A Farewell to Ultimate Power
“Considering the extraordinary character of the times in which we live, our attention should unremittingly be fixed on the safety of our country.” -Thomas Jefferson, his final message to Congress, 1809
It is always imperative for students of history to consider the words and deeds of their subject in the context of the time in which they lived. The book currently occupying my night stand is Pulitzer Prize winner John Meacham’s Thomas Jefferson, The Art of Power. I have lifted the title of this commentary and accompanying quote from chapter 39 of Meacham’s biography of America’s own Renaissance man. Meacham is better than most biographers at providing readers a rich historical backdrop to see the world through the eyes of, in this case, Thomas Jefferson.
Jefferson was our third president, serving from 1801 through 1809, sandwiched between John Adams and James Madison, two “Founding Fathers” of vastly differing politics and policies. Jefferson was the wartime Governor of Virginia and America’s first Secretary of State. Along with Ben Franklin, Jefferson was instrumental in securing the financial and military aid of France that helped to extricate the colonies from British rule.
To best understand Jefferson’s international views and the quote above we must see the world as a highly uncertain place and the fledgling America as a nation vulnerable to the “extraordinary character of the times”. Meacham writes, “Rather than recalling the Revolutionary War in its traditional way -as the armed struggle that lasted from Lexington and Concord in 1775 until the British defeat at Yorktown in 1781- it is illuminating in considering Jefferson to think of the struggle against Great Britain and its influence on American life as one that opened in 1764 and did not end until the battle of New Orleans brought the War of 1812 to a close in 1815.” Seen this way we interpret Jefferson as a man who “lived and governed in a Fifty Years War”.
Thomas Jefferson was a flawed man with extraordinary gifts who brought a capability to see the moment at hand as a thread in the continuous fabric of time. The conclusion of the Revolution was not an end to hostilities that threatened America but instead only a chapter in an unfinished book. Many a great man differed with Jefferson regarding his perceived threats to America, including George Washington. We can never know if his diligent stand as the protector of America’s sovereignty was the product of paranoia or a healthy respect for the geo-political peril of his day. What we do know is that America survived its infancy in a world filled with opportunistic predators hungry for its vast resources. Jefferson and his protégé Madison piloted America to a position of maturity and strength where it could withstand external and domestic threats to its independent democratic republic.
The Extraordinary Character of OUR Time
Thomas Jefferson identified two domestic dangers to the long term success of the American democratic republic, the corrupting power of large banks and the corrosive tendencies of political factions. The echoes of Jefferson’s beliefs will permeate this commentary as will his determination to safeguard what we all hold dear- the safety of America.
There is a recognition on the part of the Federal Reserve that the risks of its experimental policy are rising and may ultimately undermine the functionality of American capitalism. It is the extraordinary character of our times that governments and central bankers the world over have come to rely upon increasing debt and extreme monetary policies as a panacea for what ails the global economy. Some are under the illusion that the financial crisis that threatened to hobble the global economy under the weight of a debt deflation has subsided, cured by, of all things, more cheap debt and a flood of money. Some see bubbling equity markets as a sign of prosperity and the creation of jobs lacking purchasing power as indication of policy success. They fail to make the connection between the increasingly extreme monetary intervention in free market capitalism and suffocated growth. As these experimental policies have been the most aggressive in the 100 year history of the US Federal Reserve there is only speculation about the effect of these policies on the market economies of America and its trading partners. Even more worrisome we are left again with only conjecture in estimating the impact of policy reversal regardless of the promise of gradual policy change and the expectation for tempered market response. The fact that central banks worldwide are parroting the US Fed policies amplifies the risk of debilitating global contagion.
America has been adrift, her financial navigation hampered by the fog of faulty macroeconomic assumptions. Policy makers have deluded themselves and the citizenry about the efficacy of supply side stimulation, self-regulated financial markets and the power of monetary policy to shape social and economic outcomes. We have learned a hard lesson, that supply does not create its own demand and that supply side incentives unmatched by increased demand (purchasing power) leads to market disequilibrium in the form of over-capacity to produce and falling prices. We have grown all too familiar with the consequences of supporting profits and prices by substituting credit for wage growth, debt for real purchasing power and the resultant chronic shortage of demand compressed by a faltering finance based economy. We must see the financial crisis as a battle lost in a war spanning decades that is far from over. Recovery from the financial crisis is not signaled by the imminent change in Fed policy but will only be demonstrated when the global economy can withstand a market driven cost of capital and generate returns on real investment undistorted by interventionist monetary policy.
