political outsider like Donald Trump won the election four years ago and why socialism and populism are surging in popularity. We doubt that it is because everyone thinks their wealth is increasing. To quote Bill Clinton’s 1992 campaign manager James Carville, “It’s the economy, stupid.”

That brings us back to Jerome Powell and the Fed. The U.S. economy is driven by millions of individuals making decisions in their own best interests. Prices are best determined by those millions of people based on supply and demand – that includes the price of money or interest rates. Any governmental interference with that natural mechanism is a recipe for inefficiency and quite often failure.

If monetary policy is to be set by a small number of people in a conference room in the Eccles Building in Washington, D.C. who think they know what is best for us based on flawed data, then they should prepare themselves for even more radical social and political movements than we have already seen.

Mauldin: The Fed Has Quietly Started QE4

In September of last year, something still unexplained happened in the “repo” short-term financing market. Liquidity dried up, interest rates spiked, and the Fed stepped in to save the day.

Story over? No. The Fed has had to keep saving the day, every day, since then.

We Hear Different Theories

The most frightening one is that the repo market itself is actually fine, but a bank is wobbly and the billions in daily liquidity are preventing its collapse.

Who might it be? I have been told, by well-connected sources, that it could be a mid-sized Japanese bank. I was dubious because it would be hard to keep such a thing hidden for months.

But then this week, Bloomberg reported some Japanese banks, badly hurt by the BOJ’s negative rate policy, have turned to riskier debt to survive. So, perhaps it’s fair to wonder.

Whatever the cause, the situation doesn’t seem to be improving.

Something Wicked Is Going On

On Dec. 12 a New York Fed statement said its trading desk would increase its repo operations around year end “to ensure that the supply of reserves remains ample and to mitigate the risk of money market pressures.”

Notice at the link how the NY Fed describes its plans. The desk will offer “at least” $150 billion here and “at least” $75 billion there. That’s not how debt normally works.

Lenders give borrowers a credit limit, not a credit guarantee plus an implied promise of more. The US doesn’t (yet) have negative rates, but the Fed is giving banks negative credit limits. In a very precise violation of Bagehot’s Dictum.

We have also just finished a decade of the loosest monetary policy in American history, the partial tightening cycle notwithstanding. Something is very wrong if banks still don’t have enough reserves to keep markets liquid.

Part of it may be that regulations outside the Fed’s control prevent banks from using their reserves as needed. But that doesn’t explain why it suddenly became a problem in September, necessitating radical action that continues today.

Here’s the official line, from the  minutes of the unscheduled Oct. 4 meeting at which the FOMC approved the operation.

Staff analysis and market commentary suggested that many factors contributed to the funding stresses that emerged in mid-September. In particular, financial institutions’ internal risk limits and balance sheet costs may have slowed the distribution of liquidity across the system at a time when reserves had dropped sharply and Treasury issuance was elevated.

So the Fed blames “internal risk limits and balance sheet costs” at banks. What are these risks and costs it was unwilling to accept, and why?

We still don’t know. There are lots of theories. Some even make sense.

QE4 Has Begun

Whatever the reason, it was severe enough to make the committee agree to both repo operations and the purchase of $20 billion a month in Treasury securities and another $20 billion in agencies.

It insists the latter isn’t QE, but it sure walks and quacks like a QE duck. So, I and many others call it QE4.

As we learned with previous QE rounds, exiting is hard. Remember that 2013 “Taper Tantrum?” Ben Bernanke’s mild hint that asset purchases might not continue forever infuriated a liquidity-addicted Wall Street.

The Fed needed a couple more years to start draining the pool and then did so in the stupidest possible way by both raising rates and selling assets at the same time.

Having said that, I have to note the Fed has few good choices. As mistakes compound over time, it must pick the least-bad alternative. But with each such decision, the future options grow even worse. So eventually instead of picking the least-bad, they will have to pick the least-disastrous one. That point is drawing closer.


The Great Reset: The Collapse of the Biggest Bubble in History

New York Times best seller and renowned financial expert John Mauldin predicts an unprecedented financial crisis that could be triggered in the next five years. Most investors seem completely unaware of the relentless pressure that’s building right now. Learn more here.

Mauldin: The Dirty Secret Behind America’s “Full Employment”

Should just being “employed” make people/workers happy?

On one level, any job is better than no job. But we also derive much of our identities and self-esteem from our work.

If you aren’t happy with it, you’re probably not happy generally.

Unhappy people can still vote and are often easy marks for shameless politicians to manipulate. Their spending patterns change, too.

So it ends up affecting everyone and everything.

Unhappy Employment

There’s this plight of people who, while not necessarily poor, aren’t where they think they should be—and perhaps once were.

This disappointment isn’t just in their minds; the economy really has changed. Yes, you can probably get a job if you are physically able, but the odds it will support you and a family, if you have one, are lower than they once were.

The US Private Sector Job Quality Index aims to give data on this… distinguishing between low-wage, often part-time service jobs and higher-wage career positions.

What they have found so far isn’t encouraging.

Looking at “Production & Non-Supervisory” positions (essentially middle-class jobs), the inflation-adjusted wage gap between low-wage/low-hours jobs and high-wage/high-hours jobs widened almost fourfold between 1990 and 2018.

Worse, the good jobs are shrinking in number. In 1990, almost half (47%) were in the “high-wage” category. In 2018, it was only 37%.

Work More, Earn Less

Much of the wage gap came not from the hourly rates, but from the number of hours worked.

The labor market has basically split in two categories with little in between.

There are low-wage service jobs in which you get paid only when the employer really needs you, and higher-wage jobs that pay steady wages.

The number of young people working in the so-called gig economy, working multiple part-time jobs, is growing. And part-time jobs generally are not high-paying jobs.

This also helps explain why so many relatively well-off people feel like they are always working and ahave no free time. They aren’t imagining it. Their employers really do keep them busy.

So we really have two generally unhappy groups: people who want to work more and raise their income, and people who want to work less but keep their income.

What’s the answer? We need to find one, and to do so we must talk about it. And that is possibly an even bigger problem.

Broken Politics

The national anxiety level got where it is for many different reasons. Some are largely outside our control, like the technological advances that have replaced some human jobs.

Hence political decisions need to be made.

The problem is that the ideological gap between the median Democrat and the median Republican has widened into a huge chasm in this century.

What as recently as 2004 was a mountain-shaped distribution with a small dip in between now looks more like a volcanic crater.

The simple fact is that the “center” is shrinking. It is hard to consider compromises when positions are so hardened that no compromise is allowable.

Whatever the reason for this (which is another debate), it prevents our political system from addressing important issues. This leaves an anxious population to feel either completely abandoned, or thinking it must align with one side or the other just to survive.


The Great Reset: The Collapse of the Biggest Bubble in History

New York Times best seller and renowned financial expert John Mauldin predicts an unprecedented financial crisis that could be triggered in the next five years. Most investors seem completely unaware of the relentless pressure that’s building right now. Learn more here.

Mauldin: We Are On The Brink Of The Second “Great Depression.”

You really need to watch this video of a recent conversation between Ray Dalio and Paul Tudor Jones. Their part is about the first 40 minutes.

In this video, Ray highlights some problematic similarities between our times and the 1930s. Both feature:

  1. a large wealth gap
  1. the absence of effective monetary policy
  1. a change in the world order, in this case the rise of China and the potential for trade wars/technology wars/capital wars.

He threw in a few quick comments as their time was running out, alluding to the potential for the end of the world reserve system and the collapse of fiat monetary regimes.

Maybe it was in his rush to finish as their time is drawing to a close, but it certainly sounded a more challenging tone than I have seen in his writings.

Currency Wars

It brought to mind an essay I read last week from my favorite central banker, former BIS Chief Economist William White.

He was warning about potential currency wars, aiming particularly at the US Treasury’s seeming desire for a weaker dollar. Ditto for other governments around the world. He believes this is a prescription for disaster.

One possibility is that it might lead to a disorderly end to the current dollar based regime, which is already under strain for a variety of both economic and geopolitical reasons. To destroy an old, admittedly suboptimal, regime without having prepared a replacement could prove very costly to trade and economic growth.

Perhaps even worse, conducting a currency war implies directing monetary policy to something other than domestic price stability. There ceases to be a domestic anchor to constrain the expansion of central bank balance sheets.

Should this lead to growing suspicion of all fiat currencies, especially those issued by governments with large sovereign debts, a sharp increase in inflationary expectations and interest rates might follow. How this might interact with the record high debt ratios, both public and private, that we see in the world today, is not hard to imagine.

I called Bill to ask if he thought this was going to happen. Basically, he said no, but it shouldn’t even be considered. It was his gentlemanly way of issuing a warning.

Currency devaluations against gold were part of the root cause of the Great Depression. Coupled with protectionism and tariffs, they devastated global economic growth and trade.

The Repeat of the 1930s?

Do I think it will happen in any significant way in the next few years?

It is not my highest probability scenario. But imagine a recession that brings the US deficit to $2 trillion, possibly followed by a governmental change that raises taxes and spending.

This could bring about a second “echo” recession with even higher deficits. This would force the Federal Reserve to monetize debt in order to keep interest rates from skyrocketing, thereby weakening the dollar.

Couple this with a concurrent crisis in Europe, potentially even a eurozone breakup, resulting in countries all over the world trying to weaken their currencies with the potential for higher inflation in many places.

In such a scenario, is it hard to imagine a desperate president and Congress, toward the latter part of the next decade, regardless of which party is in control, instructing the US Treasury to use its tools to weaken the dollar?

Can you say beggar thy neighbor? Can you see other countries following that path? All as debt is increasing with no realistic exit strategy except to monetize it?


The Great Reset: The Collapse of the Biggest Bubble in History

New York Times best seller and renowned financial expert John Mauldin predicts an unprecedented financial crisis that could be triggered in the next five years. Most investors seem completely unaware of the relentless pressure that’s building right now. Learn more here.

Mauldin: The Calm Before The Economic Storm

The global economy is slowing.

Germany, for instance, may already be in recession. GDP there dropped 0.1% in this year’s second quarter, with little reason to expect better from Q3 which we will learn soon.

Whatever you call it, Germany is certainly not in a good spot. It is highly dependent on exports which, for various reasons, are weakening, particularly in their auto industry.

Meanwhile, Brexit (depending on how it ends) could greatly reduce UK purchases of German goods.

On top of that, uncertainties induced by President Trump’s trade war are deterring businesses in Europe (as well as here) from investing in future growth projects.

And overarching all of it is the technology-driven decline in globalized manufacturing.

If Germany’s “technical recession” morphs into a real recession, the rest of Europe will certainly follow. And recession in Europe—and the measures its central banks will take to fight it—won’t leave the US economy unscathed.

The Rest of the World Is Not Well

Not coincidentally, commodity-producing emerging markets are also experiencing difficulty. Ditto for some more advanced commodity exporters like Australia and Canada.

Their problem springs from lower commodity prices, but more specifically from China. My friend Sam Rines (Director and Chief Economist at Avalon Advisors) explored this in a recent note.

Much of the commodity price pressure can be blamed on slowing Chinese growth, but that is not the entire story. China is roughly 20% of global GDP on a PPP basis, and constitutes much of the incremental growth in the global economy. When China’s growth slows, the ripples are felt in many places.

Commodity prices and China’s growth rate are understandably intertwined, and that may be a difficult correlation to break down. Why? It is difficult to pinpoint the next major tailwind. And—even when speculating on the next tailwind—timing is a further difficult hurdle to overcome.

But why not try. Of the three major headwinds to commodity pricing in the post-dual stimuli world (end of China’s building spree, US dollar following QE, and slower overall global growth), the US dollar is the most likely to abate as a headwind in the near-term. Global growth is dependent largely on US and China trade policy, but there could be a marginal shift higher in growth (the worst might be over). Replacing the rapid growth of China is not easy to see. India is gaining share of global GDP. But it is not easy to see the path to a full replacement of the China commodity cycle.

We may soon see the other side of China’s growth story. Just as it had an outsized effect on global GDP on the way up, it will likely be a major drag on the way down.

Note, when my young friend Sam says “the worst may be over,” he is talking in particular about the downturn from slower Chinese growth. If you read his daily missives, as I do, he is far from predicting a US recession.

Slower growth? Yes. It sounds like he thinks we are in a slower muddle-through world for the next few quarters at least. And maybe through the next elections…

The Signs of Looming Recession

While more goods are delivered electronically and supply chains are shrinking, the movement of physical goods is still the economy’s circulatory system.

The Cass Freight Index is the most comprehensive, high-frequency indicator of this. It tends to lead the economy by a few quarters but has signaled almost every economic turning point.

So the fact its year-over-year change has been negative every single month since December 2018 is more than a little concerning.

As you can see from the chart below, there have been periods of negative growth without a recession, but the latest drop’s sheer magnitude and rapidity is eye-opening.

Freight traffic is falling, and it looks even worse when Cass digs into the specifics.

Going deeper, Cass notes that “dry van” truck volume is a fairly reliable predictor for retail sales and is still relatively healthy.

That fits what we see elsewhere about consumer spending sustaining growth. But they also note that seasonally, dry van volume should be even stronger than it is. That suggests caution as the year winds down.

Other transport modes—rail, flatbed trucks, chemical tankers—indicate real problems in the industrial economy. Manufacturers seem to have little faith consumers will keep buying at the rates they are.

And, given how much consumer spending is debt-financed, they’re probably right to be cautious. Strong retail spending is not necessarily positive. Consider this Comscore holiday spending report from November 2007.

The Friday after Thanksgiving is known for heavy spending in retail stores, but it’s clear that consumers are increasingly turning to the Internet to make their holiday purchases,” said Comscore Chairman Gian Fulgoni. “Online spending on Black Friday has historically represented an early indicator of how the rest of the season will shake out. That the 22-percent growth rate versus last year is outpacing the overall growth rate for the first three weeks of the season should be seen as a sign of positive momentum.

The Great Recession began one month after this “sign of positive momentum.” A strong holiday shopping season won’t mean we are out of the woods and could mean we are just entering them.


The Great Reset: The Collapse of the Biggest Bubble in History

New York Times best seller and renowned financial expert John Mauldin predicts an unprecedented financial crisis that could be triggered in the next five years. Most investors seem completely unaware of the relentless pressure that’s building right now. Learn more here.

Mauldin: China’s Grand Plan To Take Over The World

When the US and ultimately the rest of the Western world began to engage China, resulting in China finally being allowed into the World Trade Organization in the early 2000s, no one really expected the outcomes we see today.

There is no simple disengagement path, given the scope of economic and legal entanglements. This isn’t a “trade” we can simply walk away from.

But it is also one that, if allowed to continue in its current form, could lead to a loss of personal freedom for Western civilization. It really is that much of an existential question.

Doing nothing isn’t an especially good option because, like it or not, the world is becoming something quite different than we expected just a few years ago—not just technologically, but geopolitically and socially.

China and the West

Let’s begin with how we got here.

My generation came of age during the Cold War. China was a huge, impoverished odd duck in those years. In the late 1970s, China began slowly opening to the West. Change unfolded gradually but by the 1990s, serious people wanted to bring China into the modern world, and China wanted to join it.

Understand that China’s total GDP in 1980 was under $90 billion in current dollars. Today, it is over $12 trillion. The world has never seen such enormous economic growth in such a short time.

Meanwhile, the Soviet Union collapsed and the internet was born. The US, as sole superpower, saw opportunities everywhere. American businesses shifted production to lower-cost countries. Thus came the incredible extension of globalization.

We in the Western world thought (somewhat arrogantly, in hindsight) everyone else wanted to be like us. It made sense. Our ideas, freedom, and technology had won both World War II and the Cold War that followed it. Obviously, our ways were best.

But that wasn’t obvious to people elsewhere, most notably China. Leaders in Beijing may have admired our accomplishments, but not enough to abandon Communism.

They merely adapted and rebranded it. We perceived a bigger change than there actually was. Today’s Chinese communists are nowhere near Mao’s kind of communism. Xi calls it “Socialism with a Chinese character.” It appears to be a dynamic capitalistic market, but is also a totalitarian, top-down structure with rigid rules and social restrictions.

So here we are, our economy now hardwired with an autocratic regime that has no interest in becoming like us.

China’s Hundred-Year Marathon

In The Hundred-Year Marathon, Michael Pillsbury marshals a lot of evidence showing the Chinese government has a detailed strategy to overtake the US as the world’s dominant power.

They want to do this by 2049, the centennial of China’s Communist revolution.

The strategy has been well documented in Chinese literature, published and sanctioned by organizations of the People’s Liberation Army, for well over 50 years.

And just as we have hawks and moderates on China within the US, there are hawks and moderates within China about how to engage the West. Unfortunately, the hawks are ascendant, embodied most clearly in Xi Jinping.

Xi’s vision of the Chinese Communist Party controlling the state and eventually influencing and even controlling the rest of the world is clear. These are not merely words for the consumption of the masses. They are instructions to party members.

Grand dreams of world domination are part and parcel of communist ideologies, going all the way back to Karl Marx. For the Chinese, this blends with the country’s own long history.

It isn’t always clear to Western minds whether they actually believe the rhetoric or simply use it to keep the peasantry in line. Pillsbury says Xi Jinping really sees this as China’s destiny, and himself as the leader who will deliver it.

To that end, according to Pillsbury, the Chinese manipulated Western politicians and business leaders into thinking China was evolving toward democracy and capitalism. In fact, the intent was to acquire our capital, technology, and other resources for use in China’s own modernization.

It worked, too.

Over the last 20–30 years, we have equipped the Chinese with almost everything they need to match us, technologically and otherwise. Hundreds of billions of Western dollars have been spent developing China and its state-owned businesses.

Sometimes this happened voluntarily, as companies gave away trade secrets in the (often futile) hope it would let them access China’s huge market. Other times it was outright theft. In either case, this was no accident but part of a long-term plan.

Pillsbury (who, by the way, advises the White House including the president himself) thinks the clash is intensifying because President Trump’s China skepticism is disrupting the Chinese plan. They see his talk of restoring America’s greatness as an affront to their own dreams.

In any case, we have reached a crossroads. What do we do about China now?

Targeted Response

In crafting a response, the first step is to define the problem correctly and specifically. We hear a lot about China cheating on trade deals and taking jobs from Americans. That’s not entirely wrong, but it’s also not the main challenge.

I believe in free trade. I think David Ricardo was right about comparative advantage: Every nation is better off if all specialize in whatever they do best.

However, free trade doesn’t mean nations need to arm their potential adversaries. Nowadays, military superiority is less about factories and shipyards than high-tech weapons and cyberwarfare. Much of our “peaceful” technology is easily weaponized.

This means our response has to be narrowly targeted at specific companies and products. Broad-based tariffs are the opposite of what we should be doing. Ditto for capital controls.

They are blunt instruments that may feel good to swing, but they hurt the wrong people and may not accomplish what we want.

We should not be using the blunt tool of tariffs to fight a trade deficit that is actually necessary.  The Chinese are not paying our tariffs; US consumers are.

Importing t-shirts and sneakers from China doesn’t threaten our national security. Let that kind of trade continue unmolested and work instead on protecting our advantages in quantum computing, artificial intelligence, autonomous drones, and so on.

The Trump administration appears to (finally) be getting this. They are clearly seeking ways to pull back the various tariffs and ramping up other efforts.


The Great Reset: The Collapse of the Biggest Bubble in History

New York Times best seller and renowned financial expert John Mauldin predicts an unprecedented financial crisis that could be triggered in the next five years. Most investors seem completely unaware of the relentless pressure that’s building right now. Learn more here.

Mauldin: Modern Central Banking Is More Vulnerable Than We Think

Banks are a place where you store your cash, right? Not exactly.

When you deposit money in a checking or savings account, you aren’t just letting the bank hold it on your behalf. You are lending the bank that money and the bank is borrowing it.

That’s why deposits show as a liability on the bank’s balance sheet.

We think of banks as lenders, and they are, but they’re also borrowers. They make money by lending at higher rates than they pay as borrowers, and by leveraging their deposits via fractional reserves.

Modern Central Banking

This is obvious if you think about it.

How can your bank simultaneously a) promise you can withdraw your cash on demand and b) lend that same cash to someone else?

That’s possible only because they know only a few people will want their cash back on any given day. And if cash requirements are more than expected, they can borrow from other banks or the Federal Reserve, as needed.

Modern central banking and regulatory practices have practically eliminated the old-fashioned bank run. It still happens occasionally, but the system can absorb it.

That’s because, while depositors can withdraw cash from a given bank, it is hard to withdraw from the banking system. Even if you buy gold, the gold dealer will probably deposit your cash in their bank, leaving the system exactly where it was before.

The System Is Vulnerable

Now, the system can be shaken up if too many people decide to hold physical paper money, or they transfer deposit money into other instruments banks can’t leverage as easily.

Central bank reserve requirements also play a role. The banking system is far more elaborate than the most complicated Swiss watch but it just keeps on ticking… until it stops.

Something weird happened in September, for reasons that remain a little murky. The repurchase agreement or “repo” market seized up.

I’ll spare you a plumbing lesson; all you need to know is that repos are really, really important for overnight funding.

Without them, it’s very hard for banks, brokers, funds, and other market participants to square their books. Modern banking simply wouldn’t function and the system would shut down.

Now, this wasn’t a catastrophe. The Fed injected some liquidity and everything seems okay for now. The important part is that it shouldn’t have happened and worse, apparently no one saw it coming.

Shades of 2007–2008

We had a string of similar hiccups in 2007–2008. All were manageable but eventually they added up to something much worse. So, this wasn’t a good sign for market stability.

That’s the problem with unconventional monetary policy. It may solve your immediate problem but create bigger ones later, as French economist Frédéric Bastiat said. We now know the Fed’s 2017–2018 rate hikes, concurrent with the balance sheet reductions or “QT” (quantitative tightening), were probably too aggressive, as even the Fed now tacitly admits. I said at the time they were running a two-factor experiment with unpredictable results. Could we now be seeing them? And if so, are they over?

