It’s the Fed, Stupid!

A Messaging Tip For The Donald: It’s The Fed, Stupid!

The Fed’s core policies of 2% inflation and 0% interest rates are kicking the economic stuffings out of Flyover AmericaThey are based on the specious academic theory that financial gambling fuels economic growth and that all economic classes prosper from inflation and march in lockstep together as prices and wages ascend on the Fed’s appointed path.

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Statistical Fixations

Martin Feldstein is nowhere near as excitable as David Stockman on Fed manipulations (link to D.S.’s commentary), but they both end up at the same place: the enormous risks we are sowing with abnormal monetary policies. The economy is not nearly as healthy as the Fed would like, but pockets of the economy are bubbling up while other pockets are still deflating. There is a correlation relationship, probably causal.

The problem with “inflation targeting” is that bubble economics warps relative prices and so the correction must drive some prices down and others up. In other words, massive relative price corrections are called for. But inflation targeting targets the general price level as measured by biased sample statistics – so if the Fed is trying to prop up prices that previously bubbled up and need to decline, such as housing and stocks, they are pushing against a correction. The obvious problem has been these debt-driven asset prices, like stocks, government bonds, and real estate. In the meantime, we get no new investment that would increase labor demand.

The global economy needs to absorb the negative in order to spread the positive consequences of these easy central bank policies. The time is now because who knows what happens after the turmoil of the US POTUS election?

Ending the Fed’s Inflation Fixation

The focus is misplaced—and because it delays an overdue interest-rate rise, it is also dangerous.

By MARTIN FELDSTEIN
The Wall Street Journal, May 17, 2016 7:02 p.m. ET

The primary role of the Federal Reserve and other central banks should be to prevent high rates of inflation. The double-digit inflation rates of the late 1970s and early ’80s were a destructive and frightening experience that could have been avoided by better monetary policy in the previous decade. Fortunately, the Fed’s tighter monetary policy under Paul Volcker brought the inflation rate down and set the stage for a strong economic recovery during the Reagan years.

The Federal Reserve has two congressionally mandated policy goals: “full employment” and “price stability.” The current unemployment rate of 5% means that the economy is essentially at full employment, very close to the 4.8% unemployment rate that the members of the Fed’s Open Market Committee say is the lowest sustainable rate of unemployment.

For price stability, the Fed since 2012 has interpreted its mandate as a long-term inflation rate of 2%. Although it has achieved full employment, the Fed continues to maintain excessively low interest rates in order to move toward its inflation target. This has created substantial risks that could lead to another financial crisis and economic downturn.

The Fed did raise the federal-funds rate by 0.25 percentage points in December, but interest rates remain excessively low and are still driving investors and lenders to take unsound risks to reach for yield, leading to a serious mispricing of assets. The S&P 500 price-earnings ratio is more than 50% above its historic average. Commercial real estate is priced as if low bond yields will last forever. Banks and other lenders are lending to lower quality borrowers and making loans with fewer conditions.

When interest rates return to normal there will be substantial losses to investors, lenders and borrowers. The adverse impact on the overall economy could be very serious.
A fundamental problem with an explicit inflation target is the difficulty of knowing if it has been hit. The index of consumer prices that the Fed targets should in principle measure how much more it costs to buy goods and services that create the same value for consumers as the goods and services that they bought the year before. Estimating that cost would be an easy task for the national income statisticians if consumers bought the same things year after year. But the things that we buy are continually evolving, with improvements in quality and with the introduction of new goods and services. These changes imply that our dollars buy goods and services with greater value year after year.

Adjusting the price index for these changes is an impossibly difficult task. The methods used by the Bureau of Labor Statistics fail to capture the extent of quality improvements and don’t even try to capture the value created by new goods and services.

The true value of the national income is therefore rising faster than the official estimates of real gross domestic product and real incomes imply. For the same reason, the official measure of inflation overstates the increase in the true cost of the goods and services that consumers buy. If the official measure of inflation were 1%, the true cost of buying goods and services that create the same value to consumers may have actually declined. The true rate of inflation could be minus 1% or minus 3% or minus 5%. There is simply no way to know.

With a margin of error that large, it makes no sense to focus monetary policy on trying to hit a precise inflation target. The problem that consumers care about and that should be the subject of Fed policy is avoiding a return to the rapidly rising inflation that took measured inflation from less than 2% in 1965 to 5% in 1970 and to more than 12% in 1980.

Although we cannot know the true rate of inflation at any time, we can see if the measured inflation rate starts rising rapidly. If that happens, it would be a sign that true inflation is also rising because of excess demand in product and labor markets. That would be an indication that the Fed should be tightening monetary policy.

The situation today in which the official inflation rate is close to zero implies that the true inflation rate is now less than zero. Fortunately this doesn’t create the kind of deflation problem that would occur if households’ money incomes were falling. If that occurred, households would cut back on spending, leading to declines in overall demand and a possible downward spiral in prices and economic activity.

