Put down the Sunday newspaper; grab a pot of coffee; and call 'mom' and tell her she has to read this. Doug Rudisch has written a far-reaching summary of the true state of the world and 'why policy has failed'. Simply put, there is no faith in the system; real underlying faith and trust in the system, as opposed to the confidence born from economic steroid injections or entitlements. There is more going on than a temporary lull in animal spirits that current fiscal and monetary policy will cure. If that was the case, it would be working already.
Something has to happen to restore our collective faith. And more short term fixes and empty promises during campaign speeches and the State of the Union addresses are not where to do it. Fed policy has worked with respect to increasing the values of liquid securities and real estate, and failed to date with respect to employment and capital investment. This latest massive and expensive effort by the government and Fed designed to encourage CEOs to increase risk-taking has done the opposite and scared them into a shell or at a minimum just not worked. Whatever CEOs are afraid of; ZIRP, QE, building more roads and bridges and paying out more entitlements is not making them unafraid of those things.
We have ended up with a system where the worst of the risk takers have the ability to take the most risk and are currently taking it at extreme levels. We wish we could be more prescriptive and offer more solutions for the problems. But in order to solve a problem, you must first realize you have one. With respect to the Fed, we don’t think the U.S. realizes it has a problem.
Via Michael Krieger of Liberty Blitzkrieg blog,
The essay below is courtesy of Doug Rudisch, a friend and former fund manager, who I have known and respected since my days on Wall Street. I am extremely grateful that he took the time and effort to so insightfully write on some of the greatest issues facing our nation today and to provide this content to my readers. What follows below are some of the most powerful passages from his piece and the entire thing is embedded at the end. The whole thing is simply excellent.
What I can say with absolute certainty is that I have lost a lot of faith and trust in the system. And I am not the only one. This sentiment is running at all-time highs amongst business leaders (their collective in-actions prove it) and guys on the street. It is both sides of the barbell and middle that are upset. Often it’s one or the other, but not all three. This time it’s not at an external state, it’s directed inwards. That is a tough problem to solve. Jingoism is not the answer either as we already tried that.
If there is no faith in the system, it has a really hard time working. And I mean real underlying faith and trust in the system, as opposed to the confidence born from economic steroid injections or entitlements. These are valid notions, but as a point of clarity I am talking about a something different. There also is a subtle but important distinction between faith and trust versus confidence. Faith and trust are longer term and more powerful concepts.
There is more going on than a temporary lull in animal spirits that current fiscal and monetary policy will cure. If that was the case, it would be working already.
However as the above chart shows, things clearly changed in the 2003 and 2009 profit cycles as corporate profits surged while employment did not. My explanations:
Starting with the 2009 cycle first. In the 2008 downturn companies eliminated a lot of jobs. The depth of the downturn forced them to make the tough decision. Normally that kills consumer spend due to wage loss. But the government plugged the revenue gap with transfer payments and direct investment. See the green line go nearly vertical and it is fascinating how profit growth has mirrored the trajectory of debt growth. The consumer has started to dis-save again as well. Thus corporations kept the revenue, lost the labor, and voila record margins. You could argue unemployment is being subsidized. Like anything else, when something is subsidized, you tend to get a lot of it.
For example, see the recent new investor activity in single family homes and farmland of all things, including equity hedge funds who apparently think homes are like stocks. Maybe it’s a sign that other asset categories (equities and credit) are getting toppy or inflation expectations are increasing when hedge funds begin to foray into the single family housing market and farmland (some having little or no prior experience in these markets). At any rate, it seems odd and not good to me when policy results in hedge funds buying single family homes and farms.
Sorry Mr. Greenspan we have seen where valuing assets solely on the basis of current rates got us. If we should do that, baseball cards and chewing gum would also be great investments today. My suspicion is from here baseball cards and chewing gum will hold their value over time better than the typical company trading at 15x earnings derived from profit margins that are twice its average levels. And in point of fact according to the CPI the price of candy and chewing gum increased 31% between the years 2000-2012, while the S&P index including this year’s rip is only up 6% since 2000. Yes it matters what the price is that one pays for an asset!
There is much more going on than technology replacing labor at an accelerating rate, globalization, or a structural mismatch of skills to available jobs. Sure they are part of the problem, but not a majority. They are a convenient excuse to rationalize failed policy. Productivity growth was always hailed as a good thing, both in terms of job creation and its ability to contain inflation.
The important similarity to both profit cycles is that they were driven by credit growth that supported corporate revenues above what consumer income alone would have. In both cases corporate profits were the offsetting asset relative to the liability of government and consumer debt. The credit growth of 2003 proved itself not only un-sustainable, but tremendously costly. That loss of consumer credit has now been shifted to the government balance sheet and that of the US Federal Reserve. By definition, this also is unsustainable in some form. Sure it can continue to grow, but if it does at some point I believe it has to resolve itself painfully through higher rates or inflation, some other form of taxation or confiscation, or something else I can’t think of.
Won’t it be interesting if going forward economic cycles are not marked by the supply of excess production capacity, but instead the supply of excess credit which creates asset bubbles as opposed to excess production capacity? I believe CEO’s have more rational expectations than certain classes of investors, namely the renters, who are a very big group collectively investing enormous amounts of capital. Thus policy causes a rice in price in certain asset classes (often as we have seen recently to irrational levels) more effectively than it stimulates investment by businesses in capital or labor. The costs and risks of monetary policy attempting to substitute for un-sound structural policy are much greater than the potential benefits! It just causes asset bubbles and does not drive employment.