No one knows, but the Fed looks rattled. And a rattled Fed isn’t what we need.


The Great Reset: The Collapse of the Biggest Bubble in History

New York Times best seller and renowned financial expert John Mauldin predicts an unprecedented financial crisis that could be triggered in the next five years. Most investors seem completely unaware of the relentless pressure that’s building right now. Learn more here.

Mauldin: How GE Screwed Over Its Retirees

Remember “defined benefit” pensions?

That is the kind of plan in which the employer guarantees the worker a set monthly benefit for life. They are increasingly scarce except for small closely held corporations.

The same rules apply for small closely held businesses as for large corporations.

These plans can be great tools for independent professionals and small business owners. But if you have thousands of employees, DB plans are expensive and risky.

The company is legally obligated to pay the benefits at whatever the cost turns out to be, which is hard to predict.

The advantage is you can use some hopeful accounting to set aside less cash now and deal with the benefit problems later. The problem is “later” comes faster than you would like, and procrastination can be a bitch.

That Brings Us to the Lesson for Today

On October 7, General Electric (GE) announced several changes to its defined benefit pension plans. Among them:

  • Some 20,000 current employees who still have a legacy-defined benefit plan will see their benefits frozen as of January 2021. After then, they will accrue no further benefits and make no more contributions. The company will instead offer them matching payments in its 401(k) plan.
  • About 100,000 former GE employees who earned benefits but haven’t yet started receiving them will be offered a one-time, lump sum payment instead. This presents employees with a very interesting proposition. Almost exactly like a Nash equilibrium. More below…

The first part of the announcement is growing standard. But the second part is more interesting, and that’s where I want to focus.

Suppose you are one of the ex-GE workers who earned benefits. As of now, GE has promised to give you some monthly payment when you retire. Say it’s $1,000 a month.

What is the present value of that promised income stream? It depends on your life expectancy, inflation, interest rates and other factors. You can calculate it, though. Say it is $200,000.

Is GE offering to write you a generous check for $200,000? No. We know this because GE’s press release says:

Company funds will not be used to make the lump sum distributions. All distributions will be made from existing pension plan assets in the GE Pension Trust. The company does not expect the plan’s funded status to decrease as a result of this offer. At year-end 2018, the plan’s funded ratio was 80 percent (GAAP).

So GE is not offering to give away its own money, or to take it from other workers. It is simply offering ex-employees their own benefits earlier than planned. But under what assumptions? And how much? The press release didn’t say.

If that’s you, should you take the offer? It’s not an easy call because you are making a bet on the viability of General Electric.

The choice GE pensioners face is one many of us will have to make in the coming years. GE isn’t the only company in this position.

Unrealistic Assumptions

When GE says its plan is 80% funded under GAAP, it necessarily makes an assumption about the plan’s future investment returns.

I dug around their 2018 annual report and found the “expected rate of return” was 8.50% as recently as 2009, when they dropped it to 8.00%, then 7.50% in 2014, to now 6.75%.

So over a decade they went from staggeringly unrealistic down to seriously unrealistic. They still assume that every dollar in their pension fund will grow to almost $4 in 20 years.

That means GE’s offered amounts will probably be too low, because they’ll base their offers on that expected return.

GE hires lots of engineers and other number-oriented people who will see this. Still, I doubt GE will offer more because doing so would compromise their entire corporate viability, as we’ll see in a minute.

Financial Engineering

GE has $92 billion in pension liabilities offset by roughly $70 billion in assets, plus the roughly $5 billion they’re going to “pre-fund.”

But that is based on 6.75% annual return. Which roughly assumes that in 20 years one dollar will almost quadruple.

What if you assume a 3.5% return? Then you are roughly looking at $2, which would mean the pension plan is underfunded by over $100 billion—and that’s being generous.

GE’s current market cap is less than $75 billion, meaning that technically the pension plan owns General Electric.

This is why GE and other corporations, not to mention state and local pension plans, can’t adopt realistic return assumptions. They would have to start considering bankruptcy.

If GE were to assume 3.5% to 4% future returns, which might still be aggressive in a zero-interest-rate world, they would have to immediately book pension debt that might be larger than their market cap.

GE chair and CEO Larry Culp only took over in October 2018.

We have mutual friends who have nothing but extraordinarily good things to say about him. He is clearly trying to both do the right thing for employees and clean up the balance sheet.

He was dealt a very ugly hand before he even got in the game.

GE needs an additional $5 billion per year minimum just to stave off the pension demon. That won’t make shareholders happy, but Culp is now in the business of survival, not happiness.

That is why GE wants to buy out its defined benefit plan beneficiaries. Right now, the company is on the wrong side of math.

It doesn’t have anything like Hussman’s 31X the benefits it is obligated to pay. Nor do many other plans, both public and private. Nor does Social Security.

Tough Choices

To be clear, I think GE will survive. Its businesses generate good revenue and it owns valuable assets. The company can muddle through by gradually bringing down the expected returns and buying out as many DB beneficiaries as possible. But it won’t be fun.

Pension promises are really debt by another name. The numbers are staggering even when you understate them. We never see honest accounting on this because it would make too many heads melt.

If I am a GE employee who is offered a buyout? I might seriously consider taking it because I could then define my own risk and, with my smaller amount, take advantage of investments unavailable to a $75 billion plan.


The Great Reset: The Collapse of the Biggest Bubble in History

New York Times best seller and renowned financial expert John Mauldin predicts an unprecedented financial crisis that could be triggered in the next five years. Most investors seem completely unaware of the relentless pressure that’s building right now. Learn more here.

Mauldin: Social Security Is Screwing Millennials

Social Security is a textbook illustration of how government programs go off the rails.

It had a noble goal: to help elderly and disabled Americans, who can’t work, maintain a minimal, dignified living standard.

Back then, most people either died before reaching that point or didn’t live long after it. Social Security was never intended to do what we now expect, i.e., be the primary income source for most Americans during a decade or more of retirement.

Life expectancy when Social Security began was around 56. The designers made 65 the full retirement age because it was well past normal life expectancy.

No one foresaw the various medical and technological advances that let more people reach that age and a great deal more, or the giant baby boom that would occur after World War II, or the sharp drop in birth rates in the 1960s, thanks to artificial birth control.

Those factors produced a system that simply doesn’t work.

A few modest changes back then might have avoided today’s challenge. But now, we are left with a crazy system that rewards earlier generations at the expense of later ones.

Screwing Millennials

I am a perfect example.

I’ve long said I never intend to retire, if retirement means not working at all. I enjoy my work and (knock on wood) I’m physically able to do it.

Social Security let me delay collecting benefits until now, for which I will get a higher benefit—$3,588 monthly, in my case.

Now, that $3,588 I will be getting each month isn’t random. It comes from rules that consider my lifetime income and the amount of Social Security taxes I and my employers paid.

That amount comes to $402,000 of actual dollars, not inflation-adjusted dollars. (I also paid $572,000 in Medicare taxes. Again, actual dollars, not inflation-adjusted dollars.)

What did those taxes really buy me? In other words, what if I had been allowed to invest that same money in an annuity that yielded the same benefit? Did I make a good “investment” or not?

That is actually a very complicated question, one that necessarily involves a lot of assumptions and will vary a lot among individuals.

In my case, if I live to age 90 and benefits stay unchanged, the internal real rate of return on my Social Security “investment” will be 3.84%. If I only make it to 80, that real IRR drops to 0.75%.

While this may not sound like much, it actually is. Even 1% real return (i.e., above inflation) with no credit risk is pretty good and 3.84% is fantastic. If I live past 90 it will be even better.

But this is not due to my investment genius. Four things explain my high returns.

  • Double indexing of benefits in the early 1970s (thank you, Richard Nixon).
  • I delayed claiming benefits until age 70, which I could afford to do but isn’t an option for many people.
  • I will probably live longer than average, due to both genetic factors and maintaining good health (thank you, Shane!).

But maybe most of all because

  • The system is massively screwing the next generation. From a Social Security benefit standpoint, being an early Boomer is a pretty good deal.

Social Security structurally favors its earliest users. The big winners are not the Baby Boomers like me, but our parents.

They paid less and received more. But we Boomers are still getting a whale of a deal compared to our grandchildren.

Now, consider a male who is presently age 25, and who earns $50,000 every year from now until age 67, his full retirement age.

Such a person is not going to get anything like the benefits I do, especially with benefit cuts, which my friend Larry estimates will be as high as 24.5%.

So, if this person lives an average lifespan and gets only those reduced benefits, his real internal rate of return will be -0.23%.

I suspect very few in the Millennial generation know this and they’re going to be mad when they find out. I don’t blame them, either.

The Next Quadrillion

The reason Millennials won’t see anything like the benefits today’s retirees get is simple math. The money simply isn’t there.

The so-called trust fund (which is really an accounting fiction, but go with me here) exists because the payroll taxes coming into the system long exceeded the benefits going to retirees.

That is no longer the case.

Social Security is now “draining” the trust fund to pay benefits. This can only continue for so long. Projections show the surplus will disappear in 2034. A few tweaks might buy another year or two. Then what?

Well, the answer is pretty simple. If Congress stays paralyzed and does nothing, then under current law Social Security can only pay out the cash it receives via payroll taxes. That will be only 77% of present benefits—a 23% pay cut for millions of retirees.

And please understand, there is no trust fund. Congress already spent that money and must borrow more to make up the difference.

This IS going to happen. Math guarantees it.

Missing Opportunities

These problems would be less serious if more people saved for their own retirements and viewed Social Security as the supplement.

There are good reasons many haven’t done so. Worker incomes have stagnated while living costs keep rising.

But more important, telling people to invest their own money presumes they have investment opportunities and the ability to seize them. That may not be the case.

The prior generations to whom Social Security was so generous also had the advantage of 5% or better bond yields or bank certificates of deposits at very low risk.

That is unattainable now. And let’s not even talk about mass numbers of uninformed people buying stocks at today’s historically high valuations. That won’t end well.

So, if your solution is to put people in private accounts and have them invest their own retirement money, I’m sorry but it just won’t work.

It will have the same result as those benefit cuts we find so dreadful: millions of frustrated and angry retirees.

So, what is the answer if you are in retirement or approaching it? The easiest answer is to raise the retirement age. Yes, that’s really just a disguised way to cut benefits, but making it 70 or 75 would get the program a lot closer to its original intent.

Today’s 65-year-olds are in much better shape than people that age were in 1936 or even 1970.

(Note, I would still leave the option for people who are truly disabled to retire younger. I get that not everybody is a writer and/or an investment adviser who makes their living in front of the computer or on the phone. Some people wear out their bodies and really deserve to retire earlier.)


The Great Reset: The Collapse of the Biggest Bubble in History

New York Times best seller and renowned financial expert John Mauldin predicts an unprecedented financial crisis that could be triggered in the next five years. Most investors seem completely unaware of the relentless pressure that’s building right now. Learn more here.

Mauldin: Economics Is Like Quantum Physics

I often say a writer is nothing without readers. I am blessed to have some of the world’s greatest. Your feedback never fails to inspire and enlighten me.

My last week’s That Time Keynes Had a Point letter brought many more comments than usual. Apparently Keynes is still provocative 73 years after his death, no matter what you say about him.

But my real point was about the twisted economic thought that is having dangerous effects on us all. And we can’t blame it just on Keynes.

Today I want to share some of the feedback I received, add a few thoughts, and then show you some real-world consequences that are only getting worse. But first, let me wax philosophic for a minute.

Economic Dispute

This economic dispute is, at its core, a very old argument about how we understand reality. The ancient Greek philosopher Aristotle might agree with some of today’s economists. He taught deductive reasoning with the classic syllogism:

  • All men are mortal
  • Socrates is a man
  • Therefore, Socrates is mortal

In other words, Aristotle said to move from general principles to specific conclusions. That’s what the bulk of modern macroeconomics does, using their (much more elaborate) models to deduce the “best” policy choices.

Centuries later, Sir Francis Bacon turned Aristotle upside down when he advocated inductive reasoning.

Rather than start with broad principles and apply them everywhere, he said to presuppose nothing, observe events and move from specific to general as you gather more observations… what we now call the “scientific method.”

Today’s economists may think that’s what they are doing, but they often aren’t. They begin with models that purport to include all the important variables, then fit facts into the model. When the facts don’t fit, they look for new ones, never considering that the model itself may be flawed.

Furthermore, as I have shown time and time again, they assume away reality in order to construct models that are in “equilibrium” with themselves. This is supposed to give us insight into the reality that has been assumed away.

That process isn’t necessarily wrong, but it’s not science. It is the opposite of science. Bacon would be horrified to see this. He tried to show the world a better way and now, centuries later, some of our most learned professors still don’t get it.

This is sadly not just a philosophical argument. It has real consequences for real people, including you and me.

Uncertainty Principle

Speaking of science, I received this note from an actual scientist (i.e., not an economist).

“Dear John, having been an avid reader of your articles for many years now I wanted to write to say how much I tend to agree with your commentary, and in particular how much I enjoyed this week’s article. I’d like to make a couple of comments about this week’s material.

Firstly, reference was made to comparing economics with physics, and how economists suffer from “physics envy” (I should say that I have a PhD in physics from Oxford and subsequently worked as a physicist at the European Center for Nuclear Physics Research (CERN) in Geneva, Switzerland, although I left behind my career as a physicist a long time ago.)

Economies and financial markets are much more like the world of quantum mechanics than the world of classical physics. In classical physics there is complete independence between the observer and the system under observation. However, in the realms of quantum mechanics, the systems under observation are so small that the act of observation disturbs the system itself, described by Heisenberg’s Uncertainty Principle.

This situation is similar to that of financial markets, where the actions of market players is not separate from market outcomes; rather the actions of market players PRODUCE the market outcomes.

Betting on financial markets is different from betting on the outcome of an independent event, such as the outcome of a horse race or a football match. The latter are akin to classical physics where there is independence between observer and observed. Whilst actions in the betting market change the odds on which horse/team is favored to win, they don’t impact the outcome of the event, which is rather determined by the best horse/team on the day.” —Paul Shotton

Thank you, Paul, for pointing out this important distinction. I can’t pretend to understand quantum mechanics but your point about independent observation is profound.

Economists don’t just build models; they (and all of us) are parts of the model. We are the economy and the economy is us. While discussing it, we also affect it.

George Soros calls this the principle of reflexivity, the idea that a two-way feedback loop exists in which investors’ perceptions affect that environment, which in turn changes investor perceptions. (Here’s his essay explaining more.)

That means these macroeconomic models, which with their Greek letters and complex equations look very scientific to a layperson, are often at odds with the scientific method.

You can’t conduct independent observations and experiments on an entire economy. That doesn’t render the models completely useless, but greatly limits them.

Borrowing from Clint Eastwood, this might be fine if those who use these models would respect the limitations. All too often, they don’t. And this is where it gets a little complicated.

I confess that I use models. I build them and work with others who build even better ones. Models can help inform us of potential outcomes and better understand risk and reward.

But there are clearly inherent limitations on using historical or theoretical observations to predict future results.

(Dis) Equilibrium

Here are a couple more letters, taking issue with my comments on equilibrium.

“Just to clarify… Even if the economy can be modeled in some sense by a sand pile that will ultimately collapse, that does not mean that the economy is, at any point in time, not in equilibrium. In fact, it must be in equilibrium in order to form the sand pile! You could argue that the equilibrium is “unstable,” perhaps, but it is certainly a (possibly unstable) equilibrium.” —John Bruch

***

“John, I’ve been a reader for years and love your letter. But your comment today is over the top;

The entire premise of equilibrium economics is false. Efficient market hypothesis is over the top but the premise of equilibrium is perfectly modeled in your sand pile letter. Cycles have always existed and always will exist.

Natural market forces will always move markets towards equilibrium but government interference slows the process making the sand pile grow in size and magnitude. To say that the principle of equilibrium is false is just ignoring reality.

The economy is like our forests. When a fire starts in the forest you let it burn so that nature’s cycle can run its course. If you keep putting out the fire you build excess fuel and then at some point you have a catastrophic fire that no humans can control. Mother Nature eventually steps in and puts out the fire and puts life back into equilibrium.

I agree that we need to rethink economics. But the principle of equilibrium, however short lived that moment in time is, is a sure reality.” —Dennis Carver

John and Dennis raise an interesting question. The mere fact that the “sand pile” exists intact for some period of time means that equilibrium exists for that interval. Fair enough. The grains of sand do, in fact, line up so that they don’t collapse.

But we are constantly adding more sand and each additional grain changes the equilibrium. The previous equilibrium ends at that point, having been so brief as to be meaningless.

Eventually a grain of sand will create an unstable equilibrium, causing the pile to partially or completely collapse (and then be in equilibrium once again). So if no single state of equilibrium can exist for more than an instant, I would argue it’s not really “equilibrium” for any practical purpose. We can’t rely on it to continue. Every moment brings a new, unknown situation.

Let’s look at it another way. The sandpile model assumes there will be moments of instability. In economic terms, we are experiencing transitory equilibrium. The sandpile model is inherently unstable, a perfect example of Minsky’s Financial Instability Hypothesis: Stability leads to instability and the longer the period of stability, the greater the instability will be at the end.

(Nassim Taleb’s Antifragility Principle is important to understand when we think about equilibrium, or rather the lack of it. His book Antifragile is important and you should at least read the first half.)

My old friend and early economics mentor Dr. Gary North sees this idea of “equilibrium” as not just wrong, but downright evil.

In his 1963 textbook for upper division economics students, [Israel] Kirzner wrote about the assumptions of economists regarding the use of equilibrium as an explanatory model. They use it to describe the system of feedback that the price system provides the market place. “The state of equilibrium should be looked upon as an imaginary situation where there is a complete dovetailing of the decisions made by all the participating individuals.”

This means not only perfect knowledge of available economic opportunities, but also men’s universal willingness to cooperate with each other. In short, it conceives of men as angels in heaven, with fallen angels having conveniently departed for hell and its constant disequilibrium, where totalitarian central power is needed to co-ordinate their efforts. “A market that is not in equilibrium should be looked upon as reflecting a discordancy between the various decisions being made.”

The heart of free market economic analysis is the concept of monetary profits and losses as feedback devices that persuade people to cooperate with each other in order to increase their wealth. “But the theorist knows that the very fact of disequilibrium itself sets into motion forces that tend to bring about equilibrium (with respect to current market attitudes)” (Market Theory and the Price System, p. 23). Presumably, even devils cooperate on this basis. They, too, prefer profits to losses.

Biblically speaking, this theory of equilibrium is wrong. It is not just wrong; it is evil. It adopts the idea of man as God as its foremost conceptual tool to explain people’s economic behavior. It explains the market process as man’s move in the direction of divinity. Economists are not content to explain the price system as a useful arrangement that rewards people with accurate knowledge who voluntary cooperate with each other. They explain the economic progress of man and the improvement of man’s knowledge as a pathway to divinity, however hypothetical. The science of economics in its humanist framework rests on the divinization of man as a conceptual ideal.

Setting aside the theology, the point here is that economists assume human beings are perfectly rational and consistent, or at least wish to be. That’s what makes equilibrium possible.

But we know humans aren’t perfect or consistent. So how can we have equilibrium? We can’t, unless we assume markets are in equilibrium because they act in a manner we deem appropriate or ideal.

Insane Ideas

Again, this isn’t an academic argument. People who believe these ideas either hold seats of power or have influence on those who do. They truly think they can twist some knobs on their models and make everything better.

If we just had better monetary or fiscal policy, if the government could tax the right people and distribute the money correctly, everyone would be so much better off. And of course, their highly complex models and theories will conveniently lead to their desired political conclusions.

It is increasingly obvious that conventional monetary policy is useless now that rates have been so low for so long, and everyone believes they will remain low.

Nothing the central banks do incentivizes anyone to make immediate growth-generating decisions. If you need to borrow money, you likely did it long ago.

A new Deutsche Bank analysis says the major world economies now have government debt, on average, exceeding 70% of GDP, the highest peacetime level of the past 150 years.


Source: Financial Times

This is obviously unsustainable but the economics profession (and the bankers) desperately want to sustain it. With monetary tools no longer useful, they are turning to fiscal policy. Serious people are mapping strategies like helicopter money, debt monetization, MMT, and worse.

These all, in various ways, essentially say that government debt doesn’t matter, and in some cases we actually need more of it. Historically, the only way that can be right is if we are on the cusp of another WW2-like crisis.

This horrifying but well-researched Bloomberg article is chock full of links to insane ideas. Some look superficially attractive, especially to those unfamiliar with even basic economics. Many have familiar, heavyweight names attached to them. All have, to me at least, a whiff of desperation. They are frantic attempts to make the world stop spinning.

I don’t think these ideas will work. I think we are beyond the black hole’s event horizon. Bad things are going to happen, culminating in some kind of globally coordinated debt liquidation I have dubbed the Great Reset. I really see no other way out.

Every day brings more signs of the impending crisis. Duke University’s latest quarterly CFO survey found more than half of finance chiefs foresee a US recession before the 2020 election. Possibly worse, they project only a 1% increase in capital spending over the next 12 months.

An economy in which near-zero interest rates can’t spur more investment than that is an economy with serious problems. And I expect them to get worse, not better.

Furthermore, an increasing body of evidence says that increasing sovereign debt is a slow but inexorable drag on GDP. It is like the frog being boiled in water, but so slowly that we as citizens don’t really understand what is happening to us. We do sense something is wrong, though. Hence today’s worldwide populist movements.

The driver for 1930s populism was the Great Depression and unemployment. Now the impetus is rising debt and underemployment, with people unable to improve their lives as past generations did. Millions no longer expect to be better off economically than their parents. That frustration is sparking unproductive political partisanship and has the potential to bring political chaos as governments try to protect their own technology and businesses.

