March 31, 2019
The halls of higher learning can be glorious.
Except for economists. Their science has been called dismal. Their outlook is often dreary. And they are so often wrong.
Eric P. Leve, CFA: Many of us at Bailard are schooled in economics. Yet, we chose to pursue finance, which affords the luxury of picking among economic insights for the few indicators that actually translate into investment outcomes. Still, we are all consumers, residents and savers, all the things economists would call economic agents and the broader economy does affect us day-to-day. More than any time in the past century, the litany of economic theories has broadly failed to describe life after the Great Financial Crisis (GFC). Here, Peter and I ruminate on that and come to some conclusions as to the sources of this failure.
Peter M. Hill: Eric, a useful intro but I think the failure goes far beyond this post-GFC era. While the U.S. believed it had beaten the 1960’s business and economic cycle through Keynesian tools (namely, counter-cyclical fiscal policy), back home in Britain we were experiencing what would later become known in the U.S. as stagflation, or the combination of low growth and high inflation.
This was something deemed unlikely by Keynesian thinkers. It was a far cry from the levels of inflation and severity of stagflation experienced in both nations in the wake of the 1973 oil embargo.
Eric: You’re right. And that 1970’s experience also slayed the idea of the Phillips Curve: a trade-off between unemployment and inflation. This “death” of the Phillips Curve seems to describe a lot of economic theories. These theories get promulgated as a “law” of economics. Then real-time experience leads economists to recognize that the “law” is simplistic, with a limited scope or time-frame to evaluate true efficacy.
Peter: Even further, it’s funny how some of these theories get completely flipped around. Economists used to talk about “crowding out,” or the risk that indebted governments issuing too much debt would push interest rates so high that corporate borrowers would be crowded out by the interest rate levels. This would result in the government needing to again issue more debt, thus reducing the economic growth that may have been generated by that corporate borrowing. Now, it’s the inverse. We talk of “crowding in,” or the idea that, in times when economic growth is tepid, consumers and corporations rein in their spending out of fear. Government spending leads to an increase in Gross Domestic Product (GDP), which reduces the fear and brings back those animal spirits. For me, that’s a theory that sounds a lot like Keynesianism rehashed. And it certainly hasn’t passed the sniff test any time in my life.
One knee-jerk version of the crowding-in theory might be TARP (the Troubled Asset Relief Program), a program begun in the weeks after the demise of Lehman Brothers in autumn of 2008. At its peak, TARP had made loans or investments totaling more than $400 billion1 dollars to most of the major banks in the U.S., American International Group and two of the major U.S. automakers. It undoubtedly staved off some bankruptcies and provided some succor during the worst financial crisis since the Great Depression, but it is very difficult to tell if it produced a net benefit to U.S. GDP.
Eric: This brings us to the economic theory flavor of the day: Modern Monetary Theory (MMT). This one’s a non-starter from the beginning. MMT promises the world and has been promulgated by the media but yet rests on no economic orthodoxy. The theory posits that a government can create full employment by printing money and pushing its economy to full capacity without the messiness of collecting taxes. Only when the government’s Delphic oracle sees inflation on the horizon does the government then hit the brakes on the economy by imposing taxes and selling bonds to draw all those excess dollars out of circulation. Call me simple, but I can’t imagine a politician with the will to pull that lever. It defies both common sense and human behavior. That said, the seeds of MMT are painfully obvious. In 1962, the richest 1% of Americans and the bottom 90% had an equal share of the American pie, each about 33%. According to the National Bureau of Economic Research, as of 2016, the 1% held 40% of the country’s wealth and the 90% held barely over 21%. Income disparities have driven these wealth gaps as labor’s share of the riches have diminished relative to those that have accrued to capital. Policy may be able to ameliorate some of that but, through industrial revolutions of the sort we’re currently experiencing, income disparities often lasts for a generation.
Peter: Perhaps inflation is an even bigger issue for these theories. Where has it gone? Japan’s equity bubble burst late in 1989 and began a five-year path to near-zero inflation, a level it has now been stuck at for more than 20 years. Japan’s “lost decade” has become a lost generation. In that period, the rest of the world looked on with measures of schadenfreude as their own economies and financial markets continued to hum along. The GFC turned out to be a similar watershed event for the U.S. and Europe which—in spite of exceptionally-loose monetary policy—have been unable to engender either growth or inflation since then.
Eric: I think the Western world has caught up to Japan. The rapidly-aging Japanese population was a demographic time bomb that only preceded the rest of the developed world by 20 years. As consumers age (with fewer children born to replace them and/or restricted immigration), an economy’s average age also rises. Older people tend to spend less and to bias their investments more to bonds than to equities. These forces together can lead to endemically lower interest rates. Economists now think the “neutral rate of interest,” the level of short-term interest rates at which an economy experiences full employment and stable inflation,2 is much lower than it has been for most of modern history. And, given current demographic trends, it may stay low for a very long time. This may mean the traditional economic chestnut where rising levels of debt lead to higher interest rates may not play out in the short or medium term. In this case, a fresh perspective on the economic landscape is not favorable for savers: a scenario with continued, rather low interest rates coupled with the risk that future rates could spike higher than traditional models might have expected. A possible catalyst for that is the incremental changes in central bank balance sheets away from holdings of U.S. Treasury debt into other currencies and gold.
Peter: Thanks, Eric. An interesting conversation but, as you and I know, predicting economic outcomes is a very tough game. Even doing it well doesn’t necessarily tell us all that much about other markets, like equities. So far, this low interest rate environment has been a strong tailwind for global stocks, and may well continue to be.