Preface
We have covered a lot of economic ground over the past 22 years. I’m grateful to say that many of you have been with me from the beginning. Writings have taken us from Adam Smith to Karl Marx, John Maynard Keynes to Milton Friedman, and Hyman Minsky to Friedrich Hayek. We’ve sprinkled in philosophers, physicists, poets and futurists. We’ve meandered far and wide in what, at times, may have seemed unrelated paths.
We have arrived at a point in this long journey where all the paths converge. Nearly everything we have explored in the past will have meaning as we ponder what comes next. It has always been my way to stand on the shoulders of those much brighter to see further than I ever could alone.
This two-part commentary will be particularly reliant upon an amalgam of thoughts brought to light by geniuses past and present. Most ideas and names you will recognize from previous writings and conference presentations. But to advance our inquiry about what comes next, I’ll call upon the combined wisdom of Paul McCulley and Ray Dalio. Paul is an expert on the history and workings of the Federal Reserve and Ray is a hedge fund manager, best-selling author and philanthropist. McCulley and Dalio will make their presence most valuably felt in Part Two of this commentary, but every word written will be influenced by their illuminating ideas.
To add structure to substance we will examine the swinging pendulum of power and policy. The history of American economic policy is a skirmish for supremacy waged between politicians and bankers expressed as fiscal versus monetary policy. These often-conflicting philosophies are frequently accompanied by divisive political undertones; I will do my best to exclude from this analysis.
It’s been said that after one makes a terrible mistake what matters most is what comes next.
Part One
An Observation and Two Definitions
Capitalism is performing according to its nature. It’s creating wealth, producing innovation, rewarding success and punishing failure. This beautifully self-sustaining, integrated system has the power to improve the standard of living for millions of people, in the span of a single generation.
Capitalism, for all its intricate synergies is lacking one crucial element. Free market capitalism lacks an equitable distribution mechanism to combat the overconcentration of wealth.
Overconcentration of wealth often produces shortfalls in demand that disrupt capitalism’s equilibrium. Fiscal, monetary, and even supply-side economic policy all seek to compensate for periods of disequilibrium.
Federal governments and central bankers manipulate capitalism to meet political wants and social necessities. They use two basic tools to address economic shortfalls in meeting those wants and needs. Fiscal and monetary policy are the pillars of economic policy.
Fiscal policy: The federal government taxes the wealth capitalism creates and redirects that wealth to projects designed to enhance the performance of the economy.
Monetary policy: The federal reserve manipulates the availability and cost of credit to influence spending and investment to enhance the performance of the economy.
A Time Travel Thought Experiment
To better understand monetary policy, we’re going to engage in a bit of time travel. Anyone who has ever purchased an item on credit has participated in a form of economic time travel. The purchaser transports to the future, retrieves a few paychecks and returns home with the “cash” to buy what he wants today. This buyer has accelerated his purchasing power using tomorrow’s dollars to consume today’s goodies. This buyer has also engaged in a gamble that his wages will grow sufficiently to cover living expenses and his new debt payments.
When enough consumers participate in this economic time travel, they short-change future consumption for today’s purchase; the current economy benefits while the future economy suffers a loss of purchasing power plus interest. The future economy can be hollowed out. Without increased consumption to fill the void the future economy will contract.
Staying with the time travel analogy, the future economy is suffering an imbalance between supply and demand that has yet to occur. It’s the equivalent of a time bomb, fuse lit, clock ticking toward the inevitable explosion.
Consider the most salient point about this economic thought experiment. All nations, organizations and individuals will eventually meet their future selves and reap what they have sown. This thought experiment is at the heart of the good and bad of monetary policy.
Maintaining a balance between supply and demand promotes sustainable growth, price stability and steady employment. When the balance is disturbed, unfettered markets offer effective, sometimes harsh solutions. Central bankers rely on monetary policy to intervene in market economies to restore what they believe to be equilibrium.
When demand fails to keep pace with the capacity to produce and central bankers repeatedly manipulate market forces, monetary policy can transition from short-term remedy to chronic dependence. The need to continually move consumption from the future to the present to maintain growth, price stability and profits eventually creates a deficit of such magnitude no amount of new and cheaper credit can fill.
