April 9, 2015


This month let’s continue our discussion regarding the evolving global economic landscape in the world of unprecedented monetary policy.  Increasingly, central bank policies are driving the pricing of assets; as asset prices become more disconnected from underlying fundamentals.  While prices continue to rise, economic weakness persists but that does not matter in an environment where any return is better than nothing found in low risk instruments, courtesy of our Federal Reserve.  The danger lies in the fact that the deteriorating marginal prospective return from various asset classes lies juxtaposed to a significant and widening probability of meaningful losses when prices reconnect to reality.  The Fed has engineered an uninterrupted climb in pricing so that investors are willing to accept lower and lower returns in the belief that any day of reckoning is sufficiently far away or simply will not happen for the fact that it has not happened yet after all this time. 


The Economic Cycle Research Institute [ECRI] recently penned an article that identifies what may be coming next from global governments in the wake of continued economic weakness.  The following text is from a piece from April 1 titled “Circling The Drain.”


“The world today is awash in unprecedented amounts of debt – more than ever before in human history.  According to McKinsey, all major economies today have higher Debt/GDP ratios than in 2007, with corporate debt about 1.5 times, and government debt over 1.75 times as large.  As a result, global debt has grown to some $200 trillion.”


“In the aggregate, the two ways these debts can be repaid over time are by generating sufficient real growth to do so; or by inflating away the debts, so that they can be repaid in currency that is worth much less.”


“As we have pointed out before in the context of ‘the yo-yo years,’ real GDP growth has been stair-stepping down for decades in most advanced economies.  More recently we have also noted that export prices – especially for emerging economies – have been exhibiting deflationary patterns for years, and those for advanced economies are also showing deepening deflation (International Cyclical Essentials, January 2015).”


“The hard reality is that there is no magic bullet to get stronger growth – certainly not QE, which merely attempts to pull demand forward from the future, leaving even less residual demand for later.  The other way out of the debt trap – generating inflation – is not really possible through currency devaluation because, in the aggregate, the pressures are on every economy to devalue along with others.”


“At best, economies can take turns devaluing their currencies, as they are doing now, but without much success in igniting inflation.  For instance, Japanese core inflation, adjusted for last year’s tax hike, has now dropped to zero.”


“The larger point is that, in the fullness of time, all the major economies are likely to face a day of reckoning – and earlier than most expect.  Sooner or later, the prospects of default or an equally unpalatable alternative like much higher taxes is likely to loom.  But the process may involve a rush to a succession of ‘safe’ assets in the interim, even though all of these economies are effectively circling the drain.”


“Desperate but ineffectual efforts to attain ‘escape velocity’ or even the inflation target are failing, despite round after round of QE.  To quote John Maynard Keynes from eight decades ago, ‘When the rate of interest has fallen to a very low figure and has remained there sufficiently long to show that there is no further capital construction worth doing even at that low rate, then I should agree that the facts point to the necessity of drastic social changes directed towards increasing consumption.  For it would be clear that we already had as great a stock of capital as we could usefully employ.’  What drastic social changes the present situation might ultimately require remains to be seen.”




Instead of following the more prudent economic thought found in Austrian economic beliefs which disagree with Keynes, our political leaders including the Federal Reserve believe that Keynesian philosophies that promote the government doing more and more in times of economic strain work best.  It is probably more their wanting to convey to their constituents “all that they are doing to help them” and/or for the retention of power, instead of a true understanding of the economic consequences, that make virtually all governments pursue the ideals of Keynes.


Therefore, if we are going to continue to be led by the belief that government is the answer in times of economic weakness instead of letting free markets work, we should pay attention to the quote by Keynes in the article from ECRI.  Let me quote it once again since it has significant ramifications to what may be coming sooner than later.  “When the rate of interest has fallen to a very low figure and has remained there sufficiently long to show that there is no further capital construction worth doing even at that low rate, then I should agree that the facts point to the necessity of drastic social changes directed towards increasing consumption.  For it would be clear that we already had as great a stock of capital as we could usefully employ.”


Let’s take a look each part of his statement briefly.  Interest rates are at zero and have been there for going on seven years.  And, the economy remains very weak with muted capital spending.  That should be sufficient to satisfy Keynes’ criteria for moving on to his recommendation for the necessity of drastic social changes to increase consumption.  The final part of his quote basically suggests that once the economy has reached that point, more monetary policy actions will have little effect.  I would argue that monetary policy has had more of a detrimental effect, but we are looking here at the perspective of our political leaders to anticipate what they may conjure up next. 


So, that leads to the action of “drastic social changes directed towards increasing consumption.”  If we did not have gridlock in Washington, we would already be seeing the beginnings of such action.  Who knows what types of actions the government may think of but we will likely see tax and spend programs surface that are more radical than we have seen before.  If you do not think so; who would have imagined as late as 2006, the radical monetary actions that have subsequently occurred? 


Remember, the politicians have a strong incentive to be able to tell their constituents that they are doing something to help the situation.  The problem is that much of the problem comes from what they have done before, so more radical ideas are likely to dig the hole deeper.  Think this is far-fetched?  Just remember the social agenda a number of years ago by our government, that everyone should own a home.  That “entitlement” subsidized purchases of homes with too much cheap and easy debt by people who were not in position to afford it, and that led to a massive bubble and bust. 




