Starring: Paul Krugman as The Idiot & Justin Wolfers as The Hack

Well this election certainly clarified a few things for the people of the world.  Most notably is that the experts are clueless.  Paul Krugman, notable ‘expert’ on all things economic has almost 2 million followers on Twitter and an op-ed with the NY Times.  This means he has a platform of great influence.  And yet, time and time again, he does well to prove he’s an idiot.  The following piece posted on election night.

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Well “Never” or by noon.  So he overshot by eternity.  None of us are perfect eh?  Now I shouldn’t single out Mr. Krugman as almost every market pro and economist on Earth has predicted that a Trump victory results in complete financial and human obliteration.  At least that was the message leading up to the election.

In a piece by Justin Wolfers, for the NY Times, titled “The Markets Are Afraid of Donald Trump“, written just over a month ago the message is clear from his conclusion.

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So while over the past 130 years markets tend to react well to Republicans, Justin concludes it will be different with Trump, in fact, worse than the market reaction to the greatest tragedy ever to take place on American soil.

Now if you get a chance to read the full article you’ll see that Justin gives you a glimpse at the fancy math economists use to extrapolate predictions.  It’s just enough to make you believe, “Wow this guy really knows some fancy math, he must know what he’s talking about”.   But this is the very reason economists like Justin have tragic forecasting records.   Now don’t get me wrong the math has its limited place and I’ve sat through all the same fancy math classes as Justin.   But the difference between most economists and most good economic and market analysts is understanding that markets and economics have almost nothing to do with math.

Economics and markets are studies about human behaviour and societal constructs, that is the bilateral relationships between humans and the logistic economic and financial environments.  And if you don’t understand that there is no math in the world that will help your forecasting.  Just look at Justin and Krugman.

Now I write this piece obviously in reaction to the massive clusterf*ck that occurred when Trump’s victory failed to ignite financial Armageddon as all the PhD’s predicted it would.  I can’t tell you how many calls I received yesterday from risk managers, traders, money managers, etc. trying to figure out why the market wasn’t collapsing.  And frankly, I expected it might simply as a self fulling prophecy.  That is, because everyone had been told it would so it would.  But the market, while giving a short head fake, decided that low corporate tax rates, improved breadwinner job market in the US and a bit of fiscal stimulus may be good for the economy.  Go figure.

I guess my point is that guys like Krugman and Justin are false authorities yet are major players in setting and selling economic policy.  This phenomenon of appointing idiots and hacks to roles of policy setting is a true mystery.  Until we begin to replace the policy  making industry (and it is an industry) with people who actually understand the subjects for which they are setting policy we will continue to find ourselves waking up wondering what in the hell went wrong.

 

 

 

Private Capital Allocation Matching Only the Great Depression for Inefficiency

The Summary:

  1. Economic policy objectives (monetary and fiscal) are meant to incentivize domestic private business investment, which drives incomes and the money multiplier effect, i.e. the engine of the economy.
  2. Economic policy objectives have failed because CEO’s, the private capital allocators, simply cannot accommodate business investment when the demand function is as weak as we currently find it, no matter how available and how cheap the capital.
  3. The demand function is weak because we misunderstood and ignored the side effects of trade policies and their reliance on new world economies that naturally have a lower money multiplier effect than old world economies.
  4. A materially damaged demand function leads to a misallocation of resources; for the past 15 years capital has been and continues at an accelerating rate to be allocated to cash distribution (the most economically inefficient use of capital) rather than investment, further deteriorating the demand function (economic death spiral).
  5. The only question that matters now then is;  How do we get private sector capital allocators to allocate capital more efficiently?  I’ll give you a hint, it requires indications of sustainable demand improvement and neither monetary nor fiscal policy have the capacity to generate sustainable demand improvement when the demand function is damaged to the point that CEO’s refuse to invest productively.  This then requires a new economic policy framework, one that CAN generate sustainable demand improvement, which will allow capital allocators to invest productively.

We can understand the problem without villainizing any particular stakeholders by focusing on where we are today and delivering a viable solution.  Mistakes were made and judging whether they were honest or malicious in nature is irrelevant to finding the solution.  Our focus here is a solution.

The Proof:

What is the objective of Monetary and Fiscal policy expansion?

Domestic business investment.  Both policy frameworks look to incentivize capital allocators (i.e. CEO’s) to implement microeconomic strategies that achieve macroeconomic goals (economic prosperity).  In other words,  monetary and fiscal easing/expansion look to incentivize CEO’s to allocate capital to domestic business investments (fixed and/or human capital and technology).