Under the continuing misguided monetary policy infecting global capitalism the ‘liquidity”, (credit or money) sloshing about has not been created to satisfy demand due to optimism for growth or quality investment opportunity. Instead this money has been produced in the ill-conceived fantasy that by adding to the money supply investment opportunity will magically appear. The global economy suffers from a multi-decade misallocation of resources -both capital and labor- that has robbed industrialist and worker alike of sustainable prosperity largely due to activist and extreme monetary intervention. In this environment of diminished investment opportunity a finance based economy directs excess money supply to market speculation. When interest rate uncertainty was replaced by “forward guidance” and a pledge of “low rates for a prolonged period” borrowing costs cratered and stocks soared in joyous reprise. The monetary policy component known as financial repression only intensifies the misallocation of resources to risk assets at prices sustained largely by folly of the policy itself.
I have often referred to the economic and social effects of the Techno-Global Revolution and will not belabor these points other than to reiterate one relevant idea. The TGR was propelled by the promise of growing profit, to produce more goods at lower production costs through labor substitution -machines for people, and labor arbitrage- outsourcing to the lowest cost provider. The revolution’s beneficiaries and advocates were little concerned about the connection between labor compensation and consumption. Much of the immediate financial benefit of the TGR was narrowly focused and tilted to capital, was short term in nature and produced a systemic illusion of sustainable growth for wealthy nations. The growth shift to emerging markets flattened labor compensation toward the lowest common denominator and shifted a significant portion of the demand burden to a labor force receiving a fraction of the compensation. This shift in production process resulted in three pronounced effects. The first effect of the TGR has been historic profit margins for international corporations, the second effect, a growing mismatch of the global capacity to consume what it produces, while the third was to waylay the American (consumer) middle class. This supply side focus encouraged workers to substitute debt for income. The TGR reduced the borrower’s capacity to service debt. For America the results manifest as stagnant wages, reduced labor participation rates, troubling wealth disparities and a Fed trapped precariously between the requirement to raise policy rates to avoid financial bubbles and the need to continue stimulating a fragile economy. The next inevitable cyclical contraction will likely be worsened by the Fed’s present attempts to circumvent it.
Capitalism is Effective but Inefficient
We have centuries of evidence that capitalism does the best job of delivering high standards of living to its citizens. It is the most effective system when allowed to evolve, eliminating the weak in favor of the strong. But it is wasteful and in times of change, frightening. Capitalism is messy stuff. Schumpeter coined the phrase “creative destruction” with purpose. The introduction of technological change continues to challenge our grasp of its impact on capital, labor and the relationship among trading partners. Politicians and central bankers are left to apply the strategies of the past to the evolving structural developments of the 21st century. In the past decade we have observed the dislocation of labor in many wealthy nations including our own. Workers skills have deteriorated, and worse, have become obsolete following the revolution. The TGR has exposed the shortfalls of our education system, one that presents students with degrees that often fail to meet the challenges of gainful employment. Monetary policy can only offer temporary and partial solutions. The structural dependence on continually declining interest rates is proving counterproductive, turning the periodic propulsion of stimulus into the drag of addiction and structural misallocation of financial and human resources. In short the steady diet of inflation adjusted free money has produced fat rather than lean muscle and America is suffering from the bloat. Our demographics will only add to the load we must endure.
It is beyond our ability to ignore the fact that as technological advances accelerate and money is more than abundant, productivity, the measure of economic efficiency is stagnating, a clear sign of the diminishing returns of not so modern policies.
Larry Summers and Structural Stagnation
Larry Summers has been a controversial, indestructible lightening rod in the field of public service. He has occupied seats of power as Chief Economist of the World Bank, Secretary of the Treasury and the President of Harvard. Larry has served as an advisor to several presidents and was summarily rejected by politicians and pundits alike for the position of Chairman of the Federal Reserve. Larry is brilliant and visionary while being socially and politically tone deaf. Larry has helped place focus on the concept of “Secular Stagnation”, a worrisome theory for those expecting a snappy turnaround in the fortunes of the post financial crisis world. In sum this theory postulates there will be a prolonged period of slow growth punctuated by cyclical ups and downs. Businesses and consumers will spend too little to ignite robust expansion, an environment where the specter of deflation and declining standards of living lingers in the background. Larry sees slow productivity growth tied to a lack of meaningful innovation attributed to misdirected education and skills mismatch. He fears the demographic bulge of retiring boomers whose pensions and health care costs grow with life expectancy, predicting considerable fiscal stress and economic drag. Summers paints a grim picture of a world of declining productivity and sputtering growth coupled with a shrinking work force with stagnant wages. This workforce of diminished capacity is saddled with the responsibility to support a generation of retirees draining national resources. Larry sights wealth inequality as a side effect of a structurally imbalanced economy that will only accentuate “chronically deficient demand”.
