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  • Bob Moore

What Comes Next? Part Two

Updated: Dec 20, 2019



Preface


Welcome back! Thanks for returning for Part Two of What Comes Next.


There are four important elements within the Part Two commentary:

  1. The pendulum swings from fiscal policy dominance to central bank independence in multi-decade cycles.

  2. These cycles mirror private sector leveraging and deleveraging.

  3. Short-term and long-term debt cycles are finite and have profound influence on finance-based capitalism.

  4. While monetary policy itself is not obsolete, it is very near exhaustion. Its resources are finite.

Blaise Pascal, the 17th century physicist, mathematician and theologian said, “Man’s greatness lies in his power of thought.” Consider the triumphs and blunders of economic policy over the decades. We’ve been led to success and misery by men and women convinced of their own wisdom and soundness of their solutions. We should always remember that ideas are bound and constrained by the circumstances and accumulated knowledge of their time.


As the economic landscape evolves, ideas can and do become obsolete. Ideas have a lifespan as surely as the men and women who formulate them. Good ideas, the nuggets of genius, provide building blocks empowering thought to progress along with the circumstances of the day.


There are frequently competing sets of ideas and solutions to the same challenge. In economic policy, decisions are too often binary, reducing choices to A or B, up or down, fiscal or monetary. Economists and politicians create a false dilemma when acting as if there are only two choices and that one is right and the other wrong.


Part One of this commentary consists mainly of an historical survey of the tug of war between the competing ideas of fiscal and monetary policy. The pendular swing from one philosophy to another is a lesson in crisis management initiated first by the failures of decentralized banking, then the Great Depression, and later, the stagflation of the 1970s. In 2008 the limits of monetary policy became apparent in a Minsky Moment. Hyman Minsky, the great economist, cautioned against the mirage of credit-induced stability and the reality of economic fragility.


The pendulum swings back and forth in search of long-term stability and prosperity. The most consequential equilibrium, the balance of supply and demand, is at the heart of this search.


Welcome to The Machine


The most fascinating thing about capitalism is the logic of the system. For a concise description, may I suggest viewing Ray Dalio’s 30-minute video, How the Economic Machine Works. Dalio helps viewers find order in the chaos of capitalism by illustrating its predictable, mechanical nature.

I understand capitalism as a self-correcting perpetual motion machine that churns out advancement in technology, wisdom, wealth and the human condition. When functioning in a state of equilibrium, it is a study in near-frictionless fluidity. Profitable sellers meet willing buyers at the market and share in the system’s generous prosperity.


However, when equilibrium is lost, capitalism can be punitive. As Minsky taught, there are limits and risks associated with overzealous credit creation.


Another renowned economist, Milton Friedman, recognized the power and limitations of capitalism that propel central bankers to be fervent in policy and subject to mission creep. Friedman, a monetarist, wrote, “free markets accomplish wonderful things but cannot ensure a distribution of income that enables all citizens to meet basic economic needs.”


It’s All About Demand!


In What Comes Next? Part One I wrote of capitalism’s most consequential weakness, its lack of an equitable distribution mechanism. A market economy will self-correct unsustainable wealth distribution. When the rewards of capitalism are placed in the hands of too few consumers demand will dissipate and pull prices and profits lower. The eventual outcome of underfunded demand is recession, escalating to depression, producing deflation.


Our survey of pendular economic policy shows how fiscal and monetary policy have alternated to address the structural imbalance of insufficient demand. Fiscal policy addresses deficient demand with direct government intervention through spending and tax strategy. Monetary policy is indirect and relies upon credit creation to fill the consumer void.


Monetary policy has been in the driver’s seat since 1980. Credit creation and policy interest rates, the tools of central bankers, have boosted consumer and corporate debt and spending.