Not only are nominal wages and incomes not falling in the U.S. now, they are rising at about 2% a year. The negative true inflation rate means that true real incomes are rising more rapidly than the official statistics imply. [Sounds good, huh? Not quite. Read Stockman’s analysis.]

The Federal Reserve should now eliminate the explicit inflation target policy that it adopted less than five years ago. The Fed should instead emphasize its commitment to avoiding both high inflation and declining nominal wages. That would permit it to raise interest rates more rapidly today and to pursue a sounder monetary policy in the years ahead.

inflation-vs-employment

Piqued by Piketty?

“Money makes money. And the money that money makes makes more money.”

– Benjamin Franklin

bankers2

Over the past 18 months there’s been a gushing and gnashing over the book by French economist Thomas Piketty, Capital in the Twenty-first Century. I have to admit I’m a bit late to the party and am just getting around to reading (perusing?) it. (I have a good excuse – an 18 mo. old baby.)

Seems most of the feedback has been delineated by political ideology – the left embraces Piketty’s work and the right dismisses it. Perhaps we can pursue a non-ideological tack to dissect Piketty’s take on capitalism.

Piketty has been rightly praised for the work he has led on the collection of historical wealth and income data, and he generously offers this data to the world for future study. Most of the controversy involves his particular interpretation of these historical statistics, claiming that inequalities have reached the same levels as the roaring ’20s a century earlier. Depending on one’s measures and comparisons, that might be argued as true. The devil is in the details.

Piketty makes broad claims that inequality is inherent to the internal dynamics of capitalist markets and that the interim period – 1930s-1970s – was a reversal due to the wealth destruction of the Great Depression and WWII. Then he explicates his “law” of capital that the rate of return on capital (r) will always exceed the rate of economic growth (g), leading to ever narrower concentrations of wealth among the owners of capital. But this is too broad a brush.

We need to unbundle the capitalist wealth creating process and the dynamics of distribution in order to understand why the data looks the way it does. How, when and why does r exceed g and what are the distributional consequences? Piketty so far has not provided satisfying answers.

First, he defines capital as the stock of all assets held by private individuals, corporations and governments that can be traded in the market no matter whether these assets are being productive or not. This includes land, real estate and intellectual property rights as well as collectibles such as art and jewelry. Thus, there is no distinction made between financial or physical capital or non-productive real assets and thus no explanation for why different asset classes might experience varying growth rates and what that means for wealth and incomes. The return on capital does not always exceed the growth rate and will often drop precipitously over the business or trade cycle, as well as due to the falling marginal rate of return on existing investment. (Certainly r was negative for a considerable period of time during the Great Depression, the 70s stagnation and our recent Great Recession.) With his broad brush, Piketty ignores these insightful details.

Financial assets, as claims on real assets (a form of derivative really), often fluctuate more widely than real assets. Real asset classes that are illiquid, such as art and real estate, often don’t trade, thus making true value difficult to ascertain. Let us explain why this matters (see Figure I.1 below from Piketty’s dataset): The two periods that Piketty claims represent his conclusion on inequality (red circles) were both marked by financial asset bubbles fomented by easy credit bubbles (green squares). In both cases, when the credit crunch inevitably came, these asset prices adjusted quite drastically and quickly, erasing much of the wealth accumulated during the bubble (look at the wealth shares of the 1% over time – it’s quite a roller coaster ride). The difference today is that we have harnessed public credit to maintain these inflated asset prices. Let me make the difference plain: in the panic of 1929 and the early ’30s stock brokers jumped out of windows to their untimely deaths; after the panic of Lehman’s collapse, they jumped out with Federal Reserve-issued parachutes and landed safely on their yachts and vineyards.

Income-USA-1910-2010Piketty’s graph does highlight a concern here. The massive crash in asset prices and capital incomes after 1940 was surely due to the destruction of WWII when high property values in Europe became worthless. The central banks of the world have done their utmost to prevent such a crash after 2008, but one can still manage a price correction to reassert pre-bubble values. Admittedly, this is difficult to do with debt and requires a lot of bankruptcy that needs to be managed. But instead we’ve reflated the bubble asset prices at the high end, and with them the high incomes derived from capital. Life is good when you’re the king (or the Fed chairperson).

Second, we should understand that housing is playing an outsized role in our recent widening of wealth inequality. Housing policy rewarded real estate investments over other investments during the long credit bubble that accompanied the maturation of the baby boom generation (green square on right). This gave the housing sector a double stimulus: rising demand plus a generous tax preference. When housing wealth is stripped from the current distribution of capital, wealth inequality appears much flatter (see Rognlie).