The world in general has clearly benefited from globalization and automation, but that is a hard argument to make as jobs disappear. And more jobs will disappear as technology increasingly lets businesses replace expensive humans with cheap robotics and algorithms. Sigh… I wish I had answers. Well, I do, but I don’t think they’ll going to get a great deal of traction.

This won’t be the end of the world. I really do think there are ways that you can properly position your portfolio and your personal life to not just survive but to thrive. We will get through it and be better on the other side. But it’s going to be a bumpy ride.


The Great Reset: The Collapse of the Biggest Bubble in History

New York Times best seller and renowned financial expert John Mauldin predicts an unprecedented financial crisis that could be triggered in the next five years. Most investors seem completely unaware of the relentless pressure that’s building right now. Learn more here.

J.M. Keynes: The Time He Had A Point

John Maynard Keynes once said:

“Practical men, who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back.”

While true, it doesn’t go far enough. The problem isn’t simply defunct economists or “scribblers of a few years back.”

We are in the grip of economists who, far from being defunct, hold great power. Whether they hear voices in the air (or Twitter), I can’t say, but they are indeed madmen in authority.

Not all economists are in that category. Many provide valuable insight or are at worst harmless. They don’t pretend they can change human nature or prevent the inevitable.

Unfortunately, some economists do believe those things. Worse, they are in places from which they can wreak havoc, and they are.

Last weekend I received two emails referring me to articles about the economics profession that stirred my writing juices.

I don’t agree with everything in the articles. They are, however, important because they try, at least, to describe and possibly fix the problem Keynes identified.

We have to address them, not just economically but politically. We can’t just put our heads in the sand and think this will go away.

The whole debt bubble, the income and wealth inequality angst, a growing deficit which will get worse after the next recession, and lack of economic understanding among voters is all coming home to roost.

Better to think about that now, while we can still act and maybe even change things.

False Assumptions

The first item is a July 2019 TED talk by Nick Hanauer, a self-described Seattle “plutocrat” who founded and sold several companies.

He is now a venture capital investor. Hanauer is far to my left politically, but his thinking reminds me a bit of Ray Dalio, and as we will see, some of the proponents of neo-Keynesian “new economics.”

Hanauer’s latest TED talk is titled “The dirty secret of capitalism—and a new way forward.” He begins by describing the widening inequality problem we have discussed before, then quickly zeroes in on what he thinks is the problem: neoliberal economics.

Economics has been described as the dismal science, and for good reason, because as much as it is taught today, it isn’t a science at all, in spite of all of the dazzling mathematics. In fact, a growing number of academics and practitioners have concluded that neoliberal economic theory is dangerously wrong and that today’s growing crises of rising inequality and growing political instability are the direct result of decades of bad economic theory.

What we now know is that the economics that made me so rich isn’t just wrong, it’s backwards, because it turns out it isn’t capital that creates economic growth, it’s people; and it isn’t self-interest that promotes the public good, it’s reciprocity; and it isn’t competition that produces our prosperity, it’s cooperation.

What we can now see is that an economics that is neither just nor inclusive can never sustain the high levels of social cooperation necessary to enable a modern society to thrive.

I know, those are fighting words to most free-market defenders, but hear this out. Hanauer blames the sad state of modern economics on three false assumptions.

First, it isn’t true the market is an efficient equilibrium system. You may have read my “sandpile” article that is one of my most popular ever.

It describes how our astronomically complex modern economy is anything but an equilibrium. It is a growing sandpile whose collapse is certain. As Hyman Minsky wrote, stability breeds instability.

If, as too many economists believe, you think you can manage an economy toward equilibrium, you simply help the sandpile grow bigger so its eventual collapse is even more violent. That’s how we get crises like 2008, and the one we will have again in due course.

The second false assumption is that price always equals value. That’s the heart of the efficient market hypothesis, that stock prices always reflect all available information. Clearly, they don’t, since we have all seen both overvalued and undervalued markets.

In fact, we have economist-run institutions like the Federal Reserve working to make sure prices don’t equal value.

They intentionally distort prices, starting with the most important one: the price of money, what we call “interest rates,” with all kinds of harmful effects (and often benefits to those who already own assets).

The third false assumption is that humans are rational, utility-maximizing machines who look out for our own interests first. It’s just not true.

Humans are social animals, and we will, in the right conditions, sacrifice our own interests for others. Soldiers don’t heroically jump on grenades because they’re selfish. Parents and friends often sacrifice for their children and their friends.

People accept lower returns to invest in ways they think improve the world, or pursue behaviors they feel are in the common and general interest but not their own individual interests. Happens all the time.

If we were all so naturally self-maximizing, there would be no such thing as love, which is a choice to place someone else’s good ahead of your own. If you have some hidden selfish motive, it’s not really love, is it? Not in the way any religion I know describes it.

Yet many economists persist in believing we are all competitive, all the time, and this somehow leads to equilibrium and prosperity.

That is false and if it is your base assumption, all your other answers are going to be wrong. This is not an embrace of human nature, but a denial of it.

Meanwhile, another Seattle billionaire had some words on the same subject recently. Bill Gates didn’t say exactly “economists know nothing,” but that’s clearly what he meant in this Quartz interview.

“Too bad economists don’t actually understand macroeconomics,” the Microsoft co-founder said. Asked what he meant by that, Gates continued:

“It’s not like physics where you take certain inputs and you predict certain outputs. Will interest rates ever return to normal, and why aren’t they returning to normal? You won’t get a consensus between economists quite the way that if you dropped a ball out your window and called up physicists and asked, ‘What the hell happened?’ There’s so many factors including what [economist John Maynard] Keynes called ‘animal spirits’ in the economic equation that we don’t have predictability.

Even today, people are still arguing about what happened in 2008. So it’s even harder to look forward. [Look at] the role of the bond rating agencies in 2008, which is completely unreformed. Why would that be? Well, there must be a lack of consensus.”

Both Hanauer and Gates make a point. Economists began assuming equilibrium must exist early in the 20th century. General equilibrium was wonderful because it let them model the economy on paper (and later, computers).

Economists have physics envy. In essence, they assume away whatever doesn’t fit the model. Unsurprisingly, the models don’t work when put to the test, because the assumptions are not anchored in reality.

The entire premise of equilibrium economics is false. The world is a complex system. To model it requires complexity mathematics and theory. Sadly, but not unsurprisingly, we are decades away (if ever) from actually being able to model the economy as long as one continues to assume equilibrium at some point.

Of course we can make observations and theories and propose policies. But we shouldn’t do so under the illusion that some mathematical model allows us to know what we’re doing. “Lies, damn lies and models” should have been the quote. So when Gates and Hanauer and others, including me, say that economists don’t understand economics, our real point is that they rely on incorrect models and assumptions.

It gets worse when the politicians get economists to create models for them. These economists are every bit as trained as any circus animal and they don’t even need a whip.

The economists’ assumptions inevitably lead to the conclusions the politician wants. Of course, they all have “neutral data and facts.” What would a model be without facts and data?

Necessary Debate

The second article came to me from a person who thought it ridiculous. He sent it along with a lengthy preface warning about its (in his view, false) claims.

I appreciated the thought but I am also trying very hard to break out of the tribal box. I now often say that I’m neither Republican nor Democrat, but American.

I don’t automatically reject ideas simply because of their origin. If I reject them, it’s because I have studied them and concluded they are wrong.

That said, this one has a lot of problems but is still worth reading. The author is Jared Bernstein, an economist who once advised Vice President Joe Biden. In this piece he describes what he calls a “new economics” that will create a more “just” America.

Like Dalio and Hanauer, I think Bernstein correctly identifies many of our problems. It is not the case that everything would be peachy if government just got out of the way; we have deeper issues. I completely endorse Bernstein’s first sentence: “The American economy has some serious, structural problems—and the economists are partly to blame.” He goes on:

It is not a coincidence that the new economics is in ascendency at this moment. Though by some measures, inequality has not grown much in recent years, it remains at levels as high as the late 1920s, which, for the record, didn’t end well. In one of the most disturbing developments emerging from recent research, the inequality of income and wealth is increasingly associated with the inequality of life expectancy.

The assumption that self-interested firms would self-regulate gave rise to repeated rounds of deregulation that gave us what I call the “shampoo economy”: bubble, bust, repeat. The old economics wrongly claimed we couldn’t have persistently low unemployment without spiraling inflation, yet that’s precisely what we’ve enjoyed in recent years.

In other words, the new economics isn’t arising just because we want “better” outcomes from our markets. It’s also arising because a lot of the old stuff has turned out to be just plain wrong.

That is mostly true but I think it’s because deregulation hasn’t gone far enough. Large companies use political influence to have government protect them from competition.

The result is a bunch of “zombies” engaged in counterproductive activities that market discipline would quickly send to the graveyard, were it allowed to work.

The solution, in my opinion, is not for government to further regulate private business, but for it to stop picking winners and losers. Consumers could then decide what works.

Of course, there’s room for reasonable regulation; we all want safe vehicles, clean food, etc. But regulations should promote competition, not suppress it.

I think many of Bernstein’s policy ideas won’t have the desired results, and some would be disastrous, but these are debates we need to have. We will achieve better results if we engage in them civilly and sincerely. That is hard in today’s polarized environment… but avoiding it will be even harder.

Keynesian Sense?

That brings us back to Lord Keynes. Many now regard him as one of the “defunct economists” he himself blamed for the problems of his time.

In certain quarters, “Keynesianism” is as unpalatable as socialism. In fact, while Keynes was a leftist by today’s standards, he wasn’t against capitalism.

Recently I ran across a 2009 article by Bruce Bartlett with the provocative headline, Keynes Was Really a Conservative. That overstates it, but Keynes was more conservative than you might think. Here’s Bartlett.

Keynes completely understood the central role of profit in the capitalist system. This is one reason why he was so strongly opposed to deflation and why, at the end of the day, his cure for unemployment was to restore profits to employers. He also appreciated the importance of entrepreneurship: “If the animal spirits are dimmed and the spontaneous optimism falters… enterprise will fade and die.” And he knew that the general business environment was critical for growth; hence business confidence was an important economic factor. As Keynes acknowledged, “Economic prosperity is… dependent on a political and social atmosphere which is congenial to the average businessman.”

Indeed, the whole point of The General Theory was about preserving what was good and necessary in capitalism, as well as protecting it against authoritarian attacks, by separating microeconomics, the economics of prices and the firm, from macroeconomics, the economics of the economy as a whole. In order to preserve economic freedom in the former, which Keynes thought was critical for efficiency, increased government intervention in the latter was unavoidable [at least to him]. While pure free marketers lament this development, the alternative, as Keynes saw it, was the complete destruction of capitalism and its replacement by some form of socialism.

“It is certain,” Keynes wrote, “that the world will not much longer tolerate the unemployment which… is associated—and, in my opinion, inevitably associated—with present-day capitalistic individualism. But it may be possible by a right analysis of the problem to cure the disease whilst preserving efficiency and freedom.”

In Keynes’ view, it was sufficient for government intervention to be limited to the macroeconomy—that is, to use monetary and fiscal policy to maintain total spending (effective demand), which would both sustain growth and eliminate political pressure for radical actions to reduce unemployment. “It is not the ownership of the instruments of production which is important for the State to assume,” Keynes wrote. “If the State is able to determine the aggregate amount of resources devoted to augmenting the instruments and the basic rate of reward to those who own them, it will have accomplished all that is necessary.”

One of Keynes’ students, Arthur Plumptre, explained Keynes’ philosophy this way. In his view, Hayek’s “road to serfdom” could as easily come from a lack of government as from too much. If high unemployment was allowed to continue for too long, Keynes thought the inevitable result would be socialism—total government control—and the destruction of political freedom. This highly undesirable result had to be resisted and could only be held at bay if rigid adherence to laissez-faire gave way, but not too much. As Plumptre put it, Keynes “tried to devise the minimum government controls that would allow free enterprise to work.”

There’s actually a lot to like here. A government that focuses on keeping the “macro” playing field level while letting producers and consumers control the “micro” economy would be a vast improvement over what we have now.

That last quote from Plumptre is well said. Keynes wanted “the minimum government controls that would allow free enterprise to work.” He sought a balance between central planning and anarchy. He saw a lot of room between the extremes.

Likewise, by establishing conditions in which market forces could work, Keynes sought to prevent the kind of radical policies some of his modern followers want.

The crazy ideas we now fear—negative rates, MMT and the rest—didn’t appear spontaneously. Their proponents see them as solutions to real problems. These ideas would go nowhere if the economy functioned better.

Today we’re still seeking the balance Keynes wanted. We need an economics profession with clear thinkers. They’re out there. We have to amplify their voices.


The Great Reset: The Collapse of the Biggest Bubble in History

New York Times best seller and renowned financial expert John Mauldin predicts an unprecedented financial crisis that could be triggered in the next five years. Most investors seem completely unaware of the relentless pressure that’s building right now. Learn more here.

The 60/40 Portfolio Is Riskier Than Ever

As investors we have to make assumptions about the future. We know they will likely prove wrong, but something has to guide our asset allocation decisions.

Many long-term investors assume stocks will give them 6–8% real annual returns if they simply buy and hold long enough.

Pension fund trustees hire consultants to reassure them of this “fact,” along with similar interest rate and bond forecasts, and then make investment and benefit decisions.

Those reassurances are increasingly hollow, thanks to both low rates and inflated stock valuations, yet people running massive piles of money behave as if they are unquestionably correct.

Realistic Forecasts

You can, however, find more realistic forecasts from reliable, conflict-free sources.

One of my favorites is Grantham Mayo Van Otterloo, or GMO. Here are their latest 7-year asset class forecasts, as of July 31, 2019.

These are bleak numbers if you hope to earn any positive return at all, much less 6% or more.

If GMO is right, the only answer is a large allocation to emerging markets which, because they are emerging, are also riskier.

The more typical 60/40 domestic stock/bond portfolio is a certain loss, according to GMO. (Note these are all “real” returns, which means the amount by which they exceed the inflation rate.)

Others like my friends at Research Affiliates (Rob Arnott), Crestmont Research (Ed Easterling), or John Hussman (Hussman Funds) have similar forecasts. They differ in their methodologies but the basic direction is the same.

The point is that returns in the next 7 or 10 years will not look anything like the past.

If you think these are reasonable forecasts (I do), then one reaction is to keep most of your assets in cash for at least a fractionally positive, low-risk return. That’s simple to do. But it probably won’t get you to your financial goals.

The 60/40 Fallacy

Many financial advisors, apparently unaware the event horizon is near, continue to recommend old solutions like the “60/40” portfolio.

That strategy does have a compelling history. Those who adopted and actually stuck with it (which is very hard) had several good decades. That doesn’t guarantee them several more, though. I believe times have changed.

But those decades basically started in the late ‘40s and went up until 2000. After 2000, the stock market (the S&P 500) has basically doubled, mostly in the last few years, which is less than a 4% return.

When (not if) we have a recession and the stock market drops 40% or more, index investors will have spent 20 years with a less than 1% compound annual return. A 50% drop, which could certainly happen in a recession, would wipe out all their gains, even without inflation.

And yes, there have been historical periods where stock market returns have been negative for 20 years. 1930s anyone? Yes, it is an uncomfortable parallel.

The “logic” of 60/40 is that it gives you diversification. The bonds should perform well when the stocks run into difficulty, and vice versa. You might even get lucky and have both components rise together. But you can also be unlucky and see them both fall, an outcome I think increasingly likely.

Louis Gave wrote about this last week.

Historically, the optimized portfolio of choice, and the one beloved of quant analysts everywhere, has been a balanced portfolio comprising 60% growth stocks and 40% long-dated bonds. Yet recently, this has come to look less and less like an optimized portfolio, and more and more like a “dumbbell portfolio,” in which investors hedge overvalued growth stocks with overvalued bonds.

At current valuations, such a portfolio no longer offers diversification. Instead, it is a portfolio betting outright on continued central bank intervention and ever-lower interest rates. Given some of the rhetoric coming from central bankers recently, this is a bet which could now be getting increasingly dangerous.

For the moment, I still think long-term yields will keep falling, helping the bond side of a 60/40 portfolio. Meanwhile, negative or nearly negative yields will push more money into stocks, driving up that side of the ledger.

So 60/40 could keep firing on all cylinders for a while. But it won’t do so forever, and the ending will probably be sudden and spectacular.

Which brings us to my final point.

Friends don’t let friends buy and hold

The primary investment goal as we approach the recession should be “Hold on to what you have.” Or, in other words, capital preservation.

But you may not realize that capital preservation can be better than growth, if the growth comes with too much risk. Here’s the math.

  • Recovering from a 20% loss requires a 25% gain
  • Recovering from a 30% loss requires a 43% gain
  • Recovering from a 40% loss requires a 67% gain
  • Recovering from a 50% loss requires a 100% gain
  • Recovering from a 60% loss requires a 150% gain

If you fall in one of these deep holes you will spend valuable time just getting out of it before you can even start booking any gains. Once you start to fall, the black hole won’t let go. Far better not to get too close.

I can’t say that strongly enough: Friends don’t let friends buy and hold.

You must have a well thought out hedging strategy if you’re going to be long the stock market.

If your investment advisor simply has you in a 60/40 portfolio and tells you that, “We are invested for the long term and the market will come back,” pick up your capital and walk away.

I can’t be any more blunt than that.

Past performance does not predict future results. That has never been more true than for the coming decade.

The 2020s will be more volatile and difficult for the typical buy-and-hold index fund investor than anything we have seen in my lifetime.

Active investment management is not popular right now because passive strategies have outperformed. But I think that is getting ready to change.

You should start, if you’re not already, investigating active management and more proactive investment styles. You will be much happier if you do.

Relying on past performance as the tectonic plates shift underneath us, as the central bank policies suck historical performance into their maws, we must look forward rather than backwards to design our portfolios.


The Great Reset: The Collapse of the Biggest Bubble in History

New York Times best seller and renowned financial expert John Mauldin predicts an unprecedented financial crisis that could be triggered in the next five years. Most investors seem completely unaware of the relentless pressure that’s building right now. Learn more here.

2020 Will Be The Most Volatile Year In History

The last few weeks marked a turning point in the global economy.

It’s more than the trade war. A sense of vulnerability is replacing the previous confidence—and with good reason.

We are vulnerable, and we’ll be lucky to get through the 2020s without major damage.

Let’s talk about the risks facing us in the next year or so and the economic environment in which we will face those risks.

Supply Shocks Ahead

In a recent Project Syndicate piece, NYU professor and economist Nouriel Roubini outlined three potential shocks, any one of which could trigger a recession:

  • A slower-brewing US-China technology cold war (which could have much larger long-term implications)
  • Tension with Iran that could threaten Middle East oil exports

The first of those seems to be getting worse. The second is getting no better. I consider the third one unlikely.

In any case, unlike 2008, which was primarily a demand shock, these threaten the supply of various goods. They would reduce output and thus raise prices for raw materials, intermediate goods, and/or finished consumer products.

Roubini thinks the effect would be stagflationary, similar to the 1970s.

Because these are supply and not demand shocks, if Nouriel is right, the kind of fiscal and monetary policies employed in 2008 will be less effective this time, and possibly harmful.

Interest rate cuts could aggravate price inflation instead of stimulating growth. That, in turn, would probably reduce consumer spending, which for now is the only thing standing between us and recession.

Subnormal Growth

Most of our problems come down to debt.

Debt isn’t bad and may even be good if it is used productively. Much of it isn’t.

In theory, an economy overloaded with unproductive debt should see rising interest rates due to the excess risk it is taking. Yet we are in a low and falling-rate world. Why?

Lacy Hunt of Hoisington Management proved that government debt accelerations depress business conditions. This reduces economic growth, so rates fall. The data shows the amount of GDP each dollar of new debt generates has been steadily declining.

This is a problem because, among other reasons, central banks still think lower rates are the solution to our problems. So does President Trump.

They are all sadly mistaken, but remain intent on pushing rates closer to zero and then below. This is not going to have the desired effect.

If Lacy is right, as I believe he is, the Federal Reserve is on track to do exactly the wrong thing by dropping rates further as the economy weakens.

The Fed also did the wrong thing by hiking rates in 2018. They should have been slowly raising rates in 2013 and after. They waited too long. This long string of mistakes leaves policymakers with no good choices now.

The best thing they can do is nothing, but that’s apparently not on the menu.

Paralyzed Business

All this bears down on us as other things are changing, too.

Many relate to shrinking world trade. Trump’s trade war hasn’t helped, but globalization was already reversing before he took office.

Industrial automation and other technologies are killing the “wage arbitrage” that moved Western manufacturing to low-wage countries like China. Higher wages in those places are also reducing the advantage. This will continue.

Ideally, this process would have happened gradually and given everyone time to adapt. Trump and his Svengali-like trade advisor, Peter Navarro, want it now. I think the president’s recent demand that US companies leave China wasn’t a bluff. He wants that outcome, and he has the tools to attempt to force it. The only question is whether he will.

I agree that we have to deal with China but the fact that we must do something doesn’t make everything feasible or advisable.

Tariffs are a counterproductive bad idea. Severing supply chains built over decades in less than a few years is, if possible, an even worse idea. It will kill millions of US jobs as factories shut down for lack of components.

Some say this is just more Trump negotiating bluster. Maybe so, but the mere threat paralyzes business activity.

CEOs and boards don’t make major capital commitments without some kind of certainty on their costs and returns. The president is making that impossible for many.

Europe in Shambles

Europe is rapidly turning into a major problem, too. Negative interest rates there are symptoms of an underlying disease. Italy is already in recession. Germany suffered its first negative quarter and may enter “official” recession soon.

Germany is highly export-dependent. The entire euro currency project was arguably a plot to boost German exports, and it worked pretty well.

