“If you can’t explain it simply, you don’t understand it well enough.”
Albert Einstein
As a casual student of Albert Einstein, I enjoy the challenge of trying to understand his explanations of complexities beyond my cognitive capabilities. Einstein understood both the unbridled power of science and the importance of communicating his genius to those not quite so blessed. Fortunately, Einstein was smart enough to envision what others could not and explain his discoveries so that all might see.
Too often financial pundits traffic in impenetrable complexity camouflaged in jargon to elevate their perceived expertise. The veil of complexity obscures broken logic and inconsistencies of thought. Had Einstein been a man of economics rather than physics he would have had much to say about policy built upon faulty assumptions.
While I am surely no Einstein, I do understand the value in seeing the world of economics through the eyes of my readers. I’ll take my best stab at simplifying the complex, replacing obfuscation with simple clarity.
It’s hard to ignore recent market volatility. The sharp policy reversals of the Federal Reserve can spur skepticism about the direction and quality of our leadership.
The Life and Death of the Phillips Curve
America emerged from World War II both victorious and insecure. The most powerful nation on earth had swagger but was haunted by reminders of the Great Depression. Financial disruption in 1930s America meant high unemployment, crashing stocks, bread lines, soup kitchens and flophouses. The hyperinflation that laid waste to the Weimar Republic in the 1920s cued fears of the unpredictable nature of even the strongest economies.
Uncertainty and fear spawned the Employment Act of 1946. The Federal Reserve was entrusted with constructing policy to ensure maximum employment, moderate interest rates, price stability and sustainable growth. The Fed’s levers of monetary policy were as limited then as they are today, consisting of money supply on one hand and credit cost on the other. Policy makers searched for a guiding principle to navigate the Employment Act’s mandates. Their unfortunate choice would contribute to the greatest policy and economic failure of the latter 20th Century. With a nudge from a conflicted President and a compliant Federal Reserve Chairman, a deficient theory would take the American economy far off course.
The Phillips Curve wed moderate inflation to low unemployment in a policy trade off accepting the former to achieve the latter. Sadly, the variables were limited in breadth and not aligned in reality as presumed in theory. The relationship between inflation and employment would prove tenuous and misleading.
The World is a Stage
In 1964 Lyndon Johnson was president. US involvement in Vietnam was growing in scope and expense. At times America seemed at war with itself. Scenes of US cities ablaze joined the horrors of an unpopular war as staples of the evening news. President Johnson’s New Society would redefine America’s social safety net and shock an already distressed federal budget. Johnson would not seek a return to the Oval Office in 1968. His legacy was a divided country, a failing war, a fragile economy and a weakened party. The best that could be said of Johnson’s America at the time of his departure was that inflation measured only 1% and unemployment an acceptable 5%. The good news would prove fleeting. To understand what followed the Johnson presidency we must examine what preceded it.
Act One
The Bretton Woods Agreement
The post-World War II world sought protection from hyperinflation. Memories of Germans exchanging wheel barrows of cash for a loaf of bread were fresh and frightening. In 1944, in search of stable currencies and purchasing power industrialized nations entered into the Bretton Woods Agreement. The agreement anchored international currencies to gold. Scrip from dollars to deutschmarks could be exchanged for gold upon demand.
After the war America became the dominant force in global commerce and the dollar became the world’s reserve currency. Most global trade was conducted in US dollars. Because America consumed more than it sold, our trading partners held a lot of US dollars. America was the global powerhouse and the dollar was backed by gold bars. What could go wrong?
Act Two
President Nixon and the Curve
In 1968 Richard Nixon, a politically savvy, morally deficient candidate was elected President of the United States. Although he enjoyed an electoral college landslide, his narrow margin in the popular vote accentuated the insecurity and paranoia that plagued his presidency.
Following Johnson into the Oval Office, Nixon was acutely aware of the fragile state of the US economy. Nixon embraced Keynesian Economics and the Phillips Curve as his best path to boost employment, delay recession and secure reelection. The President wanted rapid growth in money supply and low interest rates to juice the economy, masking its structural weakness.
Nixon replaced the uncooperative Fed Chairman William Martin with a pliable neophyte, Arthur Burns. Using Phillips Curve terminology Nixon is reported to have told Burns, “we’ll take inflation if necessary, but we can’t take unemployment.” Burns carried Nixon’s tune, ballooning the money supply and keeping interest rates low. Nixon told America, “We are all Keynesians now!”