Monetary policy cannot overcome market forces, halt creative destruction nor tame business cycles. In recent history the temptation to cheat the business cycle and let the good times roll has proven too much for the Fed. The unforeseen consequences of economic manipulation will eventually corner them on a policy cliff.
Monetary policy displays weaknesses. It relies on outdated concepts like the Phillips Curve, trickle-down economics and lacks flexibility to address changing economic models. Market bubbles are the scourge of monetary policy. The Techno-Global Revolution has broken monetary policy’s sextant.
There has been considerable debate about the benefits of central bank monetary policy that’s free from government influence. Some politicians note the Federal Reserve consists of appointed not elected officials.
The path of policy rates from Chairman Volker’s 20% to Chairman Bernanke’s 0% was predictable and slow moving. There were few serious objectors in Congress until the Financial Crisis produced The Great Recession. For politicians the measure of economic policy effectiveness is seen through the lens of the next election cycle. Few enjoy the foresight or luxury to consider the long-term impact of short-sighted policy. With this in mind let's turn to fiscal policy.
Fiscal policy is the use of tax revenue and targeted expenditures to influence the performance of the economy. It differs from monetary policy that manipulates general borrowing costs. Fiscal policy interjects the Federal Government directly into the free market economy in specific and selective ways.
Fiscal policy was born of frustration with the severity of boom and bust business cycles. When these cycles brought the Great Depression, political leaders sought solutions to societal problems they attributed to laissez faire capitalism.
Fiscal policy is centered upon the economic theories of late British economist John Maynard Keynes. Keynes believed that the federal government could manipulate tax rates and implement targeted spending projects to smooth the tumultuous business cycles. Keynes advocated that sustainable consumer demand was the most important contributor to economic stability.
Keynes used the concept of the Multiplier Effect to demonstrate how taxation and spending would affect aggregate consumption. The multiplier can be both positive and negative.
Positive Multiplier: When the federal government adds money to the economy those funds travel from a consumer to a business. That business spends a portion of those same funds, becoming a consumer and so forth. The higher the volume of new spending and the faster the turnover, the greater the impact of the fiscal stimulus. The measurement of the rate of turnover is known as velocity.
Proponents of fiscal policy note Keynes’ emphasis on directing stimulus to sectors and individuals with a higher propensity to spend rather than save the added funds. When funds are saved rather than spent, the multiplier effect stalls and velocity is reduced.
Negative Multiplier: When the federal government raises taxes, or cuts spending it removes funds from the economy. Those funds are not recirculated from consumer to business and so on. Both the volume and velocity are subtracted from economic metrics.
Keynesians believe that by adding and subtracting government inputs fiscal policy can influence employment, inflation and growth. Keynes suggested raising taxes and cutting spending to build a reserve during expansions, and lowering taxes and raising spending during recessions.
The specific and selective nature of fiscal policy allows for politicians to use policy to get elected and reelected. We are all familiar with “pork barrel” projects targeting important constituencies that accomplish little for the economy. This human factor reduces the effectiveness of fiscal policy. There are other potential drawbacks too.
According to a phenomenon known as crowding out, some economists believe there is a finite appetite for borrowing and each dollar borrowed by the government is one fewer available to private enterprise. Crowding out may raise borrowing costs (interest rates) negating the benefit of fiscal stimulus while reducing business opportunities.
The difficulty in forecasting something as volatile as economic conditions makes targeting selected sectors to gain specific outcomes a most challenging practice of hit and miss. Both monetary and fiscal policies work with a lag. Months pass between implementation and any observable change in economic conditions. By the time the arrow leaves the bow the wind may have shifted, or the target may have moved on. Performing cost benefit analysis is often futile. It’s easy to see why fiscal conservatives find the Keynesian tax-and-spend philosophy potentially wasteful and a cause for runaway deficits.
The most salient criticism of Keynesian theory stems from its potential to generate inflation.
The Political Tug of War
The power struggle for dominance over economic policy between politicians and bankers has a long history. Elected officials prefer expedient fiscal policy and central bankers favor manipulating the cost of credit.
