Submitted by Jeff Snider, President & CIO, Atlantic Capital Management
"Unexpected" Is Back, Right On Schedule
Before even taking into account the aftermath of the “unexpected” NFP result, it has been amazing to see over these past few months the number of experts, especially those that reside solely within the “science” of economics, proclaiming a successful engineering of the long sought-after recovery. That this has been the third such claim in as many years is lost in the noise of confusing “headwinds” that are somehow beyond the control of those that now control most everything within the financial arena. Stock speculators are beneficial components to the healthy financial transmission mechanism into the real economy (even when all they are supposed to do is provide liquidity 20,000 times per second), but anybody that dares speculate in the far more vital energy sector (or any real commodity) is the pure incarnation of evil. That these two apparently disconnected speculative classes are really one and the same shows just how obtuse (not always intentionally) economists and the pandering classes really are.
The evil energy speculators go part and parcel with the angelic stock speculators since they are only different sides of the same coin. Yet mainstream conventional economics continues to miss or ignore this. But this demonstrable ignorance is really a curiosity in that in every other case economics makes absolutely no distinction whatsoever amongst various types of activities. The “evolution” (devolution, in my opinion) of economics, especially as it has moved further and further away from qualitative analysis, favors simple quantity calculations. Lost in that transformation is the real process of real economic recovery, and modern economics will always be befuddled in this search process so long as it ignores differentiation in more important arenas.
I don’t think there is much doubt that Keynes and his intellectual contemporaries solidified the focus on quantity. The very notion of aggregate demand is essentially a statement that any and all economic activity is a perfect substitute for any and all other economic activity, regardless of “how”, “when” or, more importantly, “why” it was derived. Quantity is all that matters in aggregate demand.
Every mainstream economic strain follows this basic canon. As much as monetarism and Keynesianism proclaim and try to be at odds, often positioning themselves as the only two paths for economic and monetary policies, they are really just close ideological cousins. Keynesians seek to “create” real economy activity through the public sector, largely financed by debt. Monetarists seek to do the same exact thing, only through the private sector. But at their philosophical roots, both of these strains adhere to that pernicious notion of quantity as a perfect (or near perfect) substitute.
The monetarism that now lies at the heart of central banking and the soft central planning that has taken over the margins of the global real economy, depends on one formulation to achieve its substitute, quantity-based ends. Working primarily through the private sector, rather than the public sector where ends can be forcibly accomplished relatively easily through political processes, central banks cannot explicitly force the public to engage in activity. Of course, central banks operate on the premise that they know better how to “manage” the economic affairs of society (beginning with the application of the self-righteous, so-called fallacy of composition which bears no resemblance to actual logic [http://www.zerohedge.com/news/central-planning-update-theory-and-practice-you-are-here]), so it follows for monetarists that there are times when economic actors should not be “allowed” to set their own course. Aggregate demand is detached from the traditional notion of economics as the aggregation of individual self-actualization, so the “greater good” sometimes demands economic or financial self-immolation.
That means monetary policy has to cajole and coerce (these are not words that describe something that is “free”) the “correct” actions out of economic actors, regardless of their own tendencies and preferences. The “bunker mentality” that comes with every downturn in the business cycle (regardless of where the business cycle might actually originate) has to be defeated with monetary measures that make “safety” expensive. It matters very little how much of that bunker mentality is actually beneficial on the individual level, aggregate demand must be filled by something, and a population that cuts back on spending to save or pay down debt is following the “wrong” path. Therefore, every means or financial vehicle that promotes this antithetical process has to be financially countered by monetary measures.
Monetarily, destroying savings and dampening the desire to save is easily accomplished through ZIRP and a negative real rate of interest. Those evil oil speculators were not so evil in the early days of QE 2.0 when the Fed was trying to stoke inflationary “expectations” to try to generate “modest” negative real interest rates. In addition to making savings unappealing, ZIRP also, in the minds of central bankers/planners, increases borrowing activity (the trope that low interest rates are stimulative is still widely circulated and believed despite now years of empirical evidence to the contrary). Finally, there is the “wealth effect” of rising asset prices through the enhanced speculation that I mentioned in the beginning. Each of these measures is undertaken with the expressed understanding that they will “stimulate the economy”.