Larry’s signature quote on the issue of Secular Stagnation reads, “The record of industrial countries over the past 15 years is profoundly discouraging as to the prospects of maintaining substantial growth with financial stability”. It is difficult to find fault with many of Larry Summers observations, especially for a doom and gloom guy like me. Larry suggests that interest rates will be tamped down by economic necessity and monetary policy. It is this prediction that is most disturbing as it submits a continued reliance upon a futile solution set to an evolving dilemma.
If low interest rates are the constant companion of an economy struggling with the symptoms of “Secular Stagnation” what are negative interest rates signaling? What does this extreme form of financial repression say about the effectiveness of monetary policy to bring about positive results? Short term US Treasury Bill rates occasionally dip below zero and $2 Trillion in global debt confiscates investor capital through negative yields.
How Did We Get Here?
The concept of Political Economics escapes many casual observers but is central to this commentary. The political economy is a manifestation of the interplay of political and economic theory often in pursuit of financial interests and the power to influence policy. It speaks to preferences about the size and role of government and about the “solution set” of strategies intended to promote sustainable growth, low inflation, a strong currency and stable financial markets. Political economics influences the choice of policy transfer mechanisms- the solution set and its applications to achieve the goals stated above.
The pendulum of political economics swings from one school of thought to another and back again depending upon success in meeting the challenges of the times. Prior to the Great Depression Neo-Classical economics held center stage. At its foundation was Say’s Law, stating in large part that “supply creates its own demand”. In the 19th and early 20th century capitalism was a raucous game of boom and bust, inflation and deflation. The Great Depression shook the world to its roots spurring doubts about the sustainability of democracies and free markets. It was in the heat and aftershock of World War II that Keynesian economics took hold. The resulting philosophical change refocused policy from supply to demand, from unfettered markets to government intervention. Keynesian economics influenced policy makers around the globe. It combined the ideas that aggregate demand had the greatest impact on economic activity and that government should focus it powers on counter-cyclical, deficit spending and tax cuts to stimulate growth. These ideas were swept aside by changing public sentiment about big government’s ability to improve economic stability after a bout of economic stagnation and inflation crippled America.
In the early 1980’s the courageous Chairman of the Federal Reserve, Paul Volker suppressed inflation with tight money, near 20% interest rates and a crushing double dip recession. America emerged from this painful time with distaste for big government and a return to supply side economics with a heavy dose of Monetarism.
It’s All About the Money (Supply)
Milton Friedman and the Chicago School of Economics buried Keynes and concentrated world leaders and central bankers’ attention on modulating money supply as the key to sustainable economic growth and stability. Friedman’s followers included Margaret Thatcher, Ronald Reagan and more importantly for this commentary, Alan Greenspan and Ben Bernanke.
In an environment hostile to government spending programs manipulation of money cost and supply took precedence. Chairman Greenspan ignored the teachings of Hayek and Minsky and attempted to micro-manage American capitalism. Through a series of policy machinations that produced ever lower borrowing costs, a dependence on shaky financing mechanisms, long periods of calm and complacency all culminating in financial catastrophe the Chairman obscured market forces and undermined discipline. The Chairman led America through the economic looking glass on a journey that distorted our market economy and left his successors searching for a safe route back to capitalist reality.
From Greenspan to Bernanke to Yellen the solution set has largely been the same; namely pushing interest rates and money supply (debt-borrowing costs) to unprecedented levels in search of sustainable prosperity. All the while their path wandered further away from market forces that discipline sound economic choice instead meandering toward speculation of many sorts.