However, CEO’s have two choices on how to allocate capital.  The economically stimulating choice is productive business investment and the financial engineering choice is cash distributions.  We know the Fed has printed roughly $13T since ’08 to incentivize CEO’s with cheap capital thus providing a lower cost structure and generating a theoretically higher return on investment (ROI) by which CEO’s should be incentivized toward business investment.  Let’s see if it worked.

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The above chart depicts net domestic private business investment to GDP (blue line) and dividends to GDP (red line).  The chart  shows that the massive monetary easing that started in the mid 1990’s has failed to incentivize private business investment over cash distributions.  CEO’s are now allocating capital to cash distributions at a rate 3x higher than to private domestic business investments.  The only other time in history we’ve seen such an inefficient use of capital were the years heading into and through the great depression (note the above chart is 7 year moving avg so raw data begins in 1929; also it does not include buybacks).

Further evidence of Monetary policy failing to achieve its goal of domestic business investment.  The next chart shows annual business investment less annual additions to money stock.

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We can see from the above chart that historically business investment is a multiple of additions to money stock meaning that for every additional dollar printed we generated more than a dollar of domestic business investment.  However, since 2009 we have generated less than a dollar of productive investments for each dollar printed.  What does this mean?  It means we are printing dollars and passing those dollars through to the secondary financial markets (as depicted in the first chart above) meaning those dollars never hit the economy (i.e. 95% of secondary financial market activity is separate from the economy meaning does not expand corporate operational assets).

If we just look at straight nominal real domestic business investment, the problem again is very clear.

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Much of the period since 2009 has seen domestic investment in real dollars at levels lower than any other time over the past 5 decades and is now moving back into those lows.

For the sake of diligence, I will mention productivity separate from productive investment because I know some of you will jump on me if I don’t.  The reality is that without productive investment productivity is doomed as well but let’s look at the evidence.

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Clearly productivity has collapsed as well (source: St. Louis Fed).

So it is abundantly clear that the economic policy objective of stimulating domestic business investment (which we know is the engine of economic prosperity via money multiplier, I will spare you the data assuming we can all agree on that point) has failed.  The failure is despite the most extreme monetary easing in the history of this nation.

Why has it failed?

Janet Yellen recently stated “I don’t know why business investment is weak”.  Allow me to explain.  CEO’s cannot invest in operational expansion without the backdrop of sustainable demand expansion.  It’s that simple.  The fact that we cannot convince CEO’s to allocate toward business investment signals they’ve got too much standing capacity for a demand function that is damaged.  There is a plethora of evidence to back up this claim and so let’s look at just a couple.

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The above charts shows an already under-utilization of existing capacity and an utter collapse in per capita consumption, a terribly difficult decision then to allocate capital to more capacity.  This means that growth in domestic aggregate consumption (i.e. realized demand; i.e. top line) must come from population growth or foreign customers.

Let’s look at the prospects for population growth to provide a major boost to the domestic demand function.

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So it seems unlikely that population growth is going to provide any material pop in economic activity.

But what about foreign customers?

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Well currently exports are a relatively small but growing part of GDP.  And this is the argument of many pro ‘free’ trade economists.  Specifically the argument is that if we open up international trade, US companies can increase sales to foreign customers and thus begin to allocate again to domestic business investment.

The problem is it hasn’t worked.

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The above chart shows total manufacturing plus white collar service sector breadwinner jobs here in the US as a percent of working age population.  You’ll note that the 5 decades before 2000 breadwinner jobs remained on a steady long run average around 21.5% of working age population.  However, since 2002 we’ve been below 21% and since 2009 we’ve been below 20%.  These may seem like minor percentage losses but when you’re talking about 200M people each percentage point lost represents 2 million working age people without a good paying job.  The change from the long run average represents about 5 million more people without a breadwinner job and 8.5 million more relative to the peak of 1999.

In order to get a longer view let’s look at these jobs to total population (more data available).

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We are back to levels not seen since the late 1950’s and early 1960’s when most households could get by on one income.  That simply is not a reality anymore.  This translates to financial stress on consumers (i.e. households).

Now the argument of the free trade agreements is that while we would ship some low skilled breadwinner jobs out of the US we would more than make up those lost jobs with new world high skilled jobs.  And while it is clear from the above charts this hasn’t happened let me explain why that didn’t happen.  It is really very simple.

When GM was at its peak it employed 500K employees and a slew of upstream suppliers and vendors.  Facebook has 12K employees and maybe a relative handful of upstream suppliers and vendors.  This is simply the result of an increasingly digital rather than molecular world.  The point being, the money multiplier of new world economies is far lower than old world economies.  The result is a concentration of wealth and a reduction of income distribution.  The result of that is a damaged or much weaker demand function as we saw above.