But each and every one of those monetary means to the quantitative ends are financial economy measures. There is no direct pipeline into the real economy. Philosophically, these central measures are dependent on the idea that financial risk-taking leads to real economy risk-taking. It is an unquestioned pillar of modern economics and monetary science that encouraging “risky” behavior in the financial economy encourages and promotes “risky” behavior in the real economy. Again, risk in the financial economy is believed to be a perfect (or near perfect) substitute for real economy risk. By getting people to act on these financial impulses, getting money to flow in the financial economy, it is believed that this will eventually lead to real economy activity.
To a certain extent, that idea is correct. Financial economy activity can and does create activity in the real economy; there are real effects of monetary engineering. But not all activity is the same, and there is no perfect substitution of generic real economy activity. It really should not be such a surprise that activity founded on financial risk is not a good substitute for organic growth. And that is where this entire philosophical construction falls apart.
In reality, promotion of risk-taking in the financial economy actually cannibalizes risk-taking in the real economy. There is no doubt that financial economy risk-taking leads to activity in the real economy, thus satisfying the quantification needs of aggregate demand, but it is the wrong kind of activity. A healthy economy is based on activity that is both sustainable and efficient. Real economy activity based on engineered financial economy risk-taking is neither (especially when the process of price discovery and systemic price of financial risk are heavily manipulated).
For example, the real economy needs a steady supply of entrepreneurs willing to take on the real risk of starting, owning and operating a productive business. But entrepreneurs are humans that respond to incentives in the same way as everyone else (not mathematical formulations that conform to “logical” interpretations). During periods where heavy applications of monetary largesse are providing asset inflation, therefore “stimulating” the “wealth effect”, we see entrepreneurialism skewed toward that asset inflation rather than any other real imbalances or opportunities in the real economy. People chase returns, whether they are presented in the real economy or the financial economy. During the housing bubble, how many people started small businesses or speculated to take advantage of real estate prices? Marginal economic activity in the last decade was centered on real estate and construction. People became real estate speculators (even the portion of the labor force that shifted toward real estate because that was where the money was being made, to the point that such labor not only oriented its skill in that direction, it also moved physically to the locations that provided the most money) rather than real economy innovators. Instead of starting businesses in the real economy as monetary practitioners intended, economic actors concentrated on the financial economy that was producing what was mistakenly perceived to be the best financial returns.
It was not just entrepreneurs either. Marginally, economic participants derived more and more purchasing power from financial means rather than real economic means. Whether that meant “cashing in” equity in growing real estate prices or just accumulating consumer debt because of the psychology of asset inflation, none of that marginal activity was based on the real economy. In fact, this bend toward consumption fueled by debt actually skewed the real economy away from efficiently allocating scarce real resources into sustainable, long-term productive endeavors (such the millions of houses and condos that never should have been built, the production capacity that was created to serve that construction effort, and even the parallel production capacity that was created to serve the level of consumption the financial economy enlargement alone provided, i.e., the productive capacity devoted to consumer electronics such as big screen TV’s), including and especially labor resources.
We saw the same exact process in the dot-com bubble era as well. Instead of starting productive small businesses that were sustainable, marginally a significant segment of the workforce shifted its productive attention toward speculative activities such as daytrading (how many people quit productive jobs to focus on stock trading, preceding the class of real estate flippers that would follow?). Even business itself was shifted unproductively toward the easy money of asset inflation. Rather than the marginal creation of businesses that could become sustainable and add real productive value (and thus real wealth) to the real economy, entrepreneurs and others focused on creating or expanding businesses dedicated to some segment of the tech or internet sector whether it was needed or not (whether they actually had a real business plan or not) because that was where all the money was flowing, where the easy financial gains of artificially engineered financial risk-taking were skewing the entire system.
Throughout this entire experimentation period of monetarism (essentially the past forty years, but really since 1989) the nature of business itself has changed in response to these intentional monetary expeditions into financial risk. We have seen the rise of the age of unrelenting stock repurchases, where companies buy back shares, using scarce cash resources, to further engineer asset inflation. Building upon the base of the central bank’s efforts to create a wealth effect, these companies respond to these central incentives and invest their funds first in financial projects (including M&A) rather than real economy capital expenditures. It started out at the margins, especially in the 1980’s during the junk bond bubble, but since 2003 it has become an all-consuming focus. Businesses, regardless of their internal situations, will divert resources to stock repurchases, even resorting to borrowing money to fund them. Stock price over productive value is the name of 21st century business, and the real economy suffers for it.