Act Three
Bye-Bye Bretton Woods
America’s trade deficit multiplied as did global circulation of greenbacks. Budget deficits worsened, the war in Vietnam drained America’s treasure and fomented ever greater political unrest. None of this went unnoticed by trading partners. It became clear to all concerned that America could not convert dollars to gold on demand.
In 1971 the United States abandoned the Gold Standard and the Bretton Woods Agreement. The dollar became a fiat currency, free to float in value, untethered to the precious metal and backed only by the full faith and credit of the USA.
The printing presses at the US Treasury roared on, promoting economic growth. Political expedience surpassed good sense. The value of the dollar plunged in international currency exchange markets.
As the curtain dropped on Act Three it was evident that Nixon and America had a problem.
Act Four
Inflation
Our simplest understanding of inflation is that goods and services rise in price faster than purchasing power. Inflation is a two-sided coin. Heads: the cost of producing goods and services rises. Tails: a dollar declining in value buys less; fewer groceries, shoes for the kids and gallons of gasoline. Abandoning the Gold Standard and reckless monetary policies combined to uncork inflation. Foreign adversaries conspired to push it higher. Inflation would run wild for a decade with devastating consequences. America was vulnerable to economic forces and geo-political foes.
Employment held steady. Inflation gained momentum. Nixon’s pedal-to-the-metal monetary policy exposed faults in the Phillips Curve model. Money supply was an overlooked variable with the power to upset economic stability.
In 1971 and again in 1973 the President imposed wage and price controls to slow inflation. Nixon distorted the market economy with monetary policy and then attempted to negate the consequences with temporary restraints. Market forces may appear to succumb to manipulations but always return with an amplified vengeance, exceeding any short-term gain.
Each time the wage and price controls expired, labor unions and capitalists raced to make up lost ground. A dangerous price spiral had begun. By 1974 inflation reached double digits. America was unprotected and nervous.
US support for Israel in the Yom Kippur War prompted OPEC to weaponize oil. The Oil Embargo of 1973 quadrupled the price of gas and led to long lines and rationing at the pump for America and its allies. Energy costs would ripple through the production process of the world’s manufacturing economies. Inflation dropped deep roots and was part of the economic ecosystem. Extricating this demon would require extreme measures and great sacrifice. It would require Paul Volker.
Act Five
Savant, Savior or Satan?
In August of 1979 Arthur Burns retired, best remembered for failed policies and blind loyalty to a broken president. There was a new Chairman in town. His name was Paul Volker and his mandate was to extinguish inflation.
Gruff, stoic and 6’ 8” the cigar chomping Volker knew there would be collateral damage in his fight to eradicate spiraling inflation. His boss, Jimmy Carter, respected the new Chairman’s wisdom and fortitude. He also recognized the need for an independent, bare-knuckled Federal Reserve. Politics be damned, the President gave Volker a wide berth.
Paul Volker did his undergrad work at Princeton’s Woodrow Wilson School, his focus on public policy. In his senior thesis he criticized the Federal Reserve’s post-World War II policies for failing to curb inflation. Volker’s post-graduate work took him to Harvard and the London School of Economics. He summered with the Federal Reserve in New York conducting research. Volker served as President of the Federal Reserve Bank of New York from 1975 until his confirmation as Fed Chairman in 1979.
On November 4, 1979 Iranian students stormed the US Embassy in Tehran holding 52 hostages, a crisis for America that would last 444 days. The Iranian Revolution and the Iran-Iraq War reduced the global oil supply. An emboldened OPEC would repeat its 1979 embargo strategy, sending oil prices soaring and panic through industrialized nations.
In 1980 the inflation rate hit 14.8%. Volker responded by pushing the Fed’s policy rate from 11% to 20%. Thinking he may have landed a knockout blow against the demon the Chairman quickly reduced rates to 9.5%. Inflation rose from the canvas, invigorated by Volker’s retreat and spiked again. Volker was forced to ratchet the Funds Rate back to 20% three additional times by the middle of 1981. The Prime Rate, the basis of many business loans, topped 21%. Economists wondered if the cure might be worse than the catastrophe.