The key to the old world economy is it provides a natural tie between domestic consumption and domestic production.  That is why as total domestic consumption grew, the amount of breadwinner jobs grew proportionately (producing a steady 21.5% average of breadwinner jobs to working age pop over time).  However, subsequent to the initial build out of the new world infrastructure in the mid to late ’90’s the growth rate of new world jobs has not kept up with the supply of labour (i.e. population/consumers/consumption).  And this is a function of the digital world requiring far less labour than the molecular world and therefore  unable to replace the number of old world jobs lost to trade agreements.

I am not suggesting that international trade is a bad idea.  I’m suggesting that like with most medications there can be severe negative side effects that need to be acknowledged and also treated.  Most economists seem to abhor the notion that trade agreements do create severe negative side effects and argue with the idea that we just haven’t trained a modern workforce to match the new world.  Again they fail to recognize new world economies require far less labour and so the very basic math simply doesn’t work.

And so we cannot let the pro ‘free’ traders off the hook with their suggestion of a mis-trained workforce.  We are still consuming more old world products than at any other point in history.  We have just chosen to send the increased production of old world goods (requiring lots of labour) to foreign nations generating a growing imbalance between domestic consumption and domestic production.  This imbalance requires private and public debt to fill the gap.

The following chart shows PCE (domestic consumption) over GDI Wages & Salaries (a proxy for domestic production).  As the level increases it means that the imbalance of consumption to production is widening.

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Notably, this is another metric that we find ourselves today at a level only ever before seen around the great depression.  This is not an unimportant observation.  When we find a pattern of fundamental aspects of the economy mirroring only one other point in history and that point happens to be the period around the great depression we should definitely explore the phenomenon.

Remember personal consumption generally comes from wages and salaries (a function of domestic production), credit and welfare.  And so lost production means lost labour incomes meaning credit and welfare have to make up the short fall otherwise the domestic demand function will weaken.  The data is clear that credit and welfare have made up the shortfall.  But what we are finding is credit and welfare relative to income has a cap and so without real income growth for the past 2 decades, real top line growth (realized demand) has stalled and in several key sectors declined.  The now secular contraction and/or deceleration of Revenues and Earnings are a representation of the damaged demand function that is preventing domestic business investment.

The solution lies in repairing the demand function in order to drive domestic business investment.  But because this is a chicken and the egg problem meaning without investment we cannot improve demand but without demand improvement we won’t get business investment, the existing economic policy frameworks are trapped.  And so the solution necessarily requires a new economic policy framework.

In an effort to find such a solution, I founded a nonprofit called Institute for Sensible Economics that has developed a platform to launch a new economic policy framework, one the aligns the actors of policy setting with the objectives of policy setting.  We will be introducing the Institute and the platform post election.  Stay tuned.

If anyone is interested in learning more and potentially getting involved please reach out to me: tb@thechicagoeconomist.com  We are particularly keen to expand strategic partnerships with business associations, collegiate student groups and grass roots organizations.

 

 

88% Probability We Just Entered Recession & The Broken Monetary Mechanism That Got Us Here

My last piece “The Matrix Exposed” generated a bit of a stir.  And as per usual the PhD’s had some fairly colourful things to say to me regarding the notion that more money and more credit may actually stall an economy.  But look I’m not trying to be offensive to anyone.  I’m simply making a case that when consumer credit becomes the basis of growth, well you have a real problem.  And that is a pretty reasonable argument even without the hoards of data backing it up.

But so allow me an attempt to mend some bridges.  Let’s start by looking at the various existing frameworks that drive economic policy.  We have Monetary policy (the banks), Fiscal policy (Congress), Microeconomic policy (Corporations).  So let’s look at each.

Let’s begin with Fiscal policy.  The very first issue that should jump out to everyone is that Congress has been utterly ineffective for almost 2 decades now.  That is because the partisanship has become so intense that there simply seems no room for compromise in an effort to get any reasonable piece of legislation done.  What we are left with is a slew of outdated fiscal policies.  Perhaps most detrimental is a corporate tax rate nearly twice that of many other developed nations.

The problem with relatively (to other nations) high corporate tax rates is it means that any domestic investment, everything else equal, has a significantly longer breakeven point.  Said another way, the return on domestic investment is much lower than the return on foreign capital investment (ceteris paribus).  This is a very intuitive concept, easily digestible by all.  The implication is that the relative level of corporate tax rates here in the US incentivize corporations to invest elsewhere.

And corporate tax is now a catch 22 because government transfers have become such a robust part of the societal fabric.  We need the high corporate tax level for the transfers but the transfers are in part a result of the high corporate tax level.  This quickly becomes a highly sensitive political point of dispute.  And again with Congress completely locked down by partisanship there is essentially zero probability of any significant legislation (either tax cuts or spending initiatives) being passed anytime soon.  And so Fiscal policy is off the table.