Along the way, monetary policy has reshaped capitalism. Capitalism enjoys its most stable equilibrium with a judicious reliance upon credit creation. When rolling debt replaces revenue as the lifeblood of commerce, an insidious distortion occurs. The continuous addition of money/credit at lower borrowing costs provides a false equilibrium. An over-reliance on monetary stimulus alters business models, garbles market signals, weakens the economy and sets the stage for recurring crisis. The economic obscenity of our time is the progression of finance from a tool to facilitate capitalism’s goals, to capitalism’s addiction.


While monetary policy has masked and delayed the consequences of underfunded demand, it has, in practicality, run its course.


How Ideas Become Obsolete


Monetary policy itself is not obsolete. It is, however, very near exhaustion and is working with finite resources. Economic thoughts and theories become the policy guidelines for the central bank. The validity of these ideas changes over time, as circumstances and conditions evolve. Let’s examine how two ideas have reached their expiration dates and became harmful to their original intent.


The Taylor Rule (1993) posits that policy rates should mirror inflation plus or minus a few basis points. When the growth rate of the economy slows, policy rates are pushed below the rate of inflation to boost borrowing and consumption. But, under current circumstances, this course of action stifles growth and consumption.


For example, consider the demographic bulge of baby boomers heading into retirement. This demographic reduces investment risk by shifting retirement saving from stocks to bonds. As market interest rates fall, boomers must save more and consume less to reach their accumulation goals. Once retired, boomers will consume even less as investment income hovers at historic lows. Implementation of the Taylor Rule directly contributes to underfunded demand and produces slower growth and downward price pressures in the macroeconomy.


The Phillips Curve (1958) connects the rate of inflation to unemployment. This idea theorizes low unemployment generates “wage pull inflation”. Simply put, as the unemployment rate drops, labor is empowered to demand increased wages that will pull consumption and prices higher.


Phillips developed his theory when American labor unions were at the apex of their bargaining power. Phillip’s theory rose to prominence long before digitization and globalization combined to release powerful deflationary forces, in what we call the Techno-Global Revolution. Under the threat of automation and outsourcing, wages have grown slowly despite low unemployment.


Technology punctuates equilibrium with bursts of social and economic disruption, leaving scant room for policy missteps. Fed adherence to the Phillips Curve philosophy explains why policy rates were raised too far and too fast. When the unemployment rate dipped below 4% the Fed acted preemptively to an inflation threat that didn’t materialize. The economy stalled and risk markets tumbled. Recognizing its policy error, the Fed responded with three rate cuts in 2019.


When the capacity to produce exceeds the ability to consume, during a period of monetary policy dominance, central bankers become locked in a spiral of lower rates and riskier credit creation. Adherents to the Phillips Curve failed to recognize that the evolving economic circumstances required a similar evolution of policy.


Demographics and technology are just a few elements of change that impact the economy and can erode the validity of theories.


Adhering to and accelerating outdated theories falls into the realm of active inertia.


David Sull, in his 2008 Harvard Business Review article, defines active inertia as “management’s tendency to respond to the most disruptive changes by accelerating actions that succeeded in the past.” Sull concludes that active inertia delays needed policy shifts and prolongs episodes of decline.


The Taylor Rule and the Phillips Curve continue to influence central bank policy to this day.


Why Isn’t Cheaper Credit Leading to More Borrowing and Faster Growth?


Corporate Balance Sheet Leverage and the Economic Outlook

Debt financing moves purchasing power from the future to the present. Borrowers gamble that their income will grow sufficiently to cover expenses plus the new debt payments, including interest.


In the private sector, healthy companies make decisions to increase debt (leverage) following an analysis of the impact on future cash flows and profitability. When business entities have strong balance sheets and the economy is robust, management will readily act upon opportunities to finance future growth. So long as a business has room on its balance sheet and potential profit exceeds the cost of additional credit, companies are inclined to increase leverage.


Strong companies with room for leverage, but a dim view of business prospects, often engage in share buybacks. Cheap credit and tax-advantaged borrowing incent management to use debt to buy its company’s shares in the open market. Buybacks reduce the number of outstanding shares and increase earnings per share, pushing stock prices and management compensation higher.