But it boosted them too much, bankrupting countries like Greece which bought those exports. China, another big customer, is buying less as well.

A German recession will have a global effect. Automobile sales are down and Brexit could mean further declines. That would most assuredly deliver a German and thus a Europe-wide recession. And it will affect US exports and jobs.

Then there’s Brexit. At this point we still don’t know if the UK and EU will reach terms, but there is some risk of a hard end to this drama. News focuses on the damage within the UK, but it will also affect the EU countries, mainly Germany, who trade with the UK.

These supply chains are no less intricate and established than the US-China ones. Tearing them down and rebuilding them will take time and money. The transition costs will be significant.

Bumpy Ride

Remember when experts said to keep politics out of your investment strategy?

We no longer have that choice. Political decisions and election results around the globe now have direct, immediate market consequences. Brexit is just one example.

A far bigger one is the looming 2020 US campaign. None of the possible outcomes are particularly good. I think the best we can hope for is continued gridlock.

But between now and November 2020, none of us will know the outcome. Instead, a never-ending stream of poll results will show one side or the other has the upper hand.

That will generate high market volatility, inspiring politicians and central bankers to “do something” that will probably be the wrong thing.

As noted above, if Roubini is right then rate cuts aren’t going to help. Nor will QE. Both are simply ways of encouraging more debt which Lacy Hunt’s work shows is no longer effective at stimulating growth.

They are, however, effective at blowing up bubbles.

I expect 2020 to be one of the most volatile market years of my lifetime.


The Great Reset: The Collapse of the Biggest Bubble in History

New York Times best seller and renowned financial expert John Mauldin predicts an unprecedented financial crisis that could be triggered in the next five years. Most investors seem completely unaware of the relentless pressure that’s building right now. Learn more here.

Mauldin – Trump, You’ve Got It All Wrong

I’m going to start with a story.

There is a drug produced in China that works well on strokes and numerous other less devastating medical issues.

It is derived from pig pancreases or human urine. It isn’t approved in the US due to justifiable regulatory issues, but it is used in Europe as well as China.

A small biotechnological firm in the US has the technology to synthesize this drug without using pancreases or urine. This would be safer and cheaper.

The Chinese company agreed to pay the US company $4.5 million upon the meeting of certain guidelines and then to purchase the drug from the company at a fraction of its Chinese production cost.

The US company spent a great deal of money and met its guidelines, providing the Chinese company with everything required under the contract. The Chinese company then said, basically, “We need to see the actual process and cell lines in order to verify the process.”

That means, in essence, “Give us your intellectual property.” With that knowledge, the Chinese company would no longer have needed the US company.

When the US company had to tell shareholders that the deal fell through because it (correctly) told the Chinese company to go pound sand, its stock value plummeted.

The Chinese company knew that would happen and had bet the Americans would fold. In this case, they didn’t.

This is just a small part of the cost of Chinese intellectual property theft..

China’s Dirty Playbook

Countries that trade with each other need fair and reasonable rules governing it, and both sides must enforce the rules. Trade works only if all sides are committed to making it work

Problems occur when a country flouts the rules or enforces them selectively, as China does. I’ve often talked about China’s rapid entry into the advanced world’s economy.

In less than a few generations, it went from subsistence farming to modern industry. This happened because the US and others agreed to let their domestic businesses trade with China on favorable terms.

China was supposed to reciprocate with similar terms of its own. It pretended to, but hasn’t been thorough or consistent. This is most evident in intellectual property.

The Chinese government often steals trade secrets from foreign businesses that wish to operate in China. Software code, drug formulas, consumer goods… all find their way to Chinese companies that shamelessly copy it.

Sadly, talks to resolve these and other problems have been fruitless.

Trade Deficit… That We Need

Give Trump credit for at least recognizing the problem and trying to do something about it. Unfortunately, he has some odd ideas about what “winning” looks like.

Trump seems to believe trade deficit is some kind of scorecard. If the US buys more from China than China buys from the US, the US is losing.

That is not what it means at all.

Both sides get what they want. China (or other exporters) gets cash, we get useful goods at fair prices (or we would stop buying them).

Better yet, since we own the reserve currency, we get to pay for these goods in dollars, which then return here as the Chinese or foreign recipients invest in US assets, namely our Treasury debt.

That’s good for Americans. In fact, it’s critical.

If not for the trade deficit, US savers would have to cover our entire government debt. And we don’t save nearly enough to do that.

Our interest rates would also be much higher, and our currency much lower.

If you have the reserve currency, it is your obligation to run deficits so that the world has enough currency to conduct trade. No country south of the Rio Grande has that privilege.

The Europeans kind of, sort of do. And the Japanese. The Chinese are working diligently to make the yuan a reserve currency, though they are not there yet.

If the US fails to run a real trade deficit, we will cease to have the reserve currency. It is that simple.

The Wrong Weapon

The US is using the wrong weapon to solve the wrong problem and harming our own economy in the process.

What would work better?

I believe that Trump’s choice to leave the Trans-Pacific Partnership was a mistake.

That agreement would have set up a giant free-trade zone as a counter to China. At a minimum, it would have forced Beijing to negotiate more sincerely.

TPP had more than a few problems, but they could have been fixed. But best case, it would’ve made it much easier for companies in the US to skip over China for their supply chains.

Meanwhile, the other TPP nations went forward without the US and are now trading with each other on more favorable terms.

Thanks to Trump, Japan increasingly imports food products from Canada instead of the US.

Tariffs also don’t do any good in solving the problem. China is not paying those tariffs, we are, and any economist worth their salt (other than Navarro) knows it.

Get tough with China? Damn Skippy. But don’t make Americans pay for it. If you’re going to fight a trade war, then don’t point the gun at yourself.


The Great Reset: The Collapse of the Biggest Bubble in History

New York Times best seller and renowned financial expert John Mauldin predicts an unprecedented financial crisis that could be triggered in the next five years. Most investors seem completely unaware of the relentless pressure that’s building right now. Learn more here.

Mauldin – MMT Could Destroy This Nation

I am back from my 14th annual Maine fishing camp.

The private event at Leen’s Lodge is generally called Camp Kotok in honor of David Kotok of Cumberland Advisors who started these outings many years ago.

CNBC and others began calling it the “Shadow Fed,” but it is really just a meeting of wickedly smart people focused on economics and markets. (I am allowed to attend for comic relief.)

We discussed the world’s problems and the general mood was that many of those problems are beginning to catch up.

Among other topics, there was an open “debate” about Modern Monetary Theory (MMT) and US fiscal strategy.

There was the usual pushback, but I have to admit that I was struck by the private conversations after the debate.

Many smart, well-informed thinkers agreed MMT may be actually attempted in the next decade.

If we attempt MMT, it will end the US dollar’s reserve currency status and produce out-of-control inflation. That will essentially destroy the Boomer generation’s ability to retire with anything like most envision today.

I can’t say it any stronger. If I really see MMT coming, I will reposition my portfolio to heavily weight gold, real estate, and a few biotech companies. I simply can’t imagine a more dire economic scenario.

Unprecedented Stimulus

Many participants had read my analysis of the potential for $45 trillion worth of US debt by the end of the 2020s.

When I started talking about the potential for $20 trillion of additional quantitative easing, it was clear the question made some uncomfortable.

There was general agreement that neither political party can balance the budget. The latest “deal” between Trump and Congress raised spending $320 billion over the next two years.

The previous “sequester” deal that at least tried to limit spending is out the window. With it will go any control on the spending process. Current deficit projections will seem mild compared to what we actually get.

As I said a few weeks ago, using CBO projections from earlier this year and assuming one recession, the national debt would rise to almost $45 trillion by the end of the 2020s.

This new deal will add at least another $1.5 to $2 trillion to that amount. If there is a second recession, we would be looking at north of $50 trillion.

We don’t have $40 trillion, let alone $50 trillion, to put into federal debt. It would crowd out all funding for productive private enterprises and sharply reduce GDP growth. Which is why I expect to see massive, currently inconceivable amounts of quantitative easing.

Thinking the Unthinkable

The 2020s will force us to continually think the unthinkable. No, that is probably too mild. We are going to find ourselves having to continually DO the unthinkable.

Doom and gloom? Not really. The math is from the Congressional Budget Office.

It is politically impossible for them to project a recession, so they don’t. I would also admit that it is also statistically impossible to predict a recession, so they don’t. I don’t have such a restriction.

Below are the charts that I’ve printed in part four of the discussion with Ray Dalio a few weeks back, assuming recession in either 2020 or 2022. You can see what happens to the deficits and revenues.

This first graph assumes a recession in 2020. Note that revenues fall below mandatory spending by the middle of the decade, then never get back above mandatory spending plus defense spending.

Then by the end of the 2020s, mandatory spending will again rise to consume all tax revenue. And again, these don’t include significant off-budget spending.

This next graph assumes recession in 2022 instead of 2020. The pattern is basically the same, except that the $2-trillion deficits don’t begin until 2023. Again, this uses actual CBO projections and adjusts revenues by the same percentage they fell in 2008–2009, and recovered thereafter.

The Future Looks Grim

I asked one person after another what they thought would happen. How can we avoid this? I got no good answers. Others were clearly just as frustrated as I am. Let me tell you, I am way past frustration. I am seriously worried for the future of the Republic and our children and retirees.

I asked at least a dozen attendees (and maybe more) this question: If we introduce MMT and the result is what we all think it will be, I think there is a 50–50 chance some states will want to secede from the union. Do you agree or disagree?

I got literally no pushback on that admittedly outrageous idea. When you undertake policies that will destroy the very fabric of society in the name of “justice and equality for all,” those damaged in the process will push back.


The Great Reset: The Collapse of the Biggest Bubble in History

New York Times best seller and renowned financial expert John Mauldin predicts an unprecedented financial crisis that could be triggered in the next five years. Most investors seem completely unaware of the relentless pressure that’s building right now. Learn more here.

The Yield Curve Inverted Months Earlier Than Most Think

The inverted yield curve is one of the more reliable recession indicators.

I discussed it at length last December. At that point, we had not yet seen a full inversion. Now we have, and it appears the curve was “inverted” back then, and we just didn’t know it.

The Powell Fed spent 2018 gradually raising rates and reducing the balance sheet assets it had accumulated in the QE years.

This amounted to an additional tightening. In fact, the balance sheet reduction may have had more impact than lower rates.

Now if you assume, as Morgan Stanley does, every $200B balance sheet reduction is equivalent to another 0.25% rate increase, which I think is reasonable, then the curve effectively inverted months earlier than most now think.

Worse, the tightening from peak QE back in 2015 was far more aggressive and faster than we realized.

Worrisome Charts

Let’s go to the chart below. The light blue line is an adjusted yield curve based on the assumptions just described.

But even the nominal yield curve shows a disturbingly high recession probability. Earlier this month, the New York Fed’s model showed a 33% chance of recession in the next year.

Their next update should show those odds somewhat lower as the Fed seems intent on cutting short-term rates while other concerns raise long-term rates.

But it’s still too high for comfort, in my view.

But note that whenever the probability reached the 33% range (the only exception was 1968), we were either already in a recession or about to enter one.

For what it’s worth, I think Fed officials look at their own chart above and worry. That’s why more rate cuts won’t be surprising.

And frankly, and I know this is out of consensus, I would not rule out “preemptive quantitative easing” if the economy looks soft ahead of the election next year. Just saying…

But that’s not everyone’s view.

The Other Side of the Argument

Gavekal Research gives us this handy chart showing inversions don’t always lead to recession right away. (I noted 1968 above and I think 1998 is a separate issue. But then again, that’s me.)

Fair enough; brief inversions don’t always signal recession. But as noted, when you consider the balance sheet tightening, this one hasn’t been brief.

Note also that an end to the inversion isn’t an all-clear signal. The yield curve is often steepening even as recession unfolds.

One thing seems certain: While the yield curve may not signal recession, it isn’t signaling higher growth, either. The best you can say is that the mild expansion will continue as it has. That’s maybe better than the alternative, but doesn’t make me want to pop any champagne corks.

An inverted yield curve is similar to a fever. It simply tells us something is wrong in our economic body. And sadly, at least historically, it is right.

The Fed has always been behind the curve. To Powell’s credit, he may be trying to get in front of it, at least this time.

The Great Reset: The Collapse of the Biggest Bubble in History

New York Times best seller and renowned financial expert John Mauldin predicts an unprecedented financial crisis that could be triggered in the next five years. Most investors seem completely unaware of the relentless pressure that’s building right now. Learn more here.

Are We In A Recession Yet?

I’m often asked if recession is coming.

For quite some time now, my answer has been: “Yes, but not just yet.”

That’s still what I think today, but more of the early warning signals I have used in the past are beginning to flash again.

I see some leading indicators weakening. I see smart people like Dave Rosenberg argue we may already be in recession today.

And I see Wall Street not really caring either way, so long as it gets enough rate cuts to prop up asset prices. None of that is comforting.

The storm clouds are gathering. Someone is likely to get hit. It might be you.

Growth Has Stalled

I think we all agree this recovery cycle has been both longer and weaker than in the past. Any growth is good, of course, and certainly better than the alternative. But the last decade wasn’t a “boom” except in stock and real estate prices.

I like this chart from Lance Roberts, Chief Investment Strategist at RIA, because it shows long-term (5-year) rates of change over a long period (since 1973) in three key indicators: productivity, wage growth, and GDP growth.

You can see all three are now tepid at best compared to their historical averages:

These measures have been generally declining since the early 2000s. It suggests that whatever caused our current problems preceded the financial crisis.

But we don’t need to know the cause in order to see the effects. While not catastrophic (at least yet), they are worrisome. And, as Lance points out, a decade of bailouts and dovish monetary policy didn’t revive previous trends.

The growth deceleration is also visible if we zoom into the recent past, via the Goldman Sachs Current Activity Indicator.

It peaked in early 2018 (not coincidentally, at least in my opinion, about the time Trump started imposing tariffs on China) and slid further this year.

Much of it is due to a manufacturing slowdown, but the consumer and housing segments contributed as well.

Again, this doesn’t say recession is imminent. The US economy is still growing by most measures. But the growth is slowing and, unless something restores it, will eventually become a contraction.

My friend Lakshman Achuthan of the Economic Cycle Research Institute (ECRI) makes a good point: Recessions don’t happen from solid growth cycles.

Economies generally move into what he calls a “vulnerable stage” before something pushes them into recession. We all pretty much agree that the US economy, not to mention the global economy, is in a vulnerable stage.

It won’t take much of a shock to push it into recession.

Freight Volumes Down

Financial indicators are often somewhat disconnected from the “real” economy.

What’s happening on Main Street, where real people buy and sell real products used in everyday life? The news isn’t reassuring there, either.

The physical goods we buy—food, clothing, furniture, houses, and most everything else—have one thing in common. They (or their components) travel long distances to reach us.

Problems begin when those deliveries slow… and they are.

The Cass Freight Index (which I have followed for more than a decade) measures shipment volume (by quantity, not cost) across the economy: truck, rail, air, ship, everything.

The chart below shows its year-over-year percentage change.

You can see shipment growth picked up in 2016 following an extended weak stretch. This continued into early 2018 then a steep slide ensued.

“What’s the big deal?” you may ask. Look how long that 2014–2016 contraction lasted. It didn’t signal a recession. Two points on that…

First, that retreat sprang from an oil price collapse that began in November 2014 and quickly affected US shale production. This greatly reduced freight volumes.

Second, while it didn’t spark a generalized recession, that particular part of the economy had its very own recession, and it was a nasty one.

The current shipment contraction is potentially far worse. We can’t blame it on a sudden event like OPEC opening the spigots, nor is it focused on a particular sector. The Cass data shows declines everywhere, in everything.

Do I blame this on Trump’s trade war? Partially, yes.

“Buy and Hold” Dangers

When you start matters, and now is not a good time. You want to buy on weakness, not strength. The weakness will come, but this isn’t it.

There is a counterargument, though. Maybe all this history doesn’t matter when we have central banks doing absurd things like negative interest rates. I see real risk that the Fed will go to NIRP before all this ends.

Imagine what that will do to the trillions presently stashed in bonds. Will people (not to mention pension funds) happily pay for the privilege of being owed money? If not, where will they put their cash?

The answer, for many, may be in stocks. The resulting money flow could keep equity prices high despite negative fundamentals. I’m not predicting that outcome, but it’s possible.

We are in such bizarre times, all bets are off. It is certainly not the time for “buy and hold” unless your goal is to lose everything. If not, then you need an active, flexible, defensive investment strategy now more than ever.

The Great Reset: The Collapse of the Biggest Bubble in History

New York Times best seller and renowned financial expert John Mauldin predicts an unprecedented financial crisis that could be triggered in the next five years. Most investors seem completely unaware of the relentless pressure that’s building right now. Learn more here.

The Problem With Keynesian Economics

In The General Theory of Employment, Interest and Money, John Maynard Keynes wrote:

“The ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed the world is ruled by little else. Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually the slaves of some defunct economist.”

I think Lord Keynes himself would appreciate the irony that he has become the defunct economist under whose influence the academic and bureaucratic classes now toil, slaves to what has become as much a religious belief system as an economic theory.

Men and women who display appropriate skepticism on other topics indiscriminately funnel facts and data through a Keynesian filter without ever questioning the basic assumptions. Some go on to prescribe government policies that have profound effects upon the citizens of their nations.

And when those policies create the conditions that engender the income inequality they so righteously oppose, they often prescribe more of the same bad medicine. Like 18th-century physicians applying leeches to their patients, they take comfort that all right-minded people will concur with their recommended treatments.

This is an ongoing series of a discussion between Ray Dalio and myself (read Part 1Part 2Part 3, and Part 4) . Today’s article addresses the philosophical problem he is trying to address: income and wealth inequality.

Last week I dealt with the equally significant problem of growing debt in the United States and the rest of the world. The Keynesian tools much of the economic establishment wants to use are exacerbating the problems. Ray would like to solve it with a blend of monetary and fiscal policy, what he calls Monetary Policy 3.

The Problem with Keynesianism

Let’s start with a classic definition of Keynesianism from Wikipedia, so that we can all be comfortable that I’m not coloring the definition with my own bias (and, yes, I admit I have a bias). (Emphasis mine.)

Keynesian economics (or Keynesianism) is the view that in the short run, especially during recessions, economic output is strongly influenced by aggregate demand (total spending in the economy). In the Keynesian view, aggregate demand does not necessarily equal the productive capacity of the economy; instead, it is influenced by a host of factors and sometimes behaves erratically, affecting production, employment, and inflation.

The theories forming the basis of Keynesian economics were first presented by the British economist John Maynard Keynes in his book The General Theory of Employment, Interest and Money, published in 1936 during the Great Depression. Keynes contrasted his approach to the aggregate supply-focused “classical” economics that preceded his book. The interpretations of Keynes that followed are contentious, and several schools of economic thought claim his legacy.

Keynesian economists often argue that private sector decisions sometimes lead to inefficient macroeconomic outcomes which require active policy responses by the public sector, in particular, monetary policy actions by the central bank and fiscal policy actions by the government, in order to stabilize output over the business cycle. Keynesian economics advocates a mixed economy—predominantly private sector, but with a role for government intervention during recessions.

Central banks around the world and much of academia have been totally captured by Keynesian thinking. In the current avant-garde world of neo-Keynesianism, consumer demand—consumption—is everything. Federal Reserve policy is clearly driven by the desire to stimulate demand through lower interest rates and easy money.

And Keynesian economists (of all stripes) want fiscal policy (essentially, government budgets) to increase consumer demand. If the consumer can’t do it, the reasoning goes, then the government should step into the breach. This of course requires deficit spending and borrowed money (including from your local central bank).

Essentially, when a central bank lowers interest rates, it is encouraging banks to lend money to businesses and telling consumers to borrow money to spend. Economists like to see fiscal stimulus at the same time, as well. They point to the numerous recessions that have ended after fiscal stimulus and lower rates were applied. They see the ending of recessions as proof that Keynesian doctrine works.

This thinking has several problems.

The Flaws of Keynesian Stimulus

First, using leverage (borrowed money) to stimulate spending today must by definition reduce consumption in the future. Debt is future consumption denied or future consumption brought forward. 

Keynesian economists argue that bringing just enough future consumption into the present to stimulate positive growth outweighs the future drag on consumption, as long as there is still positive growth.

Leverage just equalizes the ups and downs. This has a certain logic, of course, which is why it is such a widespread belief.

Keynes argued, however, that money borrowed to alleviate recession should be repaid when growth resumes. My reading of Keynes does not suggest he believed in the unending fiscal stimulus his disciples encourage today.

Secondly, as has been well documented by Ken Rogoff and Carmen Reinhart, there comes a point at which too much leverage becomes destructive. There is no exact way to know that point.

It arrives when lenders, typically in the private sector, decide that borrowers (whether private or government) might have some difficulty repaying and begin asking for more interest to compensate for their risks.

An overleveraged economy can’t afford the higher rates, and economic contraction ensues. Sometimes the contraction is severe, sometimes it can be absorbed. When accompanied by the popping of an economic bubble, it is particularly disastrous and can take a decade or longer to work itself out, as the developed world is finding out now.

Every major “economic miracle” since the end of World War II has been a result of leverage. Often this leverage has been accompanied by stimulative fiscal and monetary policies. Every single “miracle” has ended in tears, with the exception of the current recent runaway expansion in China, which is still in its early stages.

Insufficient Income Causes Recessions

I would argue (along, I think, with the “Austrian” economist Hayek and other economic schools) that recessions are not the result of insufficient consumption but rather insufficient income.

Fiscal and monetary policy should aim to grow incomes over the entire range of the economy. That is best accomplished by making it easier for entrepreneurs and businesspeople to provide goods and services. When businesses increase production, they hire more workers and incomes go up.

Without income, there are no tax revenues to redistribute. Without income and production, nothing of any economic significance happens. Keynes was correct when he observed that recessions are periods of reduced consumption, but that is a result and not a cause.