Now let’s look at Monetary policy and the Fed.  If you follow my research and writing you’ll know that I’m not the Fed’s biggest fan.  That said, if we are going to have a Fed it should do what it can to be beneficial to the economy.  But so how does the Fed affect the economy?  Well it does so through interest rates and money supply.  Now the major problem with monetary policy is that it attempts to stimulate economies by incentivizing capital allocators (corporations) to be productive.  It does so by essentially dictating the cost to borrow, which flows through to breakeven point and thus return on investment.  It also increases the effective money supply in the economy (through credit i.e. fractional reserve) in an effort to kickstart a demand side that then incentivizes capital allocators (corporations) to be productive.

By being productive I mean initiating domestic capital investment, which should lead to jobs and thus demand via improved incomes; and the boom cycle begins.  And the Fed had some success historically.  But Fed/Monetary policy has been ineffective during its latest recovery program post financial crisis.  Why?  Well when we look at things like corporate debt levels we see that Fed easing did incentivize corporations to borrow but what they did with that capital countered the Fed’s objective and this is the main problem with monetary policy.  It is indirect and requires allocators to play along and this time they didn’t.

And so when we look at what corporations did with that money we find the broken mechanism of monetary policy.  Rather than initiating productive domestic investments a significant amount of those funds went to dividends, buyback and foreign capital investment.  None of which hit on the Fed’s objective for easing monetary policy.  And so while the Fed may have been genuine in its attempt to stimulate the domestic economy, it was reliant on corporate microeconomic policy to follow suit.  And that simply didn’t happen.  Let’s visualize this story with real data.

Here’s the Fed’s implemented monetary easing post financial crisis.screen-shot-2016-09-15-at-1-17-32-pm

Next chart shows that Fed policy did incentivize capital allocators (corporations) to borrow.screen-shot-2016-09-15-at-1-12-07-pm

Next chart shows that corporations have been increasing dividends as their borrowing increased.screen-shot-2016-09-15-at-12-52-40-pm

Next chart shows that corporations have taken buybacks to record levels as borrowing increased.  If you summate divs and buybacks you’ll note it is more than 100% of net income.screen-shot-2016-09-15-at-12-53-29-pm

Next chart shows the increased debt is used almost exclusively to buy back shares (cash distribution – the most inefficient use of capital). screen-shot-2016-09-15-at-1-20-35-pm

Next chart shows that real private domestic business investment peaked in Q1 ’15 at a much lower level than where it was in the late 1990’s and has again been contracting for the past year despite the most extreme monetary easing in the history of the Fed.screen-shot-2016-09-15-at-1-01-37-pm

This means that the significant increase to borrowing that was incentivized by Fed policy in order to stimulate productive domestic investment actually went to the most inefficient use of capital, i.e. cash distributions.  And that means the Fed’s monetary policy objectives failed to be realized.

Notice in the above chart that a recession (grey verticals) immediately followed every sharp drop in real net domestic business investment (recession was delayed in the 80’s but we ultimately succumbed to recession before increasing). However, today we are asked to believe record equity valuations are warranted based on near/medium term expectations despite an 88% probability that we have just entered a recession?  Well that’s a topic for another day.  Now what happens at the microeconomic level when capital is misallocated?

Next chart tells us exactly what happens.  Return on investment  and balance sheets deteriorate.  So we add risk while reducing return.  An investing 101 No – No.  screen-shot-2016-09-15-at-1-21-30-pm

The result of perpetually misallocating capital is that everyone dies in the end.  And look I have sympathy for CEO’s.  In fact, I’ve given CEO’s a pass on criticism.  It is because CEO’s are simply pawns in the system.  They are beholden to what investors demand.  And investors want returns.

Investors today, with median holding periods now less than 60 days, don’t care if a CEO can provide return through expansion of operations or contraction (raiding the balance sheet).  For the past 8 years CEO’s have only been able to provide investors a return through contraction (as a result of a damaged demand function) and so they have done so.  The problem is that while this is generally ok on a short term basis as an individual firm awaits its demand universe to correct, things are different this time.  Demand isn’t coming back because all firms have implemented the same survival policies, which become destructive to both demand and productivity on the macro level.

The result is that these corporate microeconomic policies of capital misallocation (implemented in an attempt to appease investors) are negating all of the intended benefits of Fed policy.  This means we are fully reliant then on fiscal policy which, as we already discussed, is off the table for as far as the eye can see.

And so even if we accept that all existing economic policy frameworks (fiscal, monetary, microeconomic) really do have the very best of intentions we are still effectively dead in the water.

So then what in the hell do we do?  Well there is a real and viable solution that would require no central banker, legislator or CEO involvement by creating a fourth policy framework.  Let me know if you’re interested in hearing more.