Since 1987 central bankers have had the upper hand. America is fast approaching the effective limits of monetary policy. A growing number of economists see US policy rates returning to zero when the next recession hits. Let’s track a bit of that long history to understand how we got here and where we might go next.
Let the Tugging Begin…
The loosely knit US banking system was prone to colossal failures triggering deep recessions. A strong central bank was deemed necessary to manage the risks of poorly run banks.
The Federal Reserve Act of 1913 was signed into law by President Woodrow Wilson. The Act created an American central bank with the authority to supervise banking practices, print money and to set policy interest rates.
America needed banking reform to improve economic stability in the early 1900s. To this end, the Federal Reserve was positioned to have a big influence on economic policy. The federal government and the central bank shared an uneasy balance of power.
In a general sense, the federal government and fiscal policy was the main driver of economic policy from 1913 through 1951. There was an ebb and flow to the relationship between politicians and bankers.
In 1929 the Roaring Twenties were wrapping up. The Hoover Administration and many in Congress believed the best remedy for the debilitating stock market crash and debt hangover was a dose of austerity. The federal government cut spending and moved toward a balanced budget. The central bankers tightened credit. The Smoot-Hawley Tariff Act, reluctantly signed into law by President Hoover, strained the fragile US economy. Economists argue to this day about which policy blunder tipped the country into the Great Depression. Hindsight reveals a comedy of errors and plenty of shared blame.
1933-1937
Fiscal Policy
President Franklin Roosevelt put his shoulder to the rope, pulling hard for fiscal policy. The Hoover administration’s policies of austerity and tight credit were mothballed. Roosevelt restricted the power of the Federal Reserve. The president demanded lower borrowing costs and a devalued dollar to spur international trade. The New Deal swamped the budget in red ink with government sponsored make-work projects.
At the depths of the Depression the WPA put 8.5 million men to work building infrastructure, parks and airports. The average monthly salary was $41.57.
A Recession Within a Depression
By 1937 the economy was showing signs of recovery. That spring industrial production, wages and profits returned to pre-crash 1929 levels. But inflation was running hot and budget deficits were drawing the ire of fiscal conservatives. Some business leaders thought The New Deal was hostile to business interests. Roosevelt succumbed to pressure to balance the budget and curb inflation. Fiscal stimulus paused and central bankers again tightened credit.
What followed came to be known, in Keynesian circles, as The Mistake of 1937. Industrial production and business profits swooned, and unemployment surged to 19%. Partisan bickering dominated debates about where to place blame for the dip in 1938.
Roosevelt went all-in on Keynesian economics with a new $5 billion spending package. In a “fireside chat” the president explained to America that it was up to the federal government to create an economic upturn. Government spending would be the bridge to better times by adding purchasing power to the flagging economy. Fiscal policy took the wheel. Roosevelt accepted monetary stimulation where he could get it but pushed central bankers to the sidecar.
The stimulus package put the economy on the mend and the spending programs received plenty of praise for the recovery. It wasn’t until 1942 when the US fully engaged in World War ll that economic growth surpassed pre-Depression levels.
Keynes Reigns Supreme
The end of World War ll brought celebration and anxiety. 12 million soldiers were returning from combat theaters around the globe. They would need jobs. President Harry Truman signed the Employment Act of 1946, cementing the supremacy of Keynesian philosophy in economic policy. The Act placed responsibility for economic stability, inflation and employment with the federal government. The Act aimed to maximize employment and purchasing power to ramp up the demand side of the economic equation. It was textbook Keynes.
Monetary policy played a supporting role. Fed Chairman Marriner Eccles used quantitative easing to keep interest rates low during and after the war. The Eccles Fed bought government securities to push market rates down. During the war Eccles policies worked to suppress financing costs. After the war he protected investors and the value of outstanding war bonds.
Inflation - The Fly in Keynes’ Ointment
After the Second World War inflation grabbed the headlines. By 1947 inflation reached 17%. In 1951 the US entered the Korean War. Inflation soared to 21%. The Federal Reserve began warning of runaway inflation and a deep recession if its power to control money supply and the cost of credit was not reinstated.
The first cracks in the Keynesian regime appeared. An economy relying on debt-fueled growth was prone to inflation without the braking power of monetary policy.