Entrepreneurs must be willing to create a product or offer a service in the hope there will be sufficient demand for their work. There are no guarantees, and they risk economic peril with their ventures, whether we’re talking about the local bakery or hairdressing shop or Elon Musk trying to compete with the world’s largest automakers. If government or central bank policies hamper their efforts, the economy stagnates.

The Reason Keynesianism Sticks

Many politicians and academics favor Keynesianism because it offers a theory by which government actions can become decisive in the economy. It lets governments and central banks meddle in the economy and feel justified.

It allows 12 people sitting in a board room in Washington DC to feel they are in charge of setting the most important price in the world, the price of money (interest rates) of the US dollar and that they know more than the entrepreneurs and businesspeople who are actually in the market risking their own capital every day.

This is essentially the Platonic philosopher king conceit: the hubristic notion that a small group of wise elites is capable of directing the economic actions of a country, no matter how educated or successful the populace has been on its own.

And never mind that the world has multiple clear examples of how central controls eventually slow growth and make things worse over time. It is only when free people are allowed to set their own prices of goods and services and, yes, even interest rates, that valid market-clearing prices can be determined. Trying to control them results in one group being favored over another.

In today’s world, savers and entrepreneurs are left to eat the crumbs that fall from the plates of the well-connected crony capitalists and live off the income from repressed interest rates. The irony of using “cheap money” to drive consumer demand is that retirees and savers get less money to spend, and that clearly drives their consumption down.

Why is the consumption produced by ballooning debt better than the consumption produced by hard work and savings? This is trickle-down monetary policy, which ironically favors the very large banks and institutions.

If you ask Keynesian central bankers if they want to be seen as helping the rich and connected, they will stand back and forcefully tell you “NO!” But that is what happens when you start down the road of financial repression. Someone benefits. So far it has not been Main Street.

The Great Reset: The Collapse of the Biggest Bubble in History

New York Times best seller and renowned financial expert John Mauldin predicts an unprecedented financial crisis that could be triggered in the next five years. Most investors seem completely unaware of the relentless pressure that’s building right now. Learn more here.

1995 Rate Cut & The Case For The Final Leg Of The Bull Market

Market participants want to believe today’s bull market is similar to 1995.

In 1995, July to be specific, the Fed cut rates as the stock market was setting a new record high. The next Fed meeting is July 31st, and the market is currently trading near record highs.

As Upfina recently tweeted:

That is correct, and, when the Fed cut interest rates as a preventative measure, U.S. equity markets have historically done very well. However, a quick look at the history of Fed rate cuts, and subsequent market tantrums, suggests 1995 is more of an anomaly rather than the rule.

As J.P. Morgan noted, the three “insurance cut” easing cycles in 1980, 1995 and 1998 appear to be outliers. ”

“The late 1990’s rate cuts were used as insurance against Mexican and Russian default and collapse of hedge fund Long-Term Capital Management at the time, bolstered the equity market. The only other time the S&P 500 saw stronger performance following a rate cut was in 1980. At the time, there was an 8.5% reduction in the Fed funds rate from 20% to 11.5% — a level of monetary easing that is ‘obviously not possible in the current conjuncture,'”

Another thing about the 1980’s was that the economy was just coming out of back-to-back recessions, valuations were extremely low, and dividends were high. Reagan had just passed tax reform, the banks were deregulated, and inflation and interest rates were plummeting. Household debt was only about 60% of net worth and just starting the near 40-year period of “leveraging up” which was a massive boost to consumption and ultimately economic growth.

However, despite the market performing well, the two periods in the 1980s where the Fed hiked rates led to the “Continental Illinois” failure, the “Savings and Loan crisis,” and the “1987 Crash.”

The mid-late 1990’s rate cuts was also another anomalous market environment. The Fed began a rate hiking campaign in 1993 as the economy began to stretch its legs post the 1991 recession. However, the Fed cut rates slightly in 1995, and again in 1998, to offset the risk imposed from three major market-related events. Ironically, it was the Fed’s tightening of monetary policy which caused those events to begin with.

Despite the cuts being relatively minimal, they only likely provided more liquidity to drive the massive market melt up, which was occurring from 1995 to 2000. It was a period of market nirvana as the internet became mainstream changing the way information was accessed, utilized, and institutionalized. Mutual funds were a virtual “Hoover vacuum” sucking up retail assets and lofting asset prices higher. Pension funds were finally allowed to invest in stocks rather than just Treasuries which brought massive buying power to the markets. Foreign flows also poured into Wall Street to chase the raging bull market higher. Lastly, E*Trade hit the internet and further opened the doors of the “WallStreet Casino” to the masses.

Yes, for a brief moment, the markets lofted higher as “irrational exuberance” prevailed. Of course, while the rate cuts in 1995 didn’t slow the growth of the “bubble” immediately, it wasn’t long before all the gains were wiped out by the “Dot.com” crash.

Why This Isn’t 1995?

There are lots of other differences between today and 1995.

As noted above, the Fed cut rates in 1995 as an concerns mounted over this:

“The sudden plunge of Orange County, Calif., into bankruptcy shook the market for public borrowing across the country yesterday, threatening to make it more expensive for many localities to borrow. It also left some Wall Street firms facing the potential of big losses.

And, it served as a warning of how rapidly new and popular financial strategies can sour, leaving an apparently prosperous county unable to pay its bills”

Geez, you could have written that same statement in 2008 as well.

However, let me explain why I disagree with the following mainstream thesis:

“There are certainly parallels between the environment today and 1995-1996. Back then, the Fed embarked on a series of three interest rate cuts (75 basis points) in total, the catalyst being low inflation rather than a recessionary economy, remarkably similar to today. The whole cycle lasted for seven months.” – CNBC

Let’s take a closer look.  The chart below shows several key economic indicators from 1991 to 2000.

  • Personal Incomes averaged 4% and were rising to 5% on an annual rate at the turn of the century. 
  • Employment averaged a 2.5% annual growth rate and was solid heading into 2000.
  • Industrial Production averaged about 5% annual growth and was rising in the last few months of 1999.
  • Real Consumer Spending was rising strongly headed into 2000, averaging nearly a 12% growth rate.
  • Real Wages were climbing steadily from 1991 to 1999 and hit a peak of almost 14% annualized in December 1999.
  • Real GDP was running at more than 4% annually in December of 1999.

In 1995, there was little to be worried about from an economic perspective. The Fed cut rates to hedge off the risk of a “financial contagion” from the Orange County bankruptcy.

But also note, there was absolutely “no sign of recession” in late 1999 either. 

The recession, and “Dot.com” crash, started just a few months later anyway.

However, according to CNBC, today’s economic backdrop is much like that of 1995.

Or is it? Let’s compare.

  • Personal Incomes currently average about 2% versus 4% in 1995
  • Employment is averaging about a 1.5% annualized growth rate versus 2.5% in 1995.
  • Industrial Production has averaged about 2% annual growth vs 5% previously.
  • Real Consumer Spending has averaged about 4% annual growth versus 8-10% in 1995.
  • Real Wages have averaged about a 3.5 annual growth rate versus 8-10% in 1995.
  • Real GDP has averaged about 2% annual growth over the last decade versus 3% previously.

Just as it was in 1999, there is “clearly no sign of recession” in the economic data currently.

But that doesn’t mean a recession can’t start more quickly than you think.

It’s The Debt Stupid

One of the biggest differences between today and the 1990’s is the level of indebtedness. In the 1990’s, the government ran a slight deficit coming out of the 1991 recession which eclipsed $250 Billion at time. With some slight of hand, President Clinton temporarily turned the deficit into a surplus by borrowing a $2 trillion from Social Security allowing Federal disposable income (tax revenue and other governmental income less mandated spending) to rise which supported economic growth headed into 2000.

Such is most assuredly not the case today. Since 2009, the Federal government has consistently run a deficit averaging $750 billion annually. Also, unlike the 1990’s where Federal disposable income was positive, today, it is negative for the second time since the financial crisis. Said differently, all discretionary spending plus some mandated spending must come from borrowed funds.

More importantly, economic growth from 1995 through 2000 was positive even after removing the impact of government spending. Today, if you extract out government spending, the U.S. economy has had a negative growth rate for the last 4-quarters. Or rather, the U.S. economy has been in recession. 

The Case For The Final Bull Run

While the current economic backdrop is clearly not what it was in the 1990’s, there is nonetheless a case for a continued bull market in the short-term.

First, as I discussed on Tuesday, corporate share buybacks currently account for roughly all “net purchases” of U.S. equities in recent years. To wit:

But that may well now be coming to an end. As the benefit of the recent tax cut legislation fades and corporate debt has ballooned, the amount of capital for share repurchases is declining.

“It is likely that 2018/2019 will be the potential peak of corporate share buybacks, thereby reducing the demand for equities in the market. This “artificial buyer” explains the high degree of complacency in the markets despite recent volatility. It also suggests that the “bullish outlook” from a majority of mainstream analysts could also be a mistake. 

If the economy is weakening, as it appears to be, it won’t be long until corporations redirect the cash from “share repurchases” to shoring up operations and protecting cash flows.”

There is still likely enough “juice in the tank” in repatriations to keep the markets elevated for a while longer. Also, equity outflows have currently reached levels which have denoted previous points where a reversal occurred and equity inflows pushed asset prices higher.

However, just like in 1995, when the Fed cut rates for the first time, equities did lift higher creating one of the biggest asset bubbles in human history. But that bubble popped roughly 10-years after the bull market started.

Today, the markets have already experienced a 300%+ increase and is already 10-years into the current expansion. While it is certainly possible for equities to push higher from here, it is likely the last leg of the current bull advance.

If history is any guide, the next mean reverting event will likely wipe out of the bulk of the gains made over the last 5-years.

Today isn’t 1995.

But even if it is, the end result will likely be the same also.

The 3-Big Lies About Tax Cuts & The Economic Impact

“The greatest trick the Devil ever pulled was convincing the world he didn’t exist.” The Usual Suspects (1995)

Just recently, Politico ran a story by Brain Faler entitled: “Big Businesses Paying Even Less Than Expected Under GOP Law.” To wit:

“The U.S. Treasury saw a 31 percent drop in corporate tax revenues last year, almost twice the decline official budget forecasters had predicted. Receipts were projected to rebound sharply this year, but so far they’ve only continued to fall, down by almost 9 percent or $11 billion.

Though business profits remain healthy and the economy is strong, total corporate taxes are at the lowest levels seen in more than 50 years. Analysts agree they can’t yet explain the decline in corporate tax payments.

Uhm, excuse me?

This is where I get to say, “I Told You So!”

The Big Lie #1

While the Devil may have convinced the world he doesn’t exist, it was that “corporate cronyism” devoured Washington politics.

“Our companies won’t be leaving our country any longer because our tax burden is so high.” – Donald Trump 

That was an outright lie.

First of all, there is a massive difference between “statutory,” the stated tax rate, and the “effective” tax rate, or what companies actually pay. The chart below shows corporate profits before and after-tax with a measure of what the effective tax rate was.

Just prior to the passage of the tax cut bill, the effective tax rate for U.S. companies was about 16%, or less than half of the statutory rate of 35%. After the passage of the legislation, the effective tax rate fell to 11%, again less than half of the statutory rate of 21%.

There is also the matter that every other country in the world has a “value added tax,” or VAT, added to their corporate tax rate. Dr. John Hussman did a good piece of analysis on this.

“I’ll add that another feature of Wall Street’s blissful delusion is the notion that ‘U.S. corporate taxes are the highest in the world.’ It’s striking how disingenuous this claim is. The fact is that among all OECD countries, the U.S. is also the only country that does not levy any tax at all on corporate value-added in the production of goods and services.”

“The main point is this. The argument that U.S. taxes on corporate profits are somehow oppressive relative to other countries is an apples-to-oranges comparison. It wholly ignores that the U.S. levies no value-added tax on corporations at all, whereas the value-added tax is the principal revenue source for most other countries. The rhetoric on corporate taxes here is unfiltered effluvium.

It is a myth that the U.S. has the highest corporate tax rate in the world. We simply didn’t, and don’t.

The Big Lie #2:

The second big lie was:

““It’ll be fantastic for the middle-income people and for jobs, most of all … I think we could go to 4%, 5% or even 6% [GDP growth], ultimately. We are back. We are really going to start to rock.” – Donald Trump

So, what happened?

Nearly seven months PRIOR to the passage of the legislation, I discussed that engaging in tax cuts at the end of an economic cycle would nullify the majority of the expected effect.

“Tax rates CAN make a difference in the short run, particularly when coming out of recession as it frees up capital for productive investment at a time when recovering economic growth and pent-up demand require it.”

The reason that tax receipts have fallen since the passage of tax reform is that top-line revenue growth has slowed along with both domestic and global economies. However, we already knew this was going to be an issue as we discussed in that 2017 article noted above. To wit:

Importantly, as has been stated, the proposed tax cut by President-elect Trump will be the largest since Ronald Reagan. However, in order to make valid assumptions on the potential impact of the tax cut on the economy, earnings and the markets, we need to review the differences between the Reagan and Trump eras. My colleague, Michael Lebowitz, recently penned the following on this exact issue.

‘Many investors are suddenly comparing Trump’s economic policy proposals to those of Ronald Reagan. For those that deem that bullish, we remind you that the economic environment and potential growth of 1982 was vastly different than it is today.  Consider the following table:’”

The differences between today’s economic and market environment could not be starker. The tailwinds provided by initial deregulation, consumer leveraging, declining interest rates, and inflation provided huge tailwinds for corporate profitability growth.

Just for clarity, tax rates CAN make a difference coming out of recession. However, given the economy was already growing near maximum capacity in 2018, the boost from tax cuts was mostly mitigated.

Secondly, corporations, which is where the tax cuts were primarily focused, used the tax cuts not to increase productivity, make investments, or grow revenues. Such investment most likely would have resulted in greater economic growth and higher tax revenue, however, the windfall was mainly used to manipulate stock prices through massive share buybacks.

“A recent report from Axios noted that for 2019, IT companies are again on pace to spend the most on stock buybacks this year, as the total looks set to pass 2018’s $1.085 trillion record total.”

“The reality is that stock buybacks create an illusion of profitability. Such activities do not spur economic growth or generate real wealth for shareholders, but it does provide the basis for with which to keep Wall Street satisfied and stock option compensated executives happy.”

The Big Lie #3:

The third big lie was that tax cuts would pay for themselves.

“Not only will this tax plan pay for itself, but it will pay down debt.” – Treasury Secretary Steven Mnuchin

That didn’t happen.

In fact, the debt and deficit got materially worse as I predicted they would in “3 Myths About Tax Cuts:”

“During the previous Administration, the GOP wielded ‘fiscal conservatism’ as a badge of honor. Since the election, they have completely abandoned those principals in a full-blown effort to achieve tax reform.

We are told, by these same Republican Congressman and Senators who passed a fiscally irresponsible 2018 budget of more than $4.1 trillion, that tax cuts will ‘pay for themselves’ over the next decade as higher rates of economic growth will lead to more tax collections.

Again, we see that over the “long-term” this is simply not the case. The deficit has continued to grow during every administration since Ronald Reagan. Furthermore, the widening deficit has led to a massive surge in Federal debt which is currently in excess of $22 trillion, and growing much faster than economic activity, or the nations ability to pay if off.

This was the exact point made in “Tax Cuts & The Failure To Change The Economic Balance:”

As noted in a 2014 study by William Gale and Andrew Samwick:

The argument that income tax cuts raise growth is repeated so often that it is sometimes taken as gospel. However, theory, evidence, and simulation studies tell a different and more complicated story. Tax cuts offer the potential to raise economic growth by improving incentives to work, save, and invest. But they also create income effects that reduce the need to engage in productive economic activity, and they may subsidize old capital, which provides windfall gains to asset holders that undermine incentives for new activity.

In addition, tax cuts as a stand-alone policy (that is, not accompanied by spending cuts) will typically raise the federal budget deficit. The increase in the deficit will reduce national saving — and with it, the capital stock owned by Americans and future national income — and raise interest rates, which will negatively affect investment. The net effect of the tax cuts on growth is thus theoretically uncertain and depends on both the structure of the tax cut itself and the timing and structure of its financing.”

Since the tax cut plan was poorly designed, to begin with, it did not flow into productive investments to boost economic growth. As we now know, it flowed almost entirely into share buybacks to boost executive compensation. This has had very little impact on domestic growth. The ‘sugar high’ of economic growth seen in the first two quarters of 2018 has been from a massive surge in deficit spending and the rush by companies to stockpile goods ahead of tariffs. These activities simply pull forward “future”consumption and have a very limited impact but leaves a void which must be filled in the future.

Nearly a full year after the passage of tax cuts, we face a nearly $1 Trillion deficit, a near-record trade deficit, and empty promises of surging economic activity.

It is all just as we predicted.

Recessionary Warning

While well-designed tax reforms can certainly provide for better economic growth, those tax cuts must also be combined with responsible spending in Washington. That has yet to be the case as policy-makers continue to opt for “continuing resolutions” that grow expenditures by 8% per year rather than doing the hard work of passing a budget.

Given that tax receipts fall as the economy slows, tax receipts as a percentage of GDP is a pretty good indicator of recessionary onset.

The true burden on taxpayers is government spending, because the debt requires future interest payments out of future taxes. As debt levels, and subsequently deficits, increase, economic growth is burdened by the diversion of revenue from productive investments into debt service. 

As expected, lowering corporate tax rates certainly helped businesses increase their bottom line earnings, however, it did not “trickle down” to middle-class America. As noted by Jesse Colombo:

“‘In 1929 — before Wall Street’s crash unleashed the Great Depression — the top 0.1% richest adults’ share of total household wealth was close to 25%, today, the that same group controls more wealth than the bottom 50% of the economy combined.”

Not surprisingly, focusing tax cuts on corporations, rather than individuals, only exacerbated the divide between the top 1% and the rest of the country as the reforms did not focus on the economic challenges facing us.

  • Demographics
  • Structural employment shifts
  • Technological innovations
  • Globalization
  • Financialization 
  • Global debt

These challenges will continue to weigh on economic growth, wages and standards of living into the foreseeable future.  As a result, incremental tax and policy changes will have a more muted effect on the economy as well.

As investors, we must understand the difference between a “narrative-driven” advance and one driven by strengthening fundamentals.

The first is short-term and leads to bad outcomes. The other isn’t, and doesn’t. 

One Trick Pony: The Fed Is Pushing On A String

Last week, I discussed the Fed’s recent comments suggesting they might be closer to cutting rates and restarting “QE” than not.

“In short, the proximity of interest rates to the ELB (Effective Lower Bound) has become the preeminent monetary policy challenge of our time, tainting all manner of issues with ELB risk and imbuing many old challenges with greater significance.  

“Perhaps it is time to retire the term ‘unconventional’ when referring to tools that were used in the crisis. We know that tools like these are likely to be needed in some form in future ELB spells, which we hope will be rare.”

After a decade of zero interest rates and floods of liquidity by the Fed into the financial markets, it is not surprising the initial “Pavlovian” response to those comments was to push asset prices higher.

However, as I covered in my previous article in more detail, such an assumption may be a mistake as there is a rising probability the effectiveness of QE will be much less than during the last recessionary cycle. I also suggested that such actions will drive the 10-year interest rate to ZERO. 

Not surprisingly, those comments elicited reactions from many suggesting that rates will rise sharply as inflationary pressures become problematic. 

I disagree.

First, there is no historical evidence that is the case. The chart below shows that each time the Fed embarks upon a rate reduction campaign, interest rates have fallen by 3.15% on average.

Of course, we need to add some context to the chart above. Historically, the reason the Fed cuts rates, and interest are falling, is because the Fed has acted in response to a crisis, recession, or both. The chart below shows when there is an inversion between the Fed Funds rate and 10-year Treasury it has been associated with recessionary onset.

Secondly, after a decade of QE and zero interest rates inflation, outside of asset prices, (as measured by CPI), remains muted at best. The reason that QE does not cause “inflationary” pressures is that it is an “asset swap” and doesn’t affect the money supply or the velocity of money. QE remains confined to the financial markets which lifts asset prices, but it does not impact the broader economy.

Since 2013, I have laid out the case, repeatedly, as to why interest rates will not rise. Here are a few of the most recent links for your review:

As I said, I have been fighting this battle for a while as “everyone else” has remained focused on the wrong reasons for higher interest rates. As I stated in Let’s Be Like Japan:”

This is the same liquidity trap that Japan has wrestled with for the last 20 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 lynchpin to Japan, and the U.S., remains interest rates. If interest rates rise sharply it is effectively “game over” as borrowing costs surge, deficits balloon, housing falls, revenues weaken, and consumer demand wanes. It is the worst thing that can happen to an economy that is currently remaining on life support.”

This last bolded sentence is the most important and something that Michael Lebowitz discussed in “Pulling Forward:”

“Debt allows a consumer (household, business, or government) to pull consumption forward or acquire something today for which they otherwise would have to wait. When the primary objective of fiscal and monetary policy becomes myopically focused on incentivizing consumers to borrow, spend, and pull consumption forward, there will eventually be a painful resolution of the imbalances that such policy creates. The front-loaded benefits of these tactics are radically outweighed by the long-term damage they ultimately cause.”

Unfortunately, the Fed is still misdiagnosing what ails the economy, and monetary policy is unlikely to change the outcome in the U.S., just as it failed in Japan. The reason is simple. You can’t cure a debt problem with more debt. Therefore, monetary interventions, and government spending, don’t create organic, sustainable, economic growth. Simply pulling forward future consumption through monetary policy continues to leave an ever growing void in the future that must be filled. Eventually, the void will be too great to fill.

Doug Kass made a salient point as well about the potential futility of Fed actions at the wrong end of an economic cycle.

