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.

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. 

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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.

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It now requires $3.71 of debt to create $1 of economic growth.

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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.

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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.

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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. 

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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