The Monetary Accord of 1951 restored the independence of the Fed. President Truman saw wisdom in a cooperative effort between fiscal and monetary policy makers.
The Federal Reserve continued buying 5-year Treasuries to protect war bonds but allowed other market rates to rise, dampening inflation pressures.
It’s the 1970s and the Word is Stagflation
Stagflation is complex and counter-intuitive. In the 1970s America simultaneously experienced a stagnant economy (recession), rising unemployment and increasing prices. Generally, economists associate recession with declining wages, profits and prices as jobs fall away and demand wanes.
Stagflation provided economics a much-needed reminder that it is a social rather than a hard science. Expectations of higher inflation took hold in the minds of consumers, labor unions, business leaders, retirees and politicians.
Fear of rising prices caused consumers to buy now, pushing demand and prices higher. Labor unions demanded cost of living clauses. Business leaders increased prices to offset labor contracts and rising energy prices. Retirees needed protection from inflation and politicians tied Social Security checks to the Consumer Price Index. The federal government increased spending, swelling deficits, pushing interest rates higher. Costs spiraled upward. Business investment tanked, and unemployment rose. Public perceptions and economic policies needed a jolt.
Keynes Out. Monetarists In.
Monetary Policy
President Jimmy Carter tried to boost economic activity with more government spending. He tried voluntary wage and price controls but found few takers. Fiscal policy stimulus and gentle coercion failed to break the wage and price spiral. The quiet man from Plains, Georgia took a bold policy step.
President Carter initiated a regime change in economic policy. Stagflation exposed a serious weakness in Keynesian thinking. Fiscal policy had served America well through a depression and a world war. It provided relief for the needy and opportunity for returning heroes. Fiscal policy did a great deal of heavy lifting and was exhausted.
The shift to monetary policy was not without controversy or pain. The new Fed Chairman Paul Volker stomped hard on the neck of inflation, raising policy rates from 8.25% to 20%. Each time Volker loosened his grip on credit inflation surged. The Chairman was relentless in the face of public and political criticism. Carter remained quietly supportive of the fight to curb inflation. The collateral damage was immense.
Capital spending crashed. Manufacturing, construction and farming suffered. During the deep recession of 1980-82 unemployment hit 10%. The US dollar followed rates higher putting American exports at a severe disadvantage. Exports dropped. These were bleak days for the country. Carter was a one-term president.
The war on inflation extracted a high price. The combination of tight credit, a slow economy, high interest rates, increased military spending and tax cuts contributed to large federal deficits. Volker was fired by President Reagan in 1987.
His controversial term as the 18th Chairman of the Federal Reserve marked change in economic policy framework. The fiercely independent Volker set the tone for Fed chairman in the decades to follow.
The inflation bogeyman was dead. For the time being, so too was Keynesian economics.
Moderation Leads to Addiction
Despite the pain inflicted on America by Volker’s policies, the monetarists gained firm control of the economy. Alan Greenspan, the Maestro of monetary policy used interest rates to calm the boom and bust business cycles. The period between 1989 and 2006 was coined “The Great Moderation”.
It seemed the regime change initiated by President Carter had crushed inflation and introduced a new kind of prosperity to America. Recessions were short and shallow. Unemployment remained low and consumer prices steady. A closer look at the Greenspan years reveals several serious policy flaws. It is ironic that the central bank empowered to regulate banking risk managed to increase it and helped generate an existential threat to the economy. This is the Greenspan legacy.
The Maestro used economic word salad to keep his potential critics bewildered and at bay. His semi-annual Humphrey Hawkins testimony to Congress elicited great praise and rare interrogations. But to corporations and the investment community the Greenspan message came through loud and clear. At the first sign of weakness the economy and markets could count on a surge of cheap credit. Greenspan policies helped the DOW gain 340% over his near 20-year rule. Few in Congress could decipher Greenspan’s philosophy, none would question his results.
America was transitioning to a “finance-based” economy capable of generating big profits but with an unrecognized reliance on credit to keep the lights on.
Businesses and investors became conditioned to expect the easy credit response to any miscues. Solid business models took greater risk. Poor models were subsidized, leading to more zombie companies, more zombie jobs and more time bombs. The financial sector consolidated power and grew more irresponsible under the Greenspan edict of self-regulation.