“Pushing on a string is a metaphor for the limits of monetary policy and the impotence of central banks.

Monetary policy sometimes only works in one direction because businesses and household cannot be forced to spend if they do not want to. Increasing the monetary base and banks’ reserves will not stimulate an economy if banks think it is too risky to lend and the private sector wants to save more because of economic uncertainty.

This cycle is much different than previous cycles as there are a host of anomalous conditions that will work against the likely rate cuts that lie ahead.

What has occurred in the last decade? 

  • $4 trillion of QE
  • $4 trillion of corporate debt piled up
  • $4 trillion of corporate buybacks
  • A Potemkin-like expansion in earnings per share as the share count drops to a two decade low. (h/t Rosie)
  • Meanwhile, capital spending has failed to revive (leading to negative productivity growth).

While this is not a short term call for an imminent drop in the equity market, if my concerns are prescient and fully realized we will likely see more than the process of a market making a broad and important top.

The Fed is pushing on a string.”

Monetary policy is a blunt weapon best used coming out of recession, not going into one.

Unfortunately, as Caroline Baum penned for MarketWatch recently, the Fed has little to work with at this juncture.

“No one is disputing the idea that the Fed needs additional tools at a time when the benchmark rate (2.25%-2.5%) is already low and offers little room for traditional stimulus. Historically, the fed funds rate has been reduced by 5 percentage points, on average, to combat recessions, according to Harvard University economist Lawrence Summers.

As Eberly, Stock and Wright note in their paper, when the policy rate is close to zero, it ‘imposes significant restraints on the efficacy of Fed policy, and our estimates suggest that those constraints are only partially offset by the new slope policies.’

I am not disputing that dropping rates and restarting QE won’t work at temporarily sustaining asset prices, but the reality is that such measures take time to filter through the economy. The impact of hiking rates 240 basis points over the last couple of years are still working their way through the economic system combined with the impact of tariffs on exports and consumption.

The real concern for investors, and individuals, is the real 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.

Should we have an expectation that the same monetary policies employed by Japan will have a different outcome in the U.S? This isn’t our first attempt at manipulating cycles. (H/T Doug)

“Governor Eccles: ‘Under present circumstances, there is very little, if anything, that can be done.’

Congressman T. Alan Goldsborough: ‘You mean you cannot push a string.’

Governor Eccles: ‘That is a good way to put it, one cannot push a string. We are in the depths of a depression and…, beyond creating an easy money situation through reduction of discount rates and through the creation of excess reserves, there is very little, if anything that the reserve organization can do toward bringing about recovery.’

– House Committee on Banking and Currency (in 1935)

More importantly, this is no longer a domestic question – but rather a global one since every major central bank is now engaged in a coordinated infusion of liquidity. The problem is that despite the inflation of asset prices, and suppression of interest rates, on a global scale there is scant evidence that the massive infusions are doing anything other that fueling asset bubbles in corporate debt and financial markets. The Federal Reserve is currently betting on a “one trick pony” which is that by increasing the “wealth effect” it will ultimately lead to a return of consumer confidence and a fostering of economic growth?

Currently, there is little real evidence of success.

Nonetheless, we can certainly have some fun at the Fed’s expense. My colleague Mike “Mish” Shedlock did a nice summation of the “Powell’s Pivot.” 

Bubbles B. Goode from Mike “Mish” Shedlock on Vimeo.

Hope For The Best, Plan For The Worst

Around 46 BC, Cicero wrote to a friend saying, “you must hope for the best.” To be happy in life we must always have “hope.” It is “hope” which is the beacon that lights the pathway from the darkness that eventually befalls everyone at one point or another in their life.

However, when it comes to financial planning and investing we should consider Benjamin Disraeli’s version from “The Wondrous Tale Of Alroy:”

“I am prepared for the worst, but hope for the best.” 

During very late stage bull markets, the financial press is lulled into a sense of complacency that markets will only rise. It is during these late stage advances you start seeing a plethora articles suggesting simple ways to create wealth. Here are a few of the most recent ones I have seen:

  • The Power Of Compounding
  • The New Math Of Retirement: Save 10%.
  • 3-Easy Steps To Retire Early

It’s easy.

Just stick your money in an index fund and “viola” you will be rich.

It reminds me of the old Geico commercials: “It’s so easy a cave man can do it.”

The problem is that these articles are all written by individuals who have never seen, must less survived, a bear market. Bear markets change your way of thinking.

For instance, Grant Sabatier has been in the media a good bit as of late with his success story of going from a net worth of $2.26 to $1 million in 5-years. It is quite an accomplishment. So what was his secret? Save like crazy and invest in index funds, stocks and REIT’s. It’s simple, as long as you have the benefit of a liquidity driven stock market make it all work. (As is always the case, the best way to become a millionaire is to write a book about how to become a millionaire.)

This is all a symptom of the decade-long bull market which has all but erased the memories of the financial crisis.

Following the financial crisis, you didn’t see stories like these. The brutal reality of what happened to individual’s life savings, and lives, was too brutal to discuss. No longer were there mentions of “buy and hold” investing, “dollar cost averaging,” and “buying dips.”

10-years, and 300% gains later, those brutal lessons have been forgotten as the “Wall Street Casino” has finally reignited the “animal spirits” of individuals.

Animal spirits came from the Latin term “spiritus animalis” which means the breath that awakens the human mind. Its use can be traced back as far as 300BC where the term was used in human anatomy and physiology in medicine. It referred to the fluid or spirit that was responsible for sensory activities and nerves in the brain. Besides the technical meaning in medicine, animal spirits was also used in literary culture and referred to states of physical courage, gaiety, and exuberance.

It’s more modern usage came about in John Maynard Keynes’ 1936 publication, “The General Theory of Employment, Interest, and Money,” wherein he used the term to describe the human emotions driving consumer confidence. Ultimately, the “breath that awakens the human mind,” was adopted by the financial markets to describe the psychological factors which drive investors to take action in the financial markets.

The 2008 financial crisis revived the interest in the role that “animal spirits” could play in both the economy and the financial markets. The Federal Reserve, then under the direction of Ben Bernanke, believed it to be necessary to inject liquidity into the financial system to lift asset prices in order to “revive” the confidence of consumers. The result of which would evolve into a self-sustaining environment of economic growth.

Ben Bernanke & Co. were successful in fostering a massive lift to equity prices since 2009 which, in turn, did correspond to a lift in the confidence of consumers. (The chart below is a composite index of both the University of Michigan and Conference Board surveys.)

Unfortunately, despite the massive expansion of the Fed’s balance sheet and the surge in asset prices, there was relatively little translation into wages, full-time employment, or corporate profits after tax which ultimately triggered very little economic growth.

The problem, of course, is the surge in asset prices remained confined to those with “investible wealth” but failed to deliver a boost to the roughly 90% of American’s who have experienced little benefit.  In turn, this has pushed asset prices, which should be a reflection of underlying economic growth, well in advance of the underlying fundamental realities. Since 2009, the S&P has risen by roughly 300%, while economic and earnings per share growth (which has been largely fabricated through share repurchases, wage and employment suppression and accounting gimmicks) have lagged.

The stock market has returned almost 80% since the 2007 peak which is more than twice the growth in GDP and nearly 4-times the growth in corporate revenue. (I have used SALES growth in the chart below as it is what happens at the top line of income statements and is not as subject to manipulation.) The all-time highs in the stock market have been driven by the $4 trillion increase in the Fed’s balance sheet, hundreds of billions in stock buybacks, PE expansion, and ZIRP. With Price-To-Sales ratios and median stock valuations not the highest in history, one should question the ability to continue borrowing from the future?

A Late Stage Event

Here’s a little secret, “Animal Spirits” is simply another name for “Irrational Exuberance,” as it is the manifestation of the capitulation of individuals who are suffering from an extreme case of the “FOMO’s” (Fear Of Missing Out). The chart below shows the stages of the previous bull markets and the inflection points of the appearance of “Animal Spirits.” 

Not surprisingly, the appearance of “animal spirits” has always coincided with the latter stages of a bull market advance and has been coupled with over valuation, high levels of complacency, and high levels of equity ownership.

As we wrote in detail just recently, valuations are problematic for investors going forward. When high valuations are combined with an extremely long economic expansion, the risk to the “bull market” thesis is an economic slowdown, or contraction, that derails the lofty expectations of continued earnings growth.

The rise in “animal spirits” is simply the reflection of the rising delusion of investors who frantically cling to data points which somehow support the notion “this time is different.”  As David Einhorn once stated:

The bulls explain that traditional valuation metrics no longer apply to certain stocks. The longs are confident that everyone else who holds these stocks understands the dynamic and won’t sell either. With holders reluctant to sell, the stocks can only go up – seemingly to infinity and beyond. We have seen this before.

There was no catalyst that we know of that burst the dot-com bubble in March 2000, and we don’t have a particular catalyst in mind here. That said, the top will be the top, and it’s hard to predict when it will happen.”

This is a crucially important point.

There is nothing wrong with “hoping” for the best possible outcome. However, taking actions to prepare for a negative consequence removes a good deal of the risk with very low short-term costs.

Rules Of The Road

While investing in the markets over the last decade has generated a good deal of wealth for those that have been fortunate enough to have liquid assets to invest, the next bear market will also take much, if not all of it, away.

As the last two decades should have taught the financial media by now, the stock market is not a “get wealthy for retirement” scheme. You cannot continue to under save for your retirement hoping the stock market will make up the difference. This is the same trap that pension funds all across this country have fallen into and are now paying the price for.

Chasing an arbitrary index that is 100% invested in the equity market requires you to take on far more risk that you most likely want. Two massive bear markets have left many individuals further away from retirement than they ever imagined. Furthermore, all investors lost something far more valuable than money – the TIME that was needed to prepare properly for retirement.

Investing for retirement, no matter what age you are, should be done conservatively and cautiously with the goal of outpacing inflation over time. This doesn’t mean that you should never invest in the stock market, it just means that your portfolio should be constructed to deliver a rate of return sufficient to meet your long-term goals with as little risk as possible.

  1. The only way to ensure you will be adequately prepared for retirement is to “save more and spend less.” It ain’t sexy, but it will absolutely work.
  2. You Will Be WRONG. The markets cycle, just like the economy, and what goes up will eventually come down. More importantly, the further the markets rise, the bigger the correction will be. RISK does NOT equal return.   RISK = How much you will lose when you are wrong, and you will be wrong more often than you think.
  3. Don’t worry about paying off your house. A paid off house is great, but if you are going into retirement being “house rich” and “cash poor” will get you in trouble. You don’t pay off your house UNTIL your retirement savings are fully in place and secure.
  4. In regards to retirement savings – have a large CASH cushion going into retirement. You do not want to be forced to draw OUT of a pool of investments during years where the market is declining.  This compounds the losses in the portfolio and destroys principal which cannot be replaced.
  5. Hope for the best, but plan for the worst. You should want a happy and secure retirement – so plan for the worst. If you are banking solely on Social Security and a pension plan, what would happen if the pension was cut? Corporate bankruptcies happen all the time and to companies that most never expected. By planning for the worst, anything other outcome means you are in great shape.

Most likely what ever retirement planning you have done, is wrong.

Change your assumptions, ask questions, and plan for the worst.

There is no one more concerned about YOUR money than you and if you don’t take an active interest in your money – why should anyone else?

Economic Theories & Debt Driven Realities

One of the most highly debated topics over the past few months has been the rise of Modern Monetary Theory (MMT). The economic theory has been around for quite some time but was shoved into prominence recently by Congressional Representative Alexandria Ocasio-Cortez’s “New Green Deal” which is heavily dependent on massive levels of Government funding.

There is much debate on both sides of the argument but, as is the case with all economic theories, supporters tend to latch onto the ideas they like, ignore the parts they don’t, and aggressively attack those who disagree with them. However, what we should all want is a robust set of fiscal and monetary policies which drive long-term economic prosperity for all.

Here is the problem with all economic theories – they sound great in theory, but in practice, it has been a vastly different outcome. For example, when it comes to deficits, John Maynard Keynes contended that:

“A general glut would occur when aggregate demand for goods was insufficient, leading to an economic downturn resulting in losses of potential output due to unnecessarily high unemployment, which results from the defensive (or reactive) decisions of the producers.”

In other words, when there is a lack of demand from consumers due to high unemployment, then the contraction in demand would force producers to take defensive actions to reduce output. Such a confluence of actions would lead to a recession.

In such a situation, Keynesian economics states that government policies could be used to increase aggregate demand, thus increasing economic activity and reducing unemployment and deflation. Investment by government injects income, which results in more spending in the general economy, which in turn stimulates more production and investment involving still more income and spending and so forth. The initial stimulation starts a cascade of events, whose total increase in economic activity is a multiple of the original investment.

Unfortunately, as shown below, economists, politicians, and the Federal Reserve have simply ignored the other part of the theory which states that when economic activity returns to normal, the Government should return to a surplus. Instead, the general thesis has been:

“If a little deficit is good, a bigger one should be better.”

As shown, politicians have given up be concerned with deficit reduction in exchange for the ability to spend without constraint.

However, as shown below, the theory of continued deficit spending has failed to produce a rising trend of economic growth.

When it comes to MMT, once again we see supporters grasping onto the aspects of the theory they like and ignoring the rest. The part they “like” sounds a whole lot like a “Turbotax” commercial:

The part they don’t like is:

“The only constraint on MMT is inflation.”

That constraint would come as, the theory purports, full employment causes inflationary pressures to rise. Obviously, at that point, the government could/would reduce its support as the economy would theoretically be self-sustaining.

However, as we questioned previously, the biggest issue is HOW EXACTLY do we measure inflation?

This is important because IF inflation is the ONLY constraint on debt issuance and deficits, then an accurate measure of inflation, by extension, is THE MOST critical requirement of the theory.

In other words:

“Where is the point where the policy must be reversed BEFORE you cause serious, and potentially irreversible, negative economic consequences?”

This is the part supporters dislike as it imposes a “limit” on spending whereas the idea of unconstrained debt issuance is far more attractive.

Again, there is no evidence that increasing debts or deficits, inflation or not, leads to stronger economic growth.

However, there is plenty of evidence which shows that rising debts and deficits lead to price inflation. (The chart below uses the consumer price index (CPI) which has been repeatedly manipulated and adjusted since the late 90’s to suppress the real rate of inflationary pressures in the economy. The actual rate of inflation adjusted for a basket of goods on an annual basis is significantly higher.) 

Of course, given the Government has already been running a “quasi-MMT” program for the last 30-years, the real impact has been a continued shift of dependency on the Government anyway. Currently, one-in-four households in the U.S. have some dependency on government subsidies with social benefits as a percentage of real disposable income at record highs.

If $22 trillion in debt, and a deficit approaching $1 trillion, can cause a 20% dependency on government support, just imagine the dependency that could be created at $40 trillion?

If the goal of economic policy is to create stronger rates of economic growth, then any policy which uses debt to solve a debt problem is most likely NOT the right answer.

This is why proponents of Austrian economics suggest trying something different – less debt. Austrian economics suggests that a sustained period of low interest rates and excessive credit creation results in a volatile and unstable imbalance between saving and investment. In other words, low interest rates tend to stimulate borrowing from the banking system which in turn leads, as one would expect, to the expansion of credit. This expansion of credit then creates an expansion of the supply of money.

Therefore, as one would ultimately expect, the credit-sourced boom becomes unsustainable as artificially stimulated borrowing seeks out diminishing investment opportunities. Finally, the credit-sourced boom results in widespread malinvestments. When the exponential credit creation can no longer be sustained a “credit contraction” occurs which ultimately shrinks the money supply and the markets finally “clear” which causes resources to be reallocated back towards more efficient uses.

Time To Wake Up

For the last 30 years, each Administration, along with the Federal Reserve, have continued to operate under Keynesian monetary and fiscal policies believing the model worked. The reality, however, has been most of the aggregate growth in the economy has been financed by deficit spending, credit expansion and a reduction in savings. In turn, the reduction of productive investment into the economy has led to slowing output. As the economy slowed and wages fell the consumer was forced to take on more leverage which also decreased savings. As a result of the increased leverage, more of their income was needed to service the debt.

Secondly, most of the government spending programs redistribute income from workers to the unemployed. This, Keynesians argue, increases the welfare of many hurt by the recession. What their models ignore, however, is the reduced productivity that follows a shift of resources toward redistribution and away from productive investment.

In its essential framework, MMT suggests correctly that debts and deficits don’t matter as long as the money being borrowed and spent is used for productive purposes. Such means that the investments being made create a return greater than the carrying cost of the debt used to finance the projects.

Again, this is where MMT supporters go astray. Free healthcare, education, childcare, living wages, etc., are NOT a productive investments which have a return greater than the carrying cost of the debt. In actuality, history suggests these welfare supports have a negative multiplier effect in the economy.

What is most telling is the inability for the current economists, who maintain our monetary and fiscal policies, to realize the problem of trying to “cure a debt problem with more debt.”

This is why the policies that have been enacted previously have all failed, be it “cash for clunkers” to “Quantitative Easing”, because each intervention either dragged future consumption forward or stimulated asset markets. Dragging future consumption forward leaves a “void” in the future which must be continually filled, This is why creating an artificial wealth effect decreases savings which could, and should have been, used for productive investment.

The Keynesian view that “more money in people’s pockets” will drive up consumer spending, with a boost to GDP being the end result, has been clearly wrong. It hasn’t happened in 30 years.

MMT supporters have the same view that if the government hands out money it will create stronger economic growth. There is not evidence which supports such is actually the case.

It’s time for those driving both monetary and fiscal policy to wake up. The current path we are is unsustainable. The remedies being applied today is akin to using aspirin to treat cancer. Sure, it may make you feel better for the moment, but it isn’t curing the problem.

Unfortunately, the actions being taken today have been repeated throughout history as those elected into office are more concerned about satiating the mob with bread and games” rather than suffering the short-term pain for the long-term survivability of the empire. In the end, every empire throughout history fell to its knees under the weight of debt and the debasement of their currency.

It’s time we wake up and realize that we too are on the same path.

The Important Role Of Recessions

It is a given that you should never mention the “R” word.

People assume you mean the end of the world is coming and you are sitting in cash, burying gold in the backyard, and stocking up on “beanie weenies” and ammo.

The reality is that recessions are just a necessary part of the economic cycle and the only real debate is on the timing of when the next recession will begin. Currently, most economists expect no recession until 2020 or even later. However, given the economy’s weakened ability to withstand higher interest rates, which has been compounded by a decade of artificially suppressed interest rates which have pulled forward future demand, I suspect it could come sooner.

More importantly, the decade of low rates has allowed fundamentally weak companies to stay in business by taking on cheap debt for unproductive purposes like stock buybacks and dividends. This will only serve to compound the problem of the next recession when it comes.

However, it is the Fed’s mentality of constant growth, with no tolerance for recession, which has allowed this situation to inflate rather than allowing the natural order of the economy to perform its Darwinian function of “weeding out the weak.”

As I have shown previously, today’s economy is once again at risk of a massive level of indebtedness which has been misallocated in non-productive assets. Now rising rates have become the “pin” that will lead to the quick deflation of those excesses.

Again, this isn’t a new concept but one that has repeated itself throughout history. It is more than just a coincidence that the Fed’s not-so-invisible hand has left fingerprints on previous financial unravellings.

The problem for the Federal Reserve at this juncture is that despite hopes of a “recession free” economy over the next several years, the current economic cycle is already very long historical standards.

Given the years of “ultra-accommodative” policies following the financial crisis, the majority of the ability to “pull-forward” consumption appears to have run its course. This is an issue that can’t, and won’t be, fixed by simply issuing more debt.

The Keynes/Austrian Debate

According to Keynesian theory, some microeconomic-level actions, if taken collectively by a large proportion of individuals and firms, can lead to inefficient aggregate macroeconomic outcomes, where the economy operates below its potential output and growth rate (i.e. a recession). Keynes contended that “a general glut would occur when aggregate demand for goods was insufficient, leading to an economic downturn resulting in losses of potential output due to unnecessarily high unemployment, which results from the defensive (or reactive) decisions of the producers.” In other words, when there is a lack of demand from consumers due to high unemployment then the contraction in demand would, therefore, force producers to take defensive, or react, actions to reduce output.

In such a situation, Keynesian economics states that government policies could be used to increase aggregate demand, thus increasing economic activity and reducing unemployment and deflation. Investment by government injects income, which results in more spending in the general economy, which in turn stimulates more production and investment involving still more income and spending and so forth. The initial stimulation starts a cascade of events, whose total increase in economic activity is a multiple of the original investment.

This seemed to work. From the 1950’s through the late 1970’s interest rates were in a generally rising trend with the Federal Funds rate at 0.8% in 1954 and rose to its peak of 19.1% in 1981. When the economy went through its natural and inevitable slowdowns, or recessions, the Federal Reserve could lower interest rates which in turn would incentivize producers to borrow at cheaper rates, refinance activities, etc. which spurred production and ultimately hiring and consumption.

As the economy recovered and began to grow again, the Fed would need to raise interest rates. This program seemed to work fairly well as interest rates went to a level higher than the last as the economy grew at an increasingly stronger level. This provided the Federal Reserve with plenty of room to maneuver during the next evolution of the business cycle.

However, beginning in 1980 that trend changed as we discovered the world of financial engineering, easy money, and the wealth creation ability through the abuse of leverage. However, what we did not realize then, and are still ignoring today, is that financial engineering had a very negative side effect of deteriorating economic prosperity.

The Austrian business cycle theory attempts to explain business cycles:

“As the inevitable consequence of excessive growth in bank credit, exacerbated by inherently damaging and ineffective central bank policies, which cause interest rates to remain too low for too long, resulting in excessive credit creation, speculative economic bubbles and lowered savings.”