Share buybacks are one of the least productive uses of debt, adding little to the economy in the form of research, development, higher wages or consumer demand.


Healthy companies will continue to finance growth opportunities until added debt has negative implications for future cash flows and profits. When a business has exhausted its balance sheet, it will avoid adding debt regardless of borrowing costs.


Its critical to understand that monetary policy can accelerate an economy when growth is driven by leverage. Conversely, monetary policy can stall an economy with higher borrowing costs regardless of corporate or consumer leverage.


A business may surmise the economic outlook is too weak to warrant greater debt exposure. When economic conditions deteriorate, a business may decide to shore up its balance sheet and decrease its debt exposure. This is deleveraging.


Distressed or zombie companies are exceptions to the rules of sound balance sheet management. These companies can’t deleverage and rather borrow to survive, substituting rolling debt for recurring revenue.


We observe the US economy and see businesses approaching a deleveraging cycle.


When an economy is deleveraging, the cost of credit becomes inconsequential and monetary policy impotent. Monetary policy can only influence the cost of credit, not its demand. Economists refer to this phenomenon as pushing on a string.


The big risk for American and global capitalism is that we enter a recession while consumers and companies are deleveraging.


Understanding Short-term and Long-term Debt Cycles


Low interest rates and quantitative easing have pumped massive amounts of liquidity into the credit system, yet the economy continues to languish uncomfortably close to recession. The simplest explanation for the exhaustion of monetary policy is illustrated by the relationship of short-term and long-term debt cycles.


Short-term debt cycles coincide with the business cycle, averaging 5-7 years. During a business cycle the Federal Reserve raises policy rates to slow the economy and cuts rates to stimulate growth.


It’s helpful to think of a long-term debt cycle resting atop business debt cycles, with the long-term cycle bending to the business arc. Central bank policy, expressed as the Fed Funds target rate, traces the path of the long-term debt cycle. Ray Dalio and Paul McCulley have reached the conclusion that the US and global economies are rapidly approaching the end of a long-term debt cycle.


The most challenging phase in the lifespan of central bank dominance is the simultaneous conclusion of short and long-term debt cycles.


Monetary Policy is a Finite Resource. The Clock is Ticking.


The 1970s was a period of high inflation and stagnant economic growth. President Carter initiated a paradigm shift. The pendulum swung from fatigued, Depression-era fiscal policies to a monetary policy regime.


In 1980 the monetary policy gas tank registered full with policy rates at 20%. In 2009 the tank was near-empty at the zero bound. What happened in between?

The imbalance between the capacities to produce and to consume grew steadily larger, as did the wealth gap. In a monetary policy regime, underfunded consumption is supplemented with credit. For consumer balance sheets to accommodate more credit, terms have been relaxed and extended. Longer loans at lower rates make for lower monthly payments (and upside-down consumers). Commercials advertising no money down, no payments for 6 months, zero interest and the like are signals that the long term debt cycle is winding down.


The larger the imbalance between production and consumption, and the longer it persists, the greater the need for increased credit at decreased cost. When balance sheets are tapped out, deleveraging begins. Tick. Tock.


Description of the Graph:

The graph below depicts the path of the Fed Funds target rate from 1971 to the present.


The peak of the dashed line indicates the paradigm shift from fiscal to monetary policy.


The current long-term debt cycle began in 1980 with policy rates at 20%.


The Fed Funds target rate and the long-term debt cycle move parallel to the business cycle.


These business/short-term debt cycles are captured by the colored rectangles.




Observations:

Short-term cycles are influenced by Fed policy rates and the subsequent lowering and raising of borrowing costs.


In each of the four short-term cycles A through D, policy rates declined to their trough by an average of approximately 500 basis points.


Each short-term business cycles A through D exhibits an interest rate trough that is lower than the preceding cycle.


Line segments A1 through D1 reveal that each interest rate peak is lower than the preceding cycle. Note the most recent peak in 2019 at just 2.5%.


