In the holiday spirit, One River Asset Management's Lindsay Politi will devote the next three weeks to an arc focusing on the past, present, and finally her thoughts about the future. Here goes Part I: Ghosts of Investments Past
Demographics are Destiny? The December 1938 keynote address to the American Economic Association was titled “Economic Progress and Declining Population Growth.” Slowing population growth combined with increasing technological innovation would mean perpetually low capital investment. Secular stagnation, disinflation, and underemployment were inescapable. Within months World War II began. By the end of 1941, inflation was 10%. There was capital investment of historic proportions. There was a population boom. Even seemingly inescapable trends can change more abruptly than we dare imagine.
How We Got Here: Say’s Law states that supply creates its own demand, so a secular stagnation, a general deficit in demand, cannot exist. Yet they seem to occur periodically. Irving Fisher said we’re perceiving the problem incorrectly, that “the common notion of over-production is mistaking too little money for too much goods.” Friedman tells us “inflation is always and everywhere a monetary phenomenon.” Samuelson taught Bernanke that negative interest rates would make any investment profitable, thus creating enough demand that rates wouldn’t be able to stay negative very long. So, the solution seemed obvious: more money.
The Other View: John Hobson theorized that under-consumption is a natural stage of capitalism. People consume out of income, but only fractionally because they also save. The savings turns into capital investment, which boosts supply. As this trend plays out, capital and supply grow and, on a relative basis, income and demand shrink. Credit can only exacerbate the problem because credit most naturally goes to investment, not consumption, adding to the imbalance. The ultimate resolution is for incomes to increase faster than asset prices (or asset prices to decline more precipitously than incomes).
Hobson’s Critique: What might Hobson think of the monetarist response to secular stagnation? I imagine he’d point out that trying to increase credit for investment is counterproductive because investment further increases supply, exacerbating the supply demand imbalance. Then perhaps he’d point out that inflating asset prices through QE only exacerbates the capital/income divide that is the central cause of secular stagnation. Maybe then he’d point out that, especially for a demographically older population, reducing interest income for the one group most likely to convert savings to consumption only further exacerbates the income deficit. QE likely exacerbated, not alleviated, the problem.
* * *
Anecdote: “Why was consensus so wrong in the 1960s?” asked the US pension CIO. The 1960s parallel seems to be roughly playing out today: very low unemployment leading to higher wages had disrupted the stable, low interest rate regime. In 1965-66, a shift higher in yields sparked a scary correction in stocks and housing. Recession fears drove the Fed to pause and then reverse their hikes, incorrectly.
“What did they miss?” pressed the CIO. The 1960s Fed misdiagnosed the problem -- a weak stock market and weak housing market looked like a monetary overtightening that was likely to precipitate a recession. They weren’t paying enough attention to bond market dynamics. The real affliction in the 1960s was a bond market bubble. The easiest place to see this was in negative term premium and incredibly low bond volatility.
The early stages of a bond bubble unwind look a lot like monetary overtightening. But 1966 asset price declines weren’t reflecting a problem with economic fundamentals, rather, it was the removal of distortedly low discount rates that caused the asset price declines.
That misdiagnosis led the Fed to reverse their hiking cycle and cut interest rates. And because there was no real underlying economic weakness, housing rebounded and the stock market made new highs. Inflation rebounded quickly too, and employment never weakened.
So it’s not what the 1960s Fed missed, I told the CIO, it’s that they were fitting the available information into the wrong framework. I see something similar today. Everyone is using a business cycle framework: does 2018 market volatility indicate an imminent recession or not? It’s hard to answer because it’s not even the right question.
Market corrections are ultimately about excesses: wrong decisions writ large. And what we’re seeing today is the initial unwind of the excesses built up during the secular stagnation bubble.
--- Next week when I discuss the present, I’ll point out the signposts that guide us toward this conclusion.