And then there was real estate, the most credit-sensitive sector of the economy.
In 2003-2005 the stage was set for a housing market collapse. Low rates, reckless mortgage lending and a feeding frenzy of speculative buying ended abruptly in the Minsky Moment. The US and the world’s developed economies were headed for a financial crisis.
Greenspan took MP1 beyond its limits of effectiveness, then headed for the door.
A Few More Definitions
Economists are drawing distinctions between what might be referred to as traditional monetary policy and the hybrid versions we are about to explore. Some see the hybrid versions as a natural extension of the traditional. Others view the hybrids as a sign of impending policy impotence. We will define the versions as MP1, MP2 and MP3.
MP1: Is traditional monetary policy that manipulates the cost and availability of credit in search of desired economic outcomes. Traditional monetary policy relies on interest rate cuts to accelerate economic growth and higher rates to slow it down.
MP2: Is traditional monetary policy augmented with Quantitative Easing or QE. When policy interest rates are near zero and the economy fails to respond the Federal Reserve buys government bonds and other assets to inject liquidity into the financial system.
MP3: Is the combination of MP1, MP2 and Fiscal Policy. The implementation of MP3 is an admission of the impotence of traditional monetary policy and QE to positively influence the economy. We have described historical occurrences of similar coordination during the Truman presidency, but the MP3 that lies ahead will be on a grand scale not seen before.
The Desperation of Ben Bernanke
The 20th Chairman of the Federal Reserve, Ben Bernanke inherited an economy on the brink. His predecessor had reduced the discipline of capitalism’s harshest reality, failure. Greenspan’s unfettered benevolence toward business leaders, speculators and bankers defiled capitalism for 2 decades.
The financial crisis and recession hit like a tornado. Bond geeks like to say, policy rates take the stairs up and the elevator down. Chairman Bernanke took policy rates down from 5.25% to zero in under one year. As the recession grew more threatening, Bernanke resorted to MP2 quantitative easing beyond Chairman Eccles wildest imaginings, a total of $3 trillion in stimulus to thaw the frozen financial system. But no matter how much liquidity Ben dropped on the banks and markets the economy languished. Policy rates hugged the zero bound for 7 years. The heartbeat of America’s economy remained faint and irregular. The recovery was long, slow and in constant jeopardy.
Yellen and Powell, the Eternal Monetarists
Janet Yellen and then Jerome Powell followed Bernanke. During their combined tenures they executed 9 policy rate hikes over three years. Powell began to reverse QE. Monetarist doctrine moved Janet Yellen and then Jerome Powell to raise policy rates to fight latent inflation and provide the bullets to combat the next, inevitable recession.
The monetarists failed to recognize the damage done to capitalism by decades of intervention in the business cycle. America’s economy has become soft and fragile. When policy rates climbed to 2.5% in December 2018 stocks swooned, the economy shuddered, and the president shouted.
In the decades since wresting power from the Keynesians, central bankers have ratcheted policy rates lower. Stoking a finance-based economy requires ever-cheaper credit. Households, corporations and governments now depend upon near-free credit to move consumption from the future to the now.
The Fed has run out of 500 basis point rate reductions to shock capitalism. And it now appears that borrowing costs above the rate of inflation are enough to stall growth and send the risk markets and politicians into a panic. In the eyes of many economists a return to the zero bound is inevitable when recession strikes America. A growing minority surmise that monetary policy has almost nothing left to offer a struggling economy.
MP3 is What Comes Next
In Part Two of this commentary my goals are simple. I want to sound an alarm you can’t resist. And I want to stir questions and discussion about how what comes next will impact you and your community.
I’ll rely on the ideas of Paul McCulley and Ray Dalio as the springboard to understanding the future. The decisions we make today will influence the future-self and community we run into during and after the next recession.
Disclaimer
The opinions presented within this white paper are the viewpoint of Institutional Capital Management, Inc. (ICM) at the time of distribution and are subject to change. The information contained is prepared from data sources generally believed to be reliable and available to the public, but no representation is made as to accuracy or completeness. This white paper is for general information purposes only and is not intended to provide specific advice or recommendation, nor is it an offer to purchase or sell any securities.
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