A2 through D2 indicate the period policy rates remain in the trough in each business cycle. With each successive cycle the duration of the trough is elongated.

The slope of the long-term debt cycle mirrors the US economy’s increasing reliance on credit.


The Fed Funds target rate and long-term debt cycle (the dash line) move parallel to the business cycle. Both are on a trajectory toward zero.


Conclusions:

Fed Chairman Paul Volker squeezed fiscal policy distortions from the economy with 20% rates. Monetary policy has replaced those distortions with a new set of risks.


Comparing the rate structure of business cycles since the mid-1980s reflects the economy’s cumulative reliance on increased credit creation at lower costs for longer time.


Monetary policy has required policy rate cuts averaging 500 basis points to revive business cycles A, B and C. Cycle D topped at 2.5% and has descended 75 basis points since December 2018.


The simultaneous exhaustion of short and long-term debt cycles hobbles monetary policy. This confluence of debt cycles coupled with a recession would create systemic economic distress.


Ditching the Binary Blues


When recession arrives, policy options will very likely include a combination of Keynesian and monetarist policy, what Ray Dalio refers to as acontinuum of coordinated monetary and fiscal policies.” We have referred to the continuum simply as MP3. In the event of a recession, MP3 is What Comes Next.


What might MP3 look like? The goal of MP3 is to combine very low interest rates (MP1) and quantitative easing (MP2) with government borrowing and targeted spending (fiscal policy) to produce a potent stimulus cocktail that neither fiscal nor monetary policy can achieve alone.


Proponents of MP3 recommend using near zero policy rates to finance increased issuance of government debt at very low cost. In this way, relaxed monetary policy will enable fiscal policy to stimulate the economy with minimal push back from fiscal conservatives.


In the introduction to Part Two we noted Blaise Pascal said, “man’s greatness lies in his power of thought.” I would add, so does his weakness. The effectiveness of fiscal policy, regardless of debt servicing costs, will be determined by the ability of elected officials to forgo pork barrel politics and vindictive partisanship, and instead contribute quality tax and spending policy. Can America’s broken federal government cooperate and cobble together enough nuggets of genius to develop a transformative economic policy? Can American politicians envision an economic model balancing supply, demand and price stability based upon an equitable distribution of wealth rather than continuous market intervention?


The pendulum’s swing reverses course when the underlying philosophy is bankrupt. History has taught us that both fiscal and monetary policy have finite limits. There is no reason to believe that combining exhausted monetary policy with escalating federal deficits will do any more than buy some time to get it right. Tick Tock.


While we’re on the topic of time…

The complexity of the issues clashes with my efforts to distill them into digestible segments for your consideration. To further our understanding of What Comes Next I request your indulgence as Part Three has become necessary.


Part Three Preview


We know the business cycle is alive and well. A recession is inevitable, if not precisely predictable. The economic policy solution will likely combine monetary and fiscal policy. The topics we cover in Part Three will reflect upon the pendular shift, historic fiscal policy measures, and our current political climate. We’ll use the perspective gained in our historical survey and understanding of debt cycles, to project and explore potential impacts and outcomes for local government and their communities.


Local government under the MP3 regime:

  1. Local government will become an important conduit for infrastructure improvements.

  2. Taxable Muni Bonds will be the preferred financing tool for public/private projects.

  3. The Fed will use Quantitative Easing to subsidize Taxable Muni Bond issuers, increasing demand and lowering borrowing costs.

  4. The productivity of debt issues will be critical to success of MP3 strategies.

  5. Local government investment policies will likely expand to include new income producing securities.

  6. Financial repression will continue to distort markets and regional economies, creating more risk for less reward.

  7. Modern Monetary Theory proponents will join the economic policy debate. We will define Modern Monetary Theory and examine the potential effects of this radical policy diversion.

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.


ICM is registered with the Securities and Exchange Commission (SEC) under the Investment Advisers Act of 1940. ICM clients include city and local governments, hospitals, and similar public funds investors. www.thinkicm.com