Construction, manufacturing and farming, all debt dependent and rate sensitive, struggled to survive. Unemployment hit 10% and America plunged into a deep, dark recession. Americans feared a second coming of the Great Depression. Jimmy Carter returned to Plains, Georgia, a one term President with a legacy tarnished by the sludge of a predecessor.
Some readers may recall Department of Agriculture Secretary Earl Butz encouraging farmers to plant “fence row to fence row” in the 1970s. Heeding the advice, farmers plowed more land and financed more equipment. Banks were eager to provide funding for the directive. In the early 1980s falling ag exports and rising loan rates pushed many to foreclosure. Feeling betrayed, farmers rolled tractors to the front door of the Eccles Building in D.C., home to the Federal Reserve, snarling traffic and demanding the termination of Volker and his policies.
By 1983 Volker brought the inflation rate to 3%. He had defeated the demon but at great cost. The din of public outcry left an indelible ringing in ears of politicians in Washington. The misdirected vitriol heaped upon Volker ignored his success and the true instigators of the tragedy.
The interlocked fates of Paul Volker and Jimmy Carter have not been lost on politicians and Fed Chairs who value longevity over duty to country.
Volker retired in 1987. He was succeeded by Alan Greenspan. Greenspan altered the role of the Federal Reserve for the next 30 years. Monetary policy would be subject to the whims of financial markets and the wizards of Wall Street. Each would take turns compromising economic sustainability and corrupting Fed policy.
One would be hard-pressed to argue that Volker was compassionate and measured in his response to the inflation crisis. His policies precipitated a terrible recession. There was no blueprint for his actions and no guarantee of success. Many questioned the morality of the punishing policy consequences for companies, workers and farmers who had no hand in creating the problem.
Time has elevated the general opinion of Volker and his policies. Some see them as necessary evil and others as prudent application of monetary discipline. But make no mistake, no Fed Chair since Volker has had the courage to recalibrate capitalism for its own sake and undo the harm of self-serving actors.
The Greenspan, Bernanke, Yellen, Powell Put
Milton Friedman taught his econ students at the University of Chicago that Capitalism is a system that varies in scope and capacity to generate growth, jobs and wages. It is precisely the limitations and the great rewards of this system that cause men to tinker, assuming the system can be tweaked to produce a bit more; more wealth, more jobs, more profits, higher wages.
The power of the system is its intricate simplicity. I have often described capitalism’s “ecosystem” and the connectivity of all components. The ecosystem is subject to a brutal Darwinism that allows it to evolve, grow and become stronger.
There are winners and losers. How a society chooses to deal with this “creative destruction” reflects its values and its humanity. Social safety nets may catch and retrain the fallen, targeting a reintegration into the evolving system. Idled human assets are a drag on productivity and safety-net resources. A concentration of resources in the hands of too few will ultimately break the bond between production and consumption so vital to the system.
Hubris and greed lead to manipulations that strain the system to the breaking point. Such manipulations, in time, lead to malfunction on a systemic scale. We know these failures as recessions, depressions, hyperinflation and financial crises.
Modern capitalism is a finance-based system. Leaders have tweaked the original version, super-charging it with debt to enhance production and consumption beyond inherent capabilities. Central Bankers, urged on by politicians, manipulate credit availability and cost to smooth the cycles of creative destruction.
Consumers, corporations and governments are all burdened with unprecedented debt accumulated to exaggerate their capacity to support the demands of modern capitalism and society.
So, what’s a Put? Why did Greenspan, Bernanke, Yellen and now Powell need one?
A put option is a financial device designed to reduce risk. A put option establishes a floor under the price of an asset, transferring the risk of market price decline from the investor to the issuer of the put. The buyer of the put pays a premium to the issuer to protect his investment.
Modern capitalism is fraught with credit risk. Borrowed money supports the value of company assets, salaries, bonuses and stock. Borrowed money allows consumers to buy more than their salaries command. Debt allows governments to finance services that exceed revenue. It is easy to see how credit disruptions can quickly bring modern capitalism to its knees.
Modern capitalism has experienced several such disruptions as the ecosystem has been strained to the breaking point. Volker’s successors, from Greenspan to Powell have chosen increasingly adventurous policies to protect the leveraged assets and the balance sheets of banks, governments and businesses.
The Federal Reserve has become the issuer of an economy-wide put option. When the financed-based system breaks down, the Fed floods markets and the economy with cheap credit. The false economic and market equilibrium is punctuated with repeated failure and rescue.