Counter- intuitively Japanese gross fixed business investment over the last 10 years has averaged 13.7% of GDP versus the U.S. at 10.5% of GDP, yet Japan has still grown less quickly than the U.S. Monetary policy which doesn’t work perfectly to begin with cannot overcome structural, demographic, or political problems. Oftentimes monetary policy makes these issues worse for numerous reasons including causing capital misallocation and providing steroid boosts that enable politicians to ignore making the necessary structural change that needs to occur for an economy to become sustainably healthy. This may be the worst of all the negative side-effects of monetary policy.
Ultimately either price will decline to meet wages or wages will rise to meet price.
I am sure the Fed believes that if all the sudden this money starts to work its way into the economy and it begins to overheat they can remove money or credit at the exact appropriate time and rate such that excess inflation never happens. They probably also convince themselves this is the better problem to have. The same guys that get every forecast wrong, have missed at least 2 bubbles, and who have been flummoxed by QE and ZIRP not doing what they thought it would, think they can anticipate all the global knock-on effects of this policy action and also remove the stimulus at exactly the right time and rate and engineer a smooth landing?
Where I may be understating QE’s impact is the excess liquidity and consumption that has entered the economy through specialty finance companies (consumer finance, mortgage REITs, etc.). Specialty finance companies and mortgage REITs can access capital from banks via securitizations and the repo market incredibly cheaply now (30 day rate currently 15bp) because banks have excess reserves, and then turn around and lend it, which they have started doing aggressively again (and last time this did not end well). So some segments of the economy may have received disproportionate liquidity from QE. Here are some data-points and they are scary about the degree to which certain segments of the economy seem to have re-bubbled or over- consumed due to ZIRP and excess liquidity:
- The average maturity for car loans to borrowers with blemished credit contained in asset-backed securities surpassed 70 months last year for the first time since at least 2005, according to Moody’s Investors Service, which uses General Motors Co.’s GM Financial as a bellwether for the segment. All loans longer than 72 months more than doubled to 14 percent as of April 20 from six percent in 2010, according to J.D. Power & Associates.
- Auto loans which specialty finance companies crowded into that were made in 2012 are already running at a rate of non-performance that equates to the 2006 vintage which had the record rate of non-performance
- Auto sales back to roughly 2007 levels when U-6 unemployment was about 8% and now it is 14%. How does that make sense and how is it good to once again pull a bunch a demand forward and put cars in the hands of people that may not be able to afford them, which previously helped bankrupt the industry and cost taxpayers $25b and counting
- Covenant-light loans on pace to break 2007 record issuance, already at $88b YTD (April) versus 2007 peak of $97b.
The Fed has adopted wealth effect driven policy for a long time, but it is only making people poorer. As I pointed out real median annual household income is 8% lower than it was in the year 2000. And it is not creating jobs.
By way of analogy and not to belittle the severity of either event, 9/11 became an excuse to try to occupy two countries amongst other things. Now we are figuring out it didn’t turn out so well and was very costly. Similarly the financial crisis turned into an excuse for certain economists and politicians to uncork experiments and spend money like it is going out of style. Hopefully the latter turns out better than the former. But so far, both events have led to an enormous amount of wasteful and failed government expenditure and intervention which has ballooned our deficit and diminished our influence on the world stage.
We have ended up with a system where the worst of the risk takers have the ability to take the most risk and are currently taking it at extreme levels.
And by doing it to the degree it is, the Fed is acting as if it has 100% certainty it is correct when what they are directionally doing has a long history of ending badly.
It would be interesting if the American public were able to vote on Fed policy. Both sides argue their views in several very public debates, and the population votes. My strong suspicion is ex those in the financial industry, the vote would be a resounding no. And it would be by a larger margin than by what the current president was elected with. So is the Fed having all this power and leeway a good structure? Maybe. Democratic? Certainly not.
And to be clear, I am not arguing the Fed should be politicized or even become a democracy. I do think part of the problem is it has become politicized. But I am arguing there needs to be a stricter limit on what the Fed’s powers are and how they are measured as the current governance mechanism (the mandate alone) and measurement system (the CPI and employment) has given them too much leeway.
The twelve members of the FOMC average 57 years of age with a standard deviation of only 4.5 years. The three members of the President’s Council of Economic Advisors average almost the same 56 years of age with a standard deviation of only 2.6 years. All PhDs, and a big overlap in academic institutions. Talk about a tightly grouped bunch. Now this does not guarantee they all think the same way (come from same school of thought), and self-selected themselves, but it sure increases the chances.
No system will work optimally if everyone thinks the same way, anchoring and confirmation bias will just take over. If there are twelve people in a room, and they all think the same way, you might as well just have one. As CEO if one pursues a strategy and it doesn’t work, you change it, or lose your job. In investing, if you make a bad investment, you sell it. In life, if you are in a bad relationship, you change your behavior, or end it. But apparently in economics, if a policy isn’t working, you sit in a room and agree with each other that it is great and do more of it and get promoted through the system?
As a reality test, how about a simpler basket comprised of actual home prices, college tuition (which by itself is interesting because a lot of cost factors are embedded in college tuition including labor), food (maybe just the prices of a Big Mac which are up 5.2% per year since the end of the recession and labor is also part of the price of a Big Mac) and energy (gas) and health insurance prices (includes labor). Look at how these actual prices have changed and then tell me whether or not there is inflation. Is it a perfect measure? Probably not. An interesting reality test and point of compare? You bet! And it is probably a fair bit closer to what the average consumer seems to be feeling now. This basket also would have set off giant red flags about Fed and Government policy long before the financial crisis reared its ugly head in 2008.
I wish I could be more prescriptive and offer more solutions for the problems. But in order to solve a problem, you must first realize you have one. With respect to the Fed, I don’t think the U.S. realizes it has a problem, so that is why I picked on that issue, and did my best to provide potential solutions.
Full essay is embedded below. It’s most definitely worth your time. Enjoy!