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.

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.