Two renowned economists, Hyman Minsky and Fredrick Hayek, headliners in previous commentaries, warned that false equilibrium is bought with increasing risk and cost. Minsky taught that prolonged periods of calm encourage greater risk and result in failed debt structures and ultimately financial crisis. Hayek lectured that failure without correction requires increasing levels of debt to sustain the false equilibrium. The cost of the put and the consequences of systemic failure continue to rise. The market and economic risk of failure has been transferred to the issuer of the put. The unfortunate reality is that the Fed may issue the put but it is the American public that pays the claim.
Some refer to this as the privatization of profit and the socialization of risk. Economists refer to this as moral hazard. The beneficiaries of the put pay no premium, bare no cost to obtain protection and transfer the consequences for failure to others.
The most damaging effect of the put is that it renders Darwinist creative destruction mute for the largest companies and banks, perpetuating failed practices, restricting competition and stalling economic evolution.
The clearest illustration of the Federal Reserve’s put is the multi-decade decline in policy rates from Volker’s 20% to Yellen’s 0%. Along the way financial risk takers were trained to expect a bailout whenever their excessive behavior created systemic risk. They also learned that failure had limited consequence.
Back to the Beginning to Reach the End
The Phillips Curve has been widely debunked by economic scholars. The Phillips Curve maintains considerable clout at the Fed. The fear of inflation is powerful because its effects are so devastating. There may be a correlation between inflation and employment that drifts in and out of statistical relevancy. It does not reflect causation. In modern financed-based capitalism, credit cost and money supply expansion have greater relevancy. Globalization and technology have distorted the old relationship between labor and production costs. Consumer credit has allowed labor to consume more than it earns, further distorting the relationship. And yet the Powell Fed raised policy rates 8 times.
To understand how the Techno-Global Revolution (TGR) impacted the Phillips Curve consider three big men jumping up and down in a small swimming pool. They create a sizable disturbance. But move the three men to the Pacific Ocean and their gyrations have no meaningful effect. The revolution in technology and globalizing the labor pool meant employers can exhaust numerous options before surrendering to demands for higher wages. As employment rises and wages lag, inflation stalls and the Phillips Curve loses all monetary policy relevancy.
Falling unemployment has Chairman Powell and other Phillips Curve devotees worried. The thinking is that seven years of near-zero rates must inevitably ignite inflation. There is no room for the TGR in Phillips Curve calculus.
Powell appeared to be on auto pilot, implementing a quarterly rate increase to combat nascent inflationary pressures. Superstitions die hard.
Powell has a second motivation to normalize rates. He wants to secure a policy cushion in the event of recession, a cushion that would give him room to drop credit costs enough to shock the economy back to life.
Powell had the temerity to broadcast his commitment to normalizing policy rates. Markets addicted to cheap credit questioned whether Powell would cause a recession before obtaining his desired cushion to combat a recession. Equities showed their displeasure and dependence on credit.
Stock market indices began plummeting in the US and abroad in December 2018. Powell reiterated his position in public statements, indicating neither market volatility nor political pressure would influence policy. Powell displayed an independent swagger befitting a Fed Chairman.
Powell was called on the carpet first by equity markets and then by the President. He wilted under the pressure. The Powell Fed buried its inflation fears and its devotion to the Phillips Curve. Powell followed in the footsteps of the previous three Chairman. The Powell Put was born and markets now know he is no Paul Volker. The put lives on and the Wizards of Wall Street are back in charge.
What would Albert say?
Einstein would be pleased to know that the Phillips Curve has, at least temporarily, been placed in the dustbin. But in observing the recurring deployment of the Fed’s Put Option he might just repeat his definition of insanity.
What does the rebirth of the Put mean to fixed income investors?
The put means that our greatest concern will not be runaway inflation and skyrocketing market interest rates, not in the age of the TGR. Instead we must prepare for the next recession with the acute awareness that rates may plummet once again to an inflation-adjusted zero bound.
Central bankers may tinker at the edges of the capitalist ecosystem with great care. Suspending creative destruction to alleviate the painful redistribution of financial resources will be met with fierce retribution by a system in search of lasting equilibrium.
Happy winter my friends. Enjoy the feeling of ice beneath your blades and snow under your skis. Remember your gloves, boots, hats and scarves. There is no substitute for being prepared even on the sunniest day.
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