Rather than leading to a self-sustaining recovery process where financial economy risk-taking leads to beneficial real economy processes, the enlarging financial economy, with its “easy” money returns, draws more and more resources into each bubble, away from where those resources would be far more useful and sustaining. Financial engineering just does not compliment the real economy as intended. In reality, asset bubbles are far more like vortices than bubbles. They draw in more and more formerly useful material and leave destruction in their wake, and a system that can afford less and less the imbalances that these vortices inevitably lead to.
For the purposes of central banks dedicated to aggregate demand, however, the fact that economic actors are engaging in any economic activity is counted as a success. When quantity is all that matters, these distinctions are unnecessary complications. Anyone with a modicum of common sense can differentiate economic activity and see that economic quantity that is increasingly based on artificial financial risk and its attendant asset inflation will always be wholly dependent on those characteristics, and thus fully susceptible to reverse. And reverse is always the end result since, at some point, this mistaken monetary course will always be convinced of its own success once generic activity rises to some level of quantification. At that point the prime monetary forces are removed, crashing the entire artificially constructed and distorted economic system. We have even seen this play out after each unique episode of monetary expansion ends just in this recovery/reflation period.
There are enough unambiguous historical examples that provide ample evidence to discard this entire theory of quantification, but ideology prevents unbiased readings of the evidence. This kind of monetary activity toward quantification can be called reflation since it is almost always heavily applied in the aftermath of some downturn in generic activity (there is very little effort in describing the full processes of said downturn other than generic deference to a purportedly natural business cycle; I suppose that makes these kinds of massive mistakes easier to hide when it is camouflaged within something that conventional wisdom holds to be the natural course of economic events). The housing bubble/vortex itself was nothing more than reflation out of the dot-com bust. Once the monetary “stimulus” was turned off in 2005 & 2006 (not just in the US, Japan ended its experimentation with quantitative easing) because central authorities believed they had achieved the correct quantity of activity (mathematically described by the “output gap”), the whole thing came crashing down because the financial economy had cannibalized so much of the real economy disaster was inevitable. The greater the imbalance of financial economy over real economy (and the imbalance over speculative, financial risk-taking over investment, real economy productive capacity), the less able the entire system is to absorb the very real price of undifferentiated aggregate demand. Taking a longer view, 2007 was not all that much different than 1937, including the fact that some lessons are never learned.
In the end analysis, monetarism has the entire process backwards. The demand for money and credit should be as a result of success in the real economy, not the method for creating activity there. Consumption itself should be an offshoot of economic success, not the goal of generic activity. Indeed, the entire financial economy has become displaced from its proper role as real economy compliment. Intermediation is supposed to be a tool where the real pool of savings is matched to the most productive and sustainable uses for scarce resources, enhancing the real economy through increasing the productivity of money. The modern financial economy, and the 21st century definition of intermediation, is to create any and all activity in any and all places (see Greece). This is the opposite of productivity and efficiency.
Yet it is no surprise that central banks and their financial economy, bank-first system continues in the face of so many continuous failures. The alternative is to return and revert to a complimentary, secondary (or even tertiary) role in the economic system. The bureaucracy and ideology of the financial economy, especially since it has taken on this primacy, is not really set up for returning economic power to the organic processes of true capitalism, so an ideology has been created to justify this bank-centric schematic (“if the banks fail, the economy fails”). As long as generic activity and aggregate demand rule the philosophical mainstream roost, intellectually crowding out all other real capitalist, decentralized and free-market alternatives, the case will be made to manage the “greater good” and supersede even the most basic individual actions. That there exists this fundamental flaw (among many others) of quantification of generic activity, and thus the impossibility of long-term prosperity, is lost in the obfuscation of ideological self-preservation. So “unexpected” will once again return to the headlines of nearly every economic news item, like clockwork, after each and every independent reflation effort.