The Damage Done
The futile attempt to solve a debt crisis with more debt has drawn attention away from the imbalances fomented by the TGR and in fact exacerbates them. The single solution response has damaged sound business models and has punished savers in an attempt to remedy both financial and structural disequilibrium brought about by Schumpeter’s creative destruction and the antiquated monetary response. Negative rates, born of Quantitative Easing-massive direct central bank intervention in securities markets, is the logical conclusion of this failed solution set. It is difficult to say which sectors of the economy have bubbled most. I suspect we will find the answer when the free money is withdrawn here in America. Unfortunately our trading partners are stampeding ahead in a search of export growth, in a race to lower borrowing costs and exchange rates. Beggar thy neighbor policies have no winners.
Consider the plight of insurance companies and pension funds. These companies provide financial security and protection from disaster in exchange for premiums paid. Pension funds and insurance companies are safety first investors matching long term liabilities to conservative long term bond investments. The income streams from these investments pay benefits and claims to conscientious customers. Funds and insurers that stray from this model often suffer in times of market distress. These conservative business models have been forced into a predicament- sacrifice profits, reduce coverages or take greater investment risks.
These social safety nets allow Americans to participate in free market solutions to real life problems. But through the policy of financial repression the central bank has determined these business models and functions to be subservient to the perpetuation of a badly broken financial model. Sacrificing the financial interests of insurance companies, pension funds, retirees and savers to continue down this misguided path is tantamount to burning the furniture to warm the house.
Herein lies my immediate concern for the clients of ICM, our partners in public finance. Our investment options are governed by the prudent requirements of safety, liquidity and yield. We are pushed into the very markets most distorted by the policy of financial repression. Like the pension funds and insurance companies we have been forced to sacrifice current income since 2008 as we wait for the return of economic prosperity. Taxpayer funds have returned scant income since the financial crisis. That is but half the story. The cruelest blow of all may come when interest rates rise and prices decline. We first endured the meager returns of prudent investment and next may suffer from the transfer of risk resulting from a policy of financial repression.
The Investment Outlook
While we expect a gradual climb in interest rates punctuated by tantrums of price volatility and an occasional lack of liquidity what we fear is the Fat Tail risk of the unknown. We have little doubt that the predominant philosophy of the world’s central bankers will remain consistent - to put downward pressure on rates in an attempt to keep the global economy from contraction. Our focus has been on prudent duration management to limit price risk. We have maintained high credit quality to promote liquidity should markets stiffen. We encourage robust cash flow analysis and a careful look at local revenue streams to ensure timely income and maturities. In short we are expecting a bumpier ride and have prepared for the outsized potholes if or when they appear.
It is the goal of all who strive to teach that we share perspective, shaped by our times, to expand the solution sets available in the face of profound challenges. We confront current and accepted thinking, particularly when it appears to be failing to address challenges fundamental to the greater good of society. Jefferson saw the world differently from his contemporaries. He had the courage to honor his beliefs and the conviction to act upon them. He helped lay the foundation of this amazing place we call America. As I have presented ideas that run counter to the accepted logic of our economic leaders I do so with a sense of responsibility that accompanies membership in a democracy. The challenge to America’s future presented by failure to address our economic malaise is quite real and our attention “should be unremittingly fixed on the safety of our country”.
There is an important distinction between leadership and stewardship. Leaders ask others to follow, to bend to their ambitions and will, and to adopt the leader’s truth as universal. Stewards look to preserve what is in the best interest of society’s ecosystem and to build upon its strengths and remedy weakness especially in the face of challenging circumstances.
Consider the words of George Santayana, historian and philosopher, “Skepticism is the chastity of the intellect, and it is shameful to surrender it too soon or to the first suitor.” Remain skeptical dear readers and challenge accepted theory in search of sound stewardship. And recall that solution sets are not mutually exclusive - there is no absolute truth in confronting the evolutionary and messy system of capitalism.
Capitalism presents a powerful and evolutionary force of nature - an ecosystem of great promise. I have confronted the thoughts of strict monetarism and by association the ideas of Milton Friedman, but I cannot ignore his one great truth. Friedman understood that wrapped within the power of free market capitalism was a profound limitation- he said, “Free markets accomplish wonderful things but cannot ensure a distribution of income that enables all citizens to meet basic economic needs”. It is this recognition of the limits of the world’s most dynamic system we may find new solutions. Financial repression and mountains of debt are not the singular universal solution set to what ails the global economy. Jefferson and other founding fathers feared the divisiveness of factions as they promote loyalty to singular and exclusive ideas and an inelasticity of thought that by design will fail in the face of evolutionary change.
A Happy Spring to All!
ICM Founder & President