One factor that will likely influence the “drastic social changes directed towards increasing consumption” is the growing income gap between the middle-to-low income earners and the high income earners.  The gap is at historical highs and many of the initial tactics will likely be focused on taking more from the high income group and trying to push it into the hands of the lower income group for the purposes generating more “consumption” [which is spending] in the economy.  Just read the latest thoughts from Mohamed El-Erian who used to be the CEO of Pimco and is a significant influencer of economic policy within the government.


“Income inequality has risen so much that consumption as a whole is undermined.  That’s because rich people have a much lower propensity to consume than poor people.  But it is the rich people that have captured all the income growth for the last seven years.”


“A little bit of inequality is good for the system because it creates incentives.  A lot of inequality actually creates negative economic effects.  It has become an inequality of opportunity.”


“The government should be using fiscal policy – taxing the rich more and supporting the sectors that are critical to equality of opportunity: like education and health.  I would remove loopholes that are being taken advantage of by the rich.  I would tax private equity [more].  The inheritance tax should be higher.”


It is ironic that many of the same people as well as the government who encouraged this extreme monetary policy which is THE driving force behind the income gap, are now the same ones saying that the government needs to do more to solve the problem.  They are now looking to take from the segment of the population that their own policies benefitted the most.  If you step back and think through the progression of government and monetary policies over the last two decades as well as anticipate what is to come, you find yourself in a vortex of circular reasoning and hypocrisy.  Need just one example to get your thoughts going:  government spends, government issues bonds [debt] to finance the spending, government prints money to buy the same bonds itself is issuing.


The combination of weak economic growth, extreme monetary policy that has exhausted itself, a growing perception of inequality between economic classes and a government with the proclivity to “do more” is a recipe for “drastic social changes” prescribed by Keynes.  According to Keynes, the drastic social changes are supposed to be targeted at increasing consumption in the economy to try to revive it in the midst of failing monetary policy.  As El-Erian said, lower income groups have more propensity to consume [spend] from incremental income than higher income groups.  That is why we are likely to see these anticipated “drastic” measures to be fueled by an underlying motive of redistribution of wealth.  In a sense what they are saying is that, “Since our monetary policies benefited the wrong group, we are going to take more overt measures to get that money back and put it in the hands of those which our political leaders say they are helping in all of their speeches.”  Remember the quote from one of our Presidents who had some of the best lines, “The most terrifying words in the English language are ‘I’m here from the government, and I’m here to help.’”


Even though the next significant push by the government to try and fuel economic growth may come from the fiscal side, we will continue to see the Fed use monetary policy in an active way.  Even though they have communicated that they want to raise rates possibly in June, I continue to think that they will either not raise rates this year or if they do it will later be viewed as a policy mistake by the financial community.




Not only has growth slowed back down as we will see first quarter GDP come in between zero and one percent, but the deflationary pressure that the Fed is concerned about continue.  Let’s look at a few charts to illustrate this.  First, this is a view of one of the inflation metrics the Fed watches her in the U.S.



This next chart shows that 70% of the world’s developed markets have inflation below 0.5% which is getting close to the reading at the peak of the financial crisis in 2008.  This is reflected in the fact that trillions in the global bond markets currently have negative yields.



This next chart shows that about 70% of the world’s emerging markets have negative inflation rates on the producer prices end, or corporate inputs.



These inflation metrics suggest that global monetary policy is going to continue to be very active and Europe’s big round of money printing is just getting ramped up now.




This continued aggressive global monetary policy may also continue to fuel speculation in financial assets.  I have discussed numerous times about record margin debt here in the U.S.  However, it has not reached the vertical rise seen in China.  Here is a chart showing stock purchases on margin in China. 





On the subject of China, an interesting development occurred in the area of global finance in March.  Here is a summary by a Reuters’ article on March 22.  “Sometime geopolitical shifts happen by accident rather than design.  Historians may record March 2015 as the moment when China's chequebook diplomacy came of age, giving the world's number two economy a greater role in shaping global economic governance at the expense of the United States and the international financial institutions it has dominated since World War Two.  This month European governments chose, in an ill-coordinated scramble for advantage, to join a nascent, Chinese-led Asian Infrastructure Investment Bank (AIIB) in defiance of Washington's misgivings.”  Since China was not receiving the influence it desired in the IMF, they decided to create their own world bank and many of our allies quickly joined against our wishes.  So far, this will have minor influence but it is a development worth monitoring as there is an underlying sense that world governments want to diversify away from a U.S. dollar centric world of influence, trade, and monetary exchange. 


Let’s wrap up for this month.  Since our policy leaders pursue economic thought by Keynes, it will be useful to know what actions he would have likely taken at this point in the economic cycle.  It looks like the focus as some point relatively soon may shift from the monetary side to the fiscal side.  While monetary policy will remain at extreme levels, there will be an incremental push from the tax and spend mindset to shift dollars from high income earners to lower income earners.  This redistribution strategy to reinvigorate consumption in the economy by moving dollars to those with a greater propensity to spend will have plenty of its own unintended consequences. 




If the Federal Reserve and the government let the free market finish the cleansing process started in 2008, we would not be in this quagmire now.  There are those that think we would be much worse off, but I think the pain in ’08 would have lasted longer and would have been worse, but it would have been healthy from a longer-term perspective and we would be back on a productive course by now.  Instead, the global economies still face a day of reckoning and all of the monetary actions by global central banks have only fueled more excesses that we have to deal with at some future date.


For now, the speculation continues as it has only paid to follow the printing press and ignore the fundamental supports like antiquated metrics such as valuation.  Just don’t lose sight of what is likely to come.



Joseph R. Gregory, Jr.





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