In other words, the proponents of Austrian economics believe that a sustained period of low interest rates and excessive credit creation results in a volatile and unstable imbalance between saving and investment. In other words, low interest rates tend to stimulate borrowing from the banking system that in turn leads, as one would expect, to the expansion of credit. This expansion of credit then, in turn, creates an expansion of the supply of money.

Therefore, as one would ultimately expect, the credit-sourced boom becomes unsustainable as artificially stimulated borrowing seeks out diminishing investment opportunities which ultimately results in widespread malinvestments.

When the exponential credit creation can no longer be sustained, a “credit contraction” occurs which ultimately shrinks the money supply and the markets finally “clear” which then causes resources to be reallocated back towards more efficient uses.

As shown in the chart above, actions by the Federal Reserve halted the much needed deleveraging of the household balance sheet. With incomes stagnant and debt levels still high, it is of little wonder why 80% of American’s currently have little or no “savings” to meet an everyday emergency.

Furthermore, the velocity of money has plunged as overall aggregate demand has waned.

For the last 40 years, each Administration has continued to foster the Keynesian monetary and fiscal policies believing the model worked – when in reality most of the aggregate growth in the economy has been financed by deficit spending, credit and a reduction in savings.

In turn, this surge in debt reduced both productive investments into, and the output from, the economy. As the economy slowed, and wages fell, the consumer was forced to take on more leverage which continued to decrease the savings rate. As a result, of the increased leverage, more of their income was needed to service the debt.

(The chart below shows the shortfall between the inflation-adjusted cost of living and what wages and savings will cover. The deficit is the difference that has to be made up with debt every year.)

All of these issues have weighed on the overall prosperity of the economy and what has obviously gone clearly awry is the inability for the current economists, who maintain our monetary and fiscal policies, to realize what downturns encompass.

The Fed continues to follow the Keynesian logic, mistaking recessions as periods of falling aggregate demand, and they rush to try and stimulate demand hoping to increase the rate of consumption. However, the reason the policies that have been enacted by the current Administration have all but failed to this point, be it from “cash for clunkers” to “Quantitative Easing”, is because all they have done is either to drag future consumption forward or to stimulate asset markets that create an artificial wealth effect thereby decreasing savings that could, and should have been, used for productive investment.

The Keynesian view that “more money in people’s pockets” will drive up consumer spending, with a boost to GDP being the result, is clearly wrong. It has not happened in 30 years. What is missed is that things like temporary tax cuts, or one time injections, do not create economic growth but merely reschedules it. The average American may fall for a near-term increase in their take-home pay and any increased consumption in the present will be matched by a decrease later on when the tax cut is revoked.

This is, of course, assuming the balance sheet at home is not broken. As we saw during the period of the “Great Depression” most economists thought that the simple solution was just more stimulus. Work programs, lower interest rates, government spending all didn’t work to stem the tide of the depression era.

The problem currently is that the Fed’s actions halted the “balance sheet” deleveraging process keeping consumers indebted and forcing more income to pay off the debt which detracts from their ability to consume. This is the one facet that Keynesian economics does not factor in. More importantly, it also impacts the production side of the equation as well since no act of saving ever detracts from demand. Consumption delayed, is merely a shift of consumptive ability to other individuals, and even better, money saved is often capital supplied to entrepreneurs and businesses that will use it to expand, and hire new workers.

The continued misuse of capital and continued erroneous monetary policies have instigated not only the recent downturn but actually 30 years of an insidious slow moving infection that has destroyed the American legacy. “Recessions” should be embraced and utilized to clear the “excesses” that accrue in the economic system during the first half of the economic growth cycle. Trying to delay the inevitable, only makes the inevitable that much worse in the end.

The Fed’s Mandate To Pick Your Pocket – The Real Price Of Inflation

Inflation is everywhere and always a monetary phenomenon.” – Milton Friedman

This oft-cited quote from the renowned American economist Milton Friedman suggests something important about inflation. What he implies is that inflation is a function of money, but what exactly does that mean?

To better appreciate this thought, let’s use a simple example of three people stranded on a deserted island. One person has two bottles of water, and she is willing to sell one of the bottles to the highest bidder. Of the two desperate bidders, one finds a lonely one-dollar bill in his pocket and is the highest bidder. But just before the transaction is completed, the other person finds a twenty-dollar bill buried in his backpack. Suddenly, the bottle of water that was about to sell for one-dollar now sells for twenty dollars. Nothing about the bottle of water changed. What changed was the money available among the people on the island.

As we discussed in What Turkey Can Teach Us About Gold, most people think inflation is caused by rising prices, but rising prices are only a symptom of inflation. As the deserted island example illustrates, inflation is caused by too much money sloshing around the economy in relation to goods and services. What we experience is goods and services going up in price, but inflation is actually the value of our money going down.

Historical Price Levels

The chart below is a graph of price levels in the United States since 1774. In anticipation of a reader questioning the comparison of the prices and types of goods and services available in 1774 with 2018, the data behind this chart compares the basics of life. People ate food, needed housing, and required transportation in 1774 just as they do today. While not perfect, this chart offers a reasonable comparison of the relative cost of living from one period to the next.

Chart Courtesy: Oregon State LINK

Three characteristics about this chart leap off the page.

  1. Prices were relatively stable from 1774 to 1933
  2. Before 1933, disruptions in the price level coincided with major wars
  3. The parabolic move higher in price levels after 1933

Pre-1933

As is evident in the graph, prior to 1933 major wars caused inflation, but these episodes were short lived. After the wars ended, price levels returned to pre-war levels. The reason for the temporary bouts of inflation is the surge in deficit spending required to fund war efforts. This type of spending, while critical and necessary, has no productive value. Money is spent on making highly specialized technical weaponry which are put to use or destroyed. Meanwhile, the money supply expands from the deficit spending.

To the contrary, if deficit spending is incurred for the purposes of productive infrastructure projects like roads, bridges, dams and schools, the beneficial aspects of that spending boosts productivity. Such spending lays the groundwork for the creation of new goods and services that will eventually offset inflationary effects.

Post 1933

After 1933, price levels begin to rise, regardless of peace or war, and at an increasing rate. This happened for two reasons:

First, President Franklin D. Roosevelt (FDR) took the United States off the gold standard in June 1933, setting the stage for the government to increase the money supply and run perpetual deficits. FDR, through executive order 6102, forbade “the hoarding of gold coin, gold bullion and gold certificates within the continental Unites States.” Further, this action ordered confiscation of all gold holdings by the public in exchange for $20.67 per ounce. Remarkably, one year later in a deliberately inflationary act, the government, via the Gold Reserve Act, increased the price of gold to $35 per ounce and effectively devalued the U.S. dollar. This move also had the effect of increasing the value of gold on the Federal Reserve’s balance sheet by 69% and allowed a further increase in the money supply while meeting the required gold backing.

That series of events was followed 38 years later by President Nixon formally closing the “gold window”, which was enabled by the actions of FDR decades earlier. This act prevented foreign countries from exchanging U.S. dollars for gold and essentially eliminated the gold standard. Nixon’s action eradicated any remaining monetary restrictions on U.S. budget discipline. There would no longer be direct consequences for debauching the currency through expanded money supply. For more information on Nixon’s actions, please read our article The Fifteenth of August.

The second reason prices escalated rapidly is that, following World War II, the U.S. government elected not to dismantle or meaningfully reduce the war apparatus as had been done following all prior wars. With the military industrial complex as a permanent feature of the U.S. economy and no discipline on the budget process, the most inflationary form of government spending was set to rapidly expand. Excluding World War I, defense spending during the first 40 years of the 1900’s ran at approximately 1% of GDP. Since World War II it has averaged around 5% of GDP.

Returning to Milton Friedman’s quote, it should be easier to see exactly what he meant. Re-phrasing the quote gives us an effective derivation of it.  Inflation is a deliberate act of policy.

Fed Mandate

The Fed’s dual mandate, which guides their policy actions, is a commitment to foster maximum employment and price stability. Referring back to the price level graph above, the question we ask is which part of that graph best represents a picture of price stability? Pre-1933 or post-1933? If someone earned $1,000 in 1774 and buried it in their back yard, their great, great, great grandchildren could have dug it up 150 years later and purchased an equal number of goods as when it was buried. Money, over this long time period, did not lose any of its purchasing power. On the other hand, $1,000 buried in 1933 has since lost 95% of its purchasing power.

What does it mean to live in the post-1933, Federal Reserve world of so-called “price stability”? It means we are required to work harder to keep our wages and wealth rising quicker than inflation. It means two incomes are required where one used to suffice. Both parents work, leaving children at home alone, and investments must be more risky in an effort to retain our wealth and stay ahead of the rate of inflation. Somehow, the intellectual elite in charge of implementing these policies have convinced us that this is proper and good. The reality is that imposing steadily rising price levels on all Americans has severe consequences and is a highly destructive policy.

Cantillon Effect

The graph below uses the same data as the price level graph above but depicts yearly changes in prices.

Chart Courtesy: Oregon State LINK

What is clear is that, prior to 1933, there were just as many years of falling prices as rising prices and the cumulative price level on the first chart remains relatively stable as a result. After 1933, however, Friedman’s “monetary phenomenon” takes hold. The money supply continually expands and periods of falling prices that offset periods of rising prices disappear altogether. Prices just continue rising.

There is an important distinction to be made here, and it helps explain why sustained inflation is so important to the Fed and the government. It is why inflation has been undertaken as a deliberate act of policy. As mentioned, periods of falling prices are not necessarily periods of deflation. Falling prices may be the result of technological advancements and rising productivity. Alternatively, falling prices may result from an accumulation of unproductive debt and the eventual inability to service that debt. That is the proper definition of deflation. This occurs as a symptom of excessive debt build-ups and speculative booms which lead to a glut of unfinanceable inventories. This is followed by an excess of goods and services in the market and falling prices result.

Furthermore, there are periods of hidden inflation. This occurs when observed price levels rise but only because of policies that intentionally expanded the money supply. In other words, healthy improvements in technology and productivity that should have brought about a healthy and desirable drop in prices or the cost of living are negated by easy monetary policy acting against those natural price moves. By keeping their foot on the monetary gas pedal and myopically using low inflation readings as the justification, the Fed enables a sinister and criminal transfer of wealth.

This transfer of wealth euthanizes the economy like deadly fumes which cannot be smelled, seen or felt. It works via the Cantillon Effect, which describes the point at which different parts of the population are impacted by rising prices. Under our Fed controlled monetary system, new money enters the economy through the banking and financial system. The first of those with access to the new money – the government, large corporations and wealthy households – are able to invest it before the uneven effects of inflation have filtered through the economic system. The transfer of wealth occurs quietly between the late receivers of new money (losers) and the early receivers of it (winners). Although a proponent of inflationary policies as a means of combating the depression, John Maynard Keynes correctly observed that “by continuing a process of inflation, government can confiscate, secretly and unobserved, an important part of the wealth of their citizens.”

Conclusion – Investment Considerations

In the same way that only a very small percentage of recent MBA grads could, with any coherence, tell you what inflation truly is, the investing public has been effectively brainwashed into thinking that they should benchmark their investment performance against the movements of the stock market. Unfortunately, wealth is only accumulated when it grows faster than inflation. In our modern society of continually comparing ourselves with those around us on social media, we obsess about what the S&P 500 or Dow Jones are doing day by day but fail to understand that wealth should be measured on a real basis – net of inflation.  For more on this concept, please read our article: A Shot of Absolute – Fortifying a Traditional Investment Portfolio.

Mainstream economists, either unable to decipher this process of confiscation or intentionally complicit in its rationalization, have convinced an intellectually lazy populace that some degree of rising prices is “optimal” and normal. Individuals that buy this jargon are being duped out of their wealth.

Holding elected and unelected officials accountable for a clear and proper measurement of inflation is the only way to uncover the truth of the effects of inflation. In his small but powerful book, Economics in One Lesson, Henry Hazlitt reminded us that policies should be judged based on their effect over the longer term and for society as a whole. On that simple and clear basis, we should dismiss the empty counterfactuals used as the central argument behind inflation targeting and most other monetary and fiscal policy platitudes. The policy and process of inflation is both toxic and malignant.

Plan For The Worst

Currently, things could not be better.

Stocks are hitting all time highs. Confidence is at record levels, and investors are “all in.”

But maybe it is just for those reasons that we should take a pause. Records are records for a reason.

Every strongly trending bull market throughout history has ended, usually very abruptly and with little warning. Few ever foresaw the signs leading to the “Crash of 1929,” “The Great Depression,” the “1974 Bear Market,” the “Crash of ’87”, Long-Term Capital Management, the “Dot.com” bust, the “Financial Crisis,” etc. These events are often written off as “once in a generation” or “1-in-100-year events,” however, it is worth noting these financial shocks have come along much more often than suggested. Importantly, all of these events had a significant negative impact on an individual’s “plan for retirement.”

I bring this up because I received several emails as of late questioning me about current levels of savings and investments and whether there would be enough to make it through retirement. In almost every situation, there were significant flaws in their analysis due primarily to the use of “online financial planning” tools which are fraught with wrong assumptions. I wanted to go through some very basic concepts that you need to consider when planning for your retirement whether it is in 5 years or 25 years and more importantly dispel a few myths.

The Market Does Not Return X% Per Year

One of the biggest mistakes that people make is assuming markets will grow at a consistent rate over the given time frame to retirement. There is a massive difference between compounded returns and real returns as shown. The assumption is that an investment is made in 1965 at the age of 20. In 2000, the individual is now 55 and just 10 years from retirement. The S&P index is actual through 2016 and projected through age 100 using historical volatility and market cycles as a precedent for future returns.

While the historical AVERAGE return is 7% for both series, the shortfall between “compounded” returns and “actual” returns is significant. That shortfall is compounded further when you begin to add in the impact of fees, taxes, and inflation over the given time frame.

The single biggest mistake made in financial planning is NOT to include variable rates of return in your planning process.

Furthermore, choosing rates of return for planning purposes that are outside historical norms is a critical mistake. Stocks tend to grow roughly at the rate of GDP plus dividends. Into today’s world GDP is expected to grow at roughly 2% in the future with dividends around 2% currently. The difference between 8% returns and 4% is quite substantial. Also, to achieve 8% in a 4% return environment, you must increase your return over the market by 100%. The level of “risk” that must be taken on to outperform the markets by such a degree is enormous. While markets can have years of significant outperformance, it only takes one devastating year of losses to wipe out years of accumulation.

Plan for realistic returns in the future as well as adjust and account for market swings that will impact the ending value of your money.

Most Likely You Aren’t Saving Enough

Here are some shocking statistics for you. The average salary in America is about $55,000 a year as per the US Census Bureau. A critical mistake that many individuals make is assuming that salaries will grow at some specific annual rate until you retire. As shown in the chart below, this is not necessarily a realistic assumption.

The other statistic that goes along with this is that the average American has ONLY about ONE year of salary saved up for retirement. The point to be made is that very few individuals have saved adequately enough to actual retire and live off the income their portfolio will generate.

However, for those that “THINK” they have adequate savings, they most likely need to rethink their plan. Given the highly indebted levels of the global economy today, it is impossible for interest rates to rise significantly in the future due to the impact of debt servicing requirements. This means that the old “4% rule of thumb” as a withdrawal rate likely needs to be tucked away in the history books. This also means that most individuals are not just undersaved for retirement, but grossly so. Example:

Mr. Smith needs $60,000 pre-tax to live on in retirement. At 4% interest rates he needs $1.5 million saved up. However, at 2%, that requirement jumps to $3 million.

In reality, most Americans are woefully unprepared for retirement and are hoping that Social Security, or their pension, will provide the social safety net they need to make it through. There is a real probability in the coming years that the massively underfunded status of these programs will lead to less than expected results for retirees.

Retirement Is More Costly Than You Think

Most people that I see are running around with the idea that they can retire on 70% of their current income. In reality, this will leave you far short of the retirement dream that you are hoping for. In a recent survey of 5000 retirees, the average difference between pre and post-retirement incomes was about 12%. The reason is that while your house may be paid off and your children gone at retirement – individuals tend to substitute other items that eat into the retirement budget such as picking up an expensive hobby like golf, traveling more, or spoiling grandchildren. However, the biggest bite out of retirement savings will come from the result of surging medical expenses and higher health care insurance costs.

To be safe, you should be planning on 100% of your current income stream for retirement. If you aren’t – you could find yourself coming up short, and you don’t want to find that out once you are already IN retirement.

Rules Of The Road

You cannot INVEST your way to your retirement goal. As the last two decades should have taught you by now, the stock market is not a “get wealthy for retirement” scheme. You cannot continue to under save for your retirement hoping the stock market will make up the difference. This is the same trap that pension funds all across this country have fallen into and are now paying the price for.

Chasing an arbitrary index that is 100% invested in the equity market requires you to take on far more risk that you most likely want. Two massive bear markets over the last decade have left many individuals further away from retirement than they ever imagined. Furthermore, all investors lost something far more valuable than money – the TIME that was needed to prepare properly for retirement.

Investing for retirement, no matter what age you are, should be done conservatively and cautiously with the goal of outpacing inflation over time. This doesn’t mean that you should never invest in the stock market, it just means that your portfolio should be constructed to deliver a rate of return sufficient to meet your long-term goals with as little risk as possible.

  1. The only way to ensure you will be adequately prepared for retirement is to “save more and spend less.” It ain’t sexy, but it will absolutely work.
  2. You Will Be WRONG. The markets cycle, just like the economy, and what goes up will eventually come down. More importantly, the further the markets rise, the bigger the correction will be. RISK does NOT equal return.   RISK = How much you will lose when you are wrong, and you will be wrong more often than you think.
  3. Don’t worry about paying off your house. A paid off house is great, but if you are going into retirement house rich and cash poor you will be in trouble. You don’t pay off your house UNTIL your retirement savings are fully in place and secure.
  4. In regards to retirement savings – have a large CASH cushion going into retirement. You do not want to be forced to draw OUT of a pool of investments during years where the market is declining.  This compounds the losses in the portfolio and destroys principal which cannot be replaced.
  5. Plan for the worst. You should want a happy and secure retirement – so plan for the worst. If you are banking solely on Social Security and a pension plan, what would happen if the pension was cut? Corporate bankruptcies happen all the time and to companies that most never expected. By planning for the worst, anything other outcome means you are in great shape.

Most likely what ever retirement planning you have done, is wrong. Change your assumptions, ask questions and plan for the worst. There is no one more concerned about YOUR money than you and if you don’t take an active interest in your money – why should anyone else?

How Big Of A Deleveraging Are We Talking About?

Last week, I discussed the issue of debt and why “people buy payments.” This article generated much discussion and several emails including the following.

“You argue that rising debt levels lead to slower economic growth, but what if it is slower growth leading to rising debt levels?”

This is essentially the “causation” or “correlation” argument which has been a point of contentious debate over the last several years as debt levels in the U.S. have soared higher.

One of the primary problems, not only in the U.S., but globally, is that government spending has shifted away from productive investments that create jobs (infrastructure and development) to primarily social welfare and debt service which has a negative rate of return. According to the Center On Budget & Policy Prioritiesnearly 75% of every tax dollar goes to non-productive spending. 

policybasics-wheretaxdollarsgo-f1

Here is the real kicker, though. In the first quarter of 2017, the Federal Government spent $4.27 Trillion which was equivalent to 22.45% of the nation’s entire GDP. Of that total spending, $3.61 Trillion was financed by Federal revenues and $660 billion was financed through debt. In other words, it took almost all of the revenue received by the Government just to cover social welfare and service interest on the debt. 

Debt Is The Cause, Not The Cure

Debt, if used for productive investments, can be a solution to stimulating economic growth in the short-term. However, in the U.S., debt has been squandered on increases in social welfare programs and debt service which has an effective negative return on investment. Therefore, the larger the balance of debt becomes, the more economically destructive it is by diverting an ever growing amount of dollars away from productive investments to service payments.

The relevance of debt growth versus economic growth is all too evident as shown below. Since 1980, the overall increase in debt has surged to levels that currently usurp the entirety of economic growth. With economic growth rates now at the lowest levels on record, the growth in debt continues to divert more tax dollars away from productive investments into the service of debt and social welfare.

(Note: I have not included the beginning of the Trump Presidency yet because the debt ceiling remains frozen. When the debt ceiling is lifted and the current ACTUAL debt is reflected, I will revise accordingly.)

It now requires nearly $3.00 of debt to create $1 of economic growth.

In fact, the economic deficit has never been greater. For the 30-year period from 1952 to 1982, the economic surplus fostered a rising economic growth rate which averaged roughly 8% during that period. Today, with the economy growing at an average rate of just 2%, the economic deficit has never been greater.

But again, it isn’t just Federal debt that is the problem. It is all debt.

As discussed last week, when it comes to households, which are responsible for roughly 2/3rds of economic growth through personal consumption expenditures, debt was used to sustain a standard of living well beyond what income and wage growth could support. This worked out as long as the ability to leverage indebtedness was an option. The problem is that eventually, the debt reaches a level where the level of debt service erodes the ability to consume at levels great enough to foster stronger economic growth.

In reality, the economic growth of the U.S. has been declining rapidly over the past 35 years supported only by a massive push into deficit spending by households.

What was the difference between pre-1980 and post-1980?

From 1950-1980, the economy grew at an annualized rate of 7.70%. This was accomplished with a total credit market debt to GDP ratio of less 150%. The CRITICAL factor to note is that economic growth was trending higher during this span going from roughly 5% to a peak of nearly 15%. There were a couple of reasons for this. First, lower levels of debt allowed for personal savings to remain robust which fueled productive investment in the economy. Secondly, the economy was focused primarily on production and manufacturing which has a high multiplier effect on the economy. This feat of growth also occurred in the face of steadily rising interest rates which peaked with economic expansion in 1980.

The obvious problem is the ongoing decline in economic growth over the past 35 years has kept the average American struggling to maintain their standard of living. As wage growth stagnates or declines, consumers are forced to turn to credit to fill the gap in maintaining their current standard of living. However, as more leverage is taken on, the more dollars are diverted from consumption to debt service thereby weighing on stronger rates of economic growth.

How Big Of A Deleveraging Are We Talking About?

The massive indulgence in debt, or a “credit induced boom”, has now begun to reach its inevitable conclusion. The debt driven expansion, which leads to artificially stimulated borrowing, seeks out diminishing investment opportunities. Ultimately these diminished investment opportunities lead to widespread malinvestments. Not surprisingly, we clearly saw it play out in “real-time” in 2005-2007 in everything from sub-prime mortgages to derivative instruments. Today, we see it again in mortgages, subprime auto loans, student loan debt and debt driven stock buybacks and acquisitions.

When credit creation can no longer be sustained the markets will begin to “clear” the excesses. It is only then, and must be allowed to happen, can resources be reallocated back towards more efficient uses. This is why all the efforts of Keynesian policies to stimulate growth in the economy have ultimately failed. Those fiscal and monetary policies, from TARP and QE to tax cuts, only delay the clearing process. Ultimately, that delay only potentially worsens the inevitable clearing process.

That clearing process is going to be very substantial. With the economy currently requiring roughly $3 of debt to create $1 of real, inflation-adjusted, economic growth, a reversion to a structurally manageable level of debt would involve a nearly $35 Trillion reduction of total credit market debt from current levels. 

A $35 Trillion deleveraging process is impossible. Such an event could never happen?

Really?

The last time such a reversion occurred the period was known as the “Great Depression.”

This is one of the primary reasons why economic growth (along with lower interest rates) will continue to run at lower levels going into the future. There is ultimately a limit to which indebtedness can supplant actual organic economic growth. The question is whether we have already reached that limit, which brings us to a final question.

“If the economy is doing as well as Central Banks suggest, then why, after 9-years, are the ’emergency measures’ being applied to global economies still in place?” 

More importantly, what happens when they are forced to stop.

Of course, this is why Central Banks globally are terrified of such an outcome.

Correlation or causation? You decide.

People Buy Payments & Why Rates Can’t Rise

This past week, the lovely, and talented, Danielle DiMartino-Booth and I shared a discussion on the ongoing debate of why “Rates Must Rise.”  

For the last several years, I have produced a litany of commentary (see this, this and thison why rates WILL not rise anytime soon, they CAN’T rise because of the relationship between debt and economic activity.

Most of the arguments behind the “rates must rise” scenario are based solely on the premise that since “rates are so low,” they must now go up. This theory certainly applies to the stock market which is driven as much by human emotion, as fundamentals. However, rates are an entirely different animal.

Let me explain my position using housing as an example. Housing is something everyone can understand and relate to, but the same premise applies to everything bought on credit.

People Buy Payments – Not Houses

When the average American family sits down to discuss buying a home they do not discuss buying a $125,000 house. What they do discuss is what type of house they “need” such as a three bedroom house with two baths, a two car garage, and a yard.

That is the dream part.

The reality of it smacks them in the face, however, when they start reconciling their monthly budget.

Here is a statement I have not heard discussed by the media. People do not buy houses – they buy a payment. The payment is ultimately what drives how much house they buy. Why is this important?   Because it is all about interest rates.

Over the last 30-years, a big driver of home prices has been the unabated decline of interest rates. When declining interest rates were combined with lax lending standards – home prices soared off the chart.  No money down, ultra low interest rates and easy qualification gave individuals the ability to buy much more home for their money.

The problem, however, is shown below. There is a LIMIT to how much the monthly payment can consume of a families disposable personal income.

In 1968 the average American family maintained a mortgage payment, as a percent of real disposable personal income (DPI), of about 7%. Back then, in order to buy a home, you were required to have skin in the game with a 20% down payment. Today, assuming that an individual puts down 20% for a house, their mortgage payment would consume more than 23% of real DPI. In reality, since many of the mortgages done over the last decade required little or no money down, that number is actually substantially higher. You get the point. With real disposable incomes stagnant, a rise in interest rates and inflation makes that 23% of the budget much harder to sustain.

To illustrate this point, look at the chart below. Let’s assume we buy a $125,000 home. I have projected the monthly payment of that home assuming a rise in interest rates going forward back to the long-term median of roughly 8%. Pick a rate in the future and you can see what the payment would be.

With this in mind let’s review how home buyers are affected. If we assume a stagnant purchase price of $125,000, as interest rates rise from 4% to 8% by 2027 (no particular reason for the date – in 2034 the effect is the same), the cost of the monthly payment for that same priced house rises from $600 a month to more than $900 a month – more than a 50% increase. However, this is not just a solitary effect. ALL home prices are affected at the margin by those willing and able to buy and those that have “For Sale” signs in their front yard. Therefore, if the average American family living on $55,000 a year sees their monthly mortgage payment rise by 50% it is a VERY big issue.

Assume an average American family of four (Ward, June, Wally and The Beaver) are looking for the traditional home with the white picket fence. Since they are the average American family their median family income is approximately $55,000. After taxes, expenses, etc. they realize they can afford roughly a $600 monthly mortgage payment. They contact their realtor and begin shopping for their slice of the “American Dream.”

At a 4% interest rate, they can afford to purchase a $125,000 home. However, as rates rise that purchasing power quickly diminishes. At 5% they are looking for $111,000 home. As rates rise to 6% it is a $100,000 property and at 7%, just back to 2006 levels mind you, their $600 monthly payment will only purchase a $90,000 shack. See what I mean about interest rates?

This also explains WHY America has become a nation of renters as affordability for many is no longer an option.

Since home prices, on the whole, are affected by those actively willing to sell – a rise of interest rates would lead to declines in home prices across the board as sellers reduce prices to find buyers. Since there are only a limited number of buyers in the pool at any given time, the supply / demand curve is critically affected by the variations in interest rates. This is particularly the problem when the average American is more heavily leveraged than at any point in history.

Not Just Houses, It’s Everything

The ramifications of rising interest rates do not only apply to home prices, but also on virtually every aspect of the economy. As rates rise so do rates on credit card payments, auto loans, business loans, capital expenditure profitability, leases, etc. Credit is the life blood of the economy and, as we can already see, even small changes to rates can have a big impact on demand for credit as shown below.

More importantly, despite economic reports of rising employment, low jobless claims, surging corporate profitability and continuing economic expansion, consumers have sunk themselves deeper into debt. With the gap between wages and the costs of supporting the required “standard of living” at record levels, there is little ability to absorb higher rates before it drastically curbs consumption.  

There are basically only TWO possible outcomes from here, both of them not good.

First, Janet Yellen and gang continue to hike rates until an economic recession occurs which requires them to lower rates again. As an aging demographic strains the pension and social welfare systems, the economic malaise contains rates at the lower bound. This cycle continues, as it has over the last 30-years, which has created the “Japan Syndrome” in the U.S.

The second outcome is far worse which is an economic decoupling that leads to a massive deleveraging process. Such an event started in 2008 but was stopped by Central Bank interventions which has led to an even more debt laden system currently.

The problem with most of the forecasts for the end of “low interest rates” is the assumption that we are only talking about the isolated case of a shifting of asset classes between stocks and bonds.

However, the issue of rising borrowing costs spreads through the entire financial ecosystem like a virus. The rise and fall of stock prices have very little to do with the average American and their participation in the domestic economy. Interest rates are an entirely different matter.

Since interest rates affect “payments,” increases in rates quickly have negative impacts on consumption, housing, and investment which ultimately deters economic growth. 

Again, given the current demographic, debt, pension and valuation headwinds, the future rates of growth are going to be low over the next couple of decades until a “clearing” process is completed. (This is what the “Great Depression” provided.)

While there is little room left for interest rates to fall in the current environment, there is also not a tremendous amount of room for increases.

This is what the bond market continues to tell you if you will only listen. With the 10-year bond close to 2%, and the yield curve flattening, future rate increases are limited due to limited GDP growth due to “secular stagnation.” Therefore, bond investors are going to have to adopt a “trading” strategy in portfolios as rates start to go flat-line over the next decade.

The Breaking Point & Death Of Keynes

You can almost hear the announcer for the movie trailer;

“In a world stricken by financial crisis, a country plagued by spiraling deficits and cities on the verge of collapse – a war is being waged; gauntlet’s thrown down and at the heart of it all; two dead white guys battling over the fate of the economy.”

While I am not so sure it would actually make a great movie to watch – it is the ongoing saga we will continue to witness unfold over the next decade. While the video below is entertaining, it does lay out the key differences between Keynesian and Austrian economic theories.

Just last week, the Federal Reserve released a report which forms the basis of the semi-annual testimony Ms. Yellen will give to Congress this week. There was much in this report which suggests the models the Federal Reserve continues to use are at best flawed and, at worst, broken.

For decades, ivory tower economists have heaped high praise on Keynesian policies as they have encouraged Governments to drive deeper into debt with the expectation of reviving economic growth.

The problem is – it hasn’t worked.

Here’s proof. Following the financial crisis, the Government and the Federal Reserve decided it was prudent to inject more than $33 Trillion in debt-laden injections into the economy believing such would stimulate an economic resurgence. Here is a listing of all the programs.

Unfortunately, the results have been disappointing at best, considering it took almost $17 Billion for every $1 of cumulative economic growth.

Keynes contended that a general glut would occur when aggregate demand for goods was insufficient, leading to an economic downturn resulting in losses of potential output due to unnecessarily high unemployment, which results from the defensive (or reactive) decisions of the producers.”  In other words, when there is a lack of demand from consumers due to high unemployment then the contraction in demand would, therefore, force producers to take defensive, or react, actions to reduce output.

In such a situation, Keynesian economics states that government policies could be used to increase aggregate demand, thus increasing economic activity and reducing unemployment and deflation. Investment by government injects income, which results in more spending in the general economy, which in turn stimulates more production and investment involving still more income and spending and so forth. The initial stimulation starts a cascade of events, whose total increase in economic activity is a multiple of the original investment.

Unfortunately, as shown below, monetary interventions and the Keynesian economic theory of deficit spending has failed to produce a rising trend of economic growth.

What changed?

The Breaking Point & The Death Of Keynes

Take a look at the chart above. Beginning in the 1950’s, and continuing through the late 1970’s, interest rates were in a generally rising trend along with economic growth. Consequently, despite recessions, budget deficits were non-existent allowing for the productive use of capital. When the economy went through its natural and inevitable slowdowns, or recessions, the Federal Reserve could lower interest rates which in turn would incentivize producers to borrow at cheaper rates, refinance activities, etc. which spurred production and ultimately hiring and consumption.

However, beginning in 1980 the trend changed with what I have called the “Breaking Point.” It’s hard to identify the exact culprit which ranged from the Reagan Administration’s launch into massive deficit spending, deregulation, exportation of manufacturing, a shift to a serviced based economy, or a myriad of other possibilities or even a combination of all of them. Whatever the specific reason; the policies that have been followed since the “breaking point” have continued to work at odds with the “American Dream,” and economic models.

As the banking system was deregulated, the financial system was unleashed upon the unsuspecting American public. As interest rates fell, the average American discovered the world of financial engineering, easy money, and the wealth creation ability through the use of leverage. However, what we didn’t realize then, and are slowly coming to grips with today, is that financial engineering has a very negative side effect – it deteriorated our economic prosperity.

Furthermore, this also explains why the dependency on social welfare programs is at the highest level in history. 

 

As the use of leverage crept through the system, it slowly chipped away at savings and productive investment. Without savings, consumers can’t consume, producers can’t produce and the economy grinds to a halt.

Regardless of the specific cause, each interest rate reduction that was used from that point forward to stimulate economic growth did, in fact, lead to a recovery in the economy; just not at levels as strong as they were in the previous cycle. Therefore, each cycle led to lower interest rates and economic growth slowed and as a result of consumers and producers turning to credit and savings to finance the shortfall which in turn led to lower productive investment. It was like an undetectable cancer slowing building in the system.

The “Breaking Point” in 1980 was the beginning of the end of the Keynesian economic model.

Hayek Might Have It Right

The proponents of Austrian economics believe that a sustained period of low interest rates and excessive credit creation results in a volatile and unstable imbalance between saving and investment. In other words, low interest rates tend to stimulate borrowing from the banking system which in turn leads, as one would expect, to the expansion of credit. This expansion of credit then, in turn, creates an expansion of the supply of money.

Therefore, as one would ultimately expect, the credit-sourced boom becomes unsustainable as artificially stimulated borrowing seeks out diminishing investment opportunities. Finally, the credit-sourced boom results in widespread malinvestments. When the exponential credit creation can no longer be sustained a “credit contraction” occurs which ultimately shrinks the money supply and the markets finally “clear” which then causes resources to be reallocated back towards more efficient uses.

Unfortunately, as is clearly shown in both charts above, this has hardly been the case.

Time To Wake Up

For the last 30 years, each Administration, along with the Federal Reserve, have continued to operate under Keynesian monetary and fiscal policies believing the model worked. The reality, however, has been most of the aggregate growth in the economy has been financed by deficit spending, credit expansion and a reduction in savings. In turn, this reduced productive investment in the economy and the output of the economy slowed. As the economy slowed and wages fell the consumer was forced to take on more leverage which also decreased savings. As a result of the increased leverage more of their income was needed to service the debt.

Secondly, most of the government spending programs redistribute income from workers to the unemployed. This, Keynesians argue, increases the welfare of many hurt by the recession. What their models ignore, however, is the reduced productivity that follows a shift of resources toward redistribution and away from productive investment.

All of these issues have weighed on the overall prosperity of the economy. What is most telling is the inability for the current economists, who maintain our monetary and fiscal policies, to realize the problem of trying to “cure a debt problem with more debt.”

This is why the policies that have been enacted previously have all failed, be it “cash for clunkers” to “Quantitative Easing”, because each intervention either dragged future consumption forward or stimulated asset markets. Dragging future consumption forward leaves a “void” in the future that has to be continually filled, and creating an artificial wealth effect decreases savings which could, and should have been, used for productive investment.

The Keynesian view that “more money in people’s pockets” will drive up consumer spending, with a boost to GDP being the end result, has been clearly wrong. It hasn’t happened in 30 years.

The Keynesian model died in 1980. It’s time for those driving both monetary and fiscal policy to wake up and smell the burning of the dollar. We are at war with ourselves and the games being played out by Washington to maintain the status quo is slowing creating the next crisis that won’t be fixed with another monetary bailout.

Why $19 Trillion In Debt IS A Problem

According to the World Economic Forum, the United States has achieved a new TOP 10 ranking. Tell us what we’ve won Bob:

“Coming in at #10 – the United States, at 104%, gets nothing but the privilege of being on the list of countries with the highest debt/GDP ratios.”

So…it’s just $19 Trillion? A mere doubling of the national debt in eight years isn’t really a problem, right? According to Bob Bryan at Business Insider, that answer is – no.

Debt is an issue only if you can’t repay it or if other people believe you can’t repay it. And, as Business Insider’s Myles Udland has noted, the US can literally print the money it needs to repay its debt, and it still maintains a high credit rating.”

Bob is correct. The “fear mongering” over debt levels, and President Obama’s threats of default if we “shut down the government,” are just that – fear mongering. Entitlements and interest payments are mandatory expenditures of the government which get paid regardless of whether the Government is shut down or not.

However, what Bob misses is the much bigger point which is the impact on debt levels as it relates to economic prosperity.

According to Keynesian theory, some microeconomic-level actions, if taken collectively by a large proportion of individuals and firms, can lead to inefficient aggregate macroeconomic outcomes, where the economy operates below its potential output and growth rate (i.e. a recession).

Keynes contended:

A general glut would occur when aggregate demand for goods was insufficient, leading to an economic downturn resulting in losses of potential output due to unnecessarily high unemployment, which results from the defensive (or reactive) decisions of the producers.”  

In other words, when there is a lack of demand from consumers due to high unemployment, the contraction in demand would force producers to take defensive actions to reduce output.

In such a situation, Keynesian economics states:

Government policies could be used to increase aggregate demand, thus increasing economic activity and reducing unemployment and deflation. Investment by government injects income, which results in more spending in the general economy, which in turn stimulates more production and investment involving still more income and spending and so forth. The initial stimulation starts a cascade of events, whose total increase in economic activity is a multiple of the original investment.

Keynes’ was correct in his theory. In order for government deficit spending to be effective, the “payback” from investments being made through debt must yield a higher rate of return than the debt used to fund it.

The problem is that government spending has shifted away from productive investments that create jobs (infrastructure and development) to primarily social welfare and debt service which has a negative rate of return.  According to the Center On Budget & Policy Priorities nearly 75% of every tax dollar goes to non-productive spending. 

policybasics-wheretaxdollarsgo-f1

Here is the real kicker, though. In 2014, the Federal Government spent $3.5 Trillion which was equivalent to 20% of the nation’s entire GDP. Of that total spending, $3.15 Trillion was financed by Federal revenues and $485 billion was financed through debt. In other words, it took almost all of the revenue received by the Government just to cover social welfare and service interest on the debt. In the financial markets, when you borrow from others to pay obligations you can’t afford it is known as a “Ponzi-scheme.” 

Debt Is The Cause, Not The Cure

Debt, if used for productive investments, can be a solution to stimulating economic growth in the short-term. However, in the U.S., debt has been squandered on increases in social welfare programs and debt service which has an effective negative return on investment. Therefore, the larger the balance of debt becomes, the more economically destructive it is by diverting an ever growing amount of dollars away from productive investments to service payments.

The relevance of debt growth versus economic growth is all too evident as shown below. Since 1980, the overall increase in debt has surged to levels that currently usurp the entirety of economic growth. With economic growth rates now at the lowest levels on record, the growth in debt continues to divert more tax dollars away from productive investments into the service of debt and social welfare.

Debt-GDP-Presdient-050216-2

It now requires $3.71 of debt to create $1 of economic growth.

Debt-GDP-Growth-022216

In fact, the economic deficit has never been greater. For the 30-year period from 1952 to 1982, the economic surplus fostered a rising economic growth rate which averaged roughly 8% during that period. Today, with the economy growing at an average rate of just 2%, the economic deficit has never been greater.

Debt-Economic-Deficit-022216

But it isn’t just Federal debt that is the problem. It is all debt.

When it comes to households, which are responsible for roughly 2/3rds of economic growth through personal consumption expenditures, debt was used to sustain a standard of living well beyond what income and wage growth could support. This worked out as long as the ability to leverage indebtedness was an option. The problem is that eventually, the debt reaches a level where the level of debt service erodes the ability to consume at levels great enough to foster stronger economic growth.

In reality, the economic growth of the U.S. has been declining rapidly over the past 35 years supported only by a massive push into deficit spending by households.

PCE-Wages-GDP-Debt-040416

What was the difference between pre-1980 and post-1980?

From 1950-1980, the economy grew at an annualized rate of 7.70%. This was accomplished with a total credit market debt to GDP ratio of less 150%.

The CRITICAL factor to note is economic growth was trending higher during this span going from roughly 5% to a peak of nearly 15%. There were a couple of reasons for this. First, lower levels of debt allowed for personal savings to remain robust which fueled productive investment in the economy. Secondly, the economy was focused primarily on production and manufacturing which has a high multiplier effect on the economy.  This feat of growth also occurred in the face of steadily rising interest rates which peaked with economic expansion in 1980.

The obvious problem is the ongoing decline in economic growth over the past 35 years has kept the average American struggling to maintain their standard of living. As wage growth stagnates or declines, consumers are forced to turn to credit to fill the gap in maintaining their current standard of living. However, as more leverage is taken on, the more dollars are diverted from consumption to debt service thereby weighing on stronger rates of economic growth.

Austrian’s Might Have It Right

The massive indulgence in debt, what the Austrians refer to as a “credit induced boom”, has now reached its inevitable conclusion.  The unsustainable credit-sourced boom, which leads to artificially stimulated borrowing, seeks out diminishing investment opportunities. Ultimately these diminished investment opportunities lead to widespread mal-investments. Not surprisingly, we clearly saw it play out “real-time” in everything from sub-prime mortgages to derivative instruments which was only for the purpose of milking the system of every potential penny regardless of the apparent underlying risk.

Debt-Austrian-Theory-022216

When credit creation can no longer be sustained the markets must begin to clear the excesses before the cycle can begin again. It is only then, and must be allowed to happen, can resources be reallocated back towards more efficient uses. This is why all the efforts of Keynesian policies to stimulate growth in the economy have ultimately failed. Those fiscal and monetary policies, from TARP and QE to tax cuts, only delay the clearing process. Ultimately, that delay only potentially worsens the inevitable clearing process.

That clearing process is going to be very substantial. The economy is currently requiring roughly $4 of debt to create $1 of economic growth. A reversion to a structurally manageable level of debt would involve a nearly $30 Trillion reduction of total credit market debt from current levels. 

Debt-Structurally-Maintainable-Level-022216

The economic drag from such a reduction would be a devastating process which is why Central Banks worldwide are terrified of such a reversion. In fact, the last time such a reversion occurred the period was known as the “Great Depression.”

Debt-GDP-Annual-022216

This is one of the primary reasons why economic growth will continue to run at lower levels going into the future. We will witness an economy plagued by more frequent recessionary spats, lower equity market returns and a stagflationary environment as wages remain suppressed while costs of living rise.

Bob is correct. $19 Trillion isn’t a problem for us to pay because we can simply “print money” to make those payments, not withstanding the negative consequences of doing so. However, there is an apparent problem as it relates to growth. Correlation? Maybe. Causation? Probably.


Lance Roberts

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Lance Roberts is a Chief Portfolio Strategist/Economist for Clarity Financial. He is also the host of “The Lance Roberts Show” and Chief Editor of the “Real Investment Advice” website and author of “Real Investment Daily” blog and “Real Investment Report“. Follow Lance on Facebook, Twitter, and Linked-In