So, rather than some immutable law of capitalism, perhaps Piketty has identified an artifact of short-sighted policy, especially by central banks and government housing policy. In our recent financial market “correction,” these asset prices have not really corrected, as de-leveraging of private credit (mostly in the FIRE sector) has merely been assumed by public credits. The Fed has expanded its balance sheet by about $4.5 trillion and the Treasury has increased the total debt by almost $8 trillion. With all that liquidity sloshing around, the rich have gotten richer because of their ownership of capital assets, both real and financial, while economic growth and employment have stagnated because of de-leveraging and the uncertainty of price distortions keyed off a deliberately depressed interest rate. These monetary and fiscal policies have greatly aggravated inequality and created the more serious problem of allowing those with inflated financial assets to trade them for more permanent real assets, thus narrowing the control over these real asset classes. In the distant past this was called feudalism and we risk recreating such class distinctions.

Nevertheless, Piketty hits on some key truths about the workings of capitalism, none of which are really new but are worth reiterating. First, we call it CAPITAL-ism for a reason – it depends on the accumulation and productive deployment of capital in order to create wealth. To quote Ben Franklin: “Money makes money. And the money that money makes makes more money.”

For the same reason we don’t call it LABOR-ism, because capitalism is about successful risk-taking and our property rights legal system assigns risks and returns to a priori ownership claims. For too long we’ve understood the distributional mechanism of capitalism to be wage incomes, when an increasing share of that distribution is remitted through capital ownership claims on profits. Technology and globalization has only amplified this trend. In addition, a mature capitalist society with an aging demographic depends on an increasing share of rents earned by accumulated capital.

The growing disparity of wage incomes can be largely traced to incomes associated with financial capital, such as in the FIRE sector, and by winner-take-all, or superstar, markets in many professions such as entertainment and sports, but also among corporate managerial elites. In a free and just society this inequality needs to be addressed, but turning back to a laborist model of economic development would mean turning back the tides of trade and freedom.

Rather, we need to promote capital accumulation across the broadest stretch of the population. This simple graph of the relationship between physical capital per worker and income shows the symbiosis between these two factors of production – we merely need to cease dividing them into their antagonistic corners through misguided tax policy.

capital-income – from David Weil, Economic Growth.

In addition, we need policies that promote long-term risk-taking and risk management and de-emphasize short-term asset trading. A return to saving and prudent investment will require disciplinary constraints on credit policy, something we’ve lost with too much central bank discretion over monetary policy. The question is how will we attain that discipline with a fiat monetary regime that allows credit creation according to the policy whims of the central bank and the Treasury?

The answers to inequality are not simple and certainly more complex than Piketty’s retrograde and admittedly unworkable proposal of taxing capital for redistribution by the state. The leftist appeal of this argument readily embraces the idea that wealth in private hands is somehow more easily abused than wealth in the hands of politicians and bureaucrats. Tell that to the victims of statism across former Soviet societies. Instead, wealth should be enjoyed by the widest possible swath of the citizenry to be earned by the sweat of their brows and the liberated ingenuity of their imaginations. As I presented in an earlier post, Billie Holiday makes the most insightful observation when it comes to our capitalist society: “God Bless the Child that’s got his own.”

Recovery?

QE

We have enough data and David Stockman nails it on the head here…

Q4 Obliterates The Case For QE And ZIRP

by  • February 27, 2015

The most important number in today’s Q4 GDP update was 2.3%. That’s the year/year change in real final sales from Q4 2013. As an analytical matter it means that the Great Slog continues with no sign of acceleration whatsoever.

Indeed, the statistical truth of the matter is that this year’s result amounted to a slight deceleration—–since the Y/Y gain in real final sales for Q4 2013 was 2.6%.  But beyond the decimal point variation the larger point is this: Take out the somewhat jerky quarterly impacts of inventory stocking and destocking, and view things on a year/year basis to eliminate seasonal maladjustments and data collection and timing quirks, such as the double digit gain in defense spending during Q3 and the negative rate for Q4, and what you get is a straight line slog since the recession ended in 2009.

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Currency Wars (and more…)

QE Forever

This article explains in greater detail a subject I addressed in a recent comment in the Wall St. Journal:

“…our macroeconomic models are wholly incapable of incorporating operational measures of uncertainty and risk as variables that affect human decision-making under loss aversion. We’ve created this unmeasurable sense of uncertainty by allowing exchange rates to float, leading to price volatility in asset markets because credit policy is unrestrained.

The idea of floating exchange rates was that currency markets would discipline fiscal policy across trading partners. But exchange rates don’t directly signal domestic voters in favor of policy reform and instead permit fiscal irresponsibility to flourish. Lax credit policy merely accommodates this fiscal fecklessness. The euro and ECB were tasked with reining in fiscal policy in the EU, but that has also failed with the fudging of budget deficits and the lack of a fiscal federalism mechanism.

The bottom line is that we do NOT have a rebalancing mechanism for the global economy beyond the historic business cycles of frequent corrections that are politically painful. The danger is we now may be amplifying those cycles.”

From Barron’s:

Currency Wars: Central Banks Play a Dangerous Game

As nations race to reduce the value of their money, the global economy takes a hit.”

Feb. 13, 2015
It’s the central banks’ world, and we’re just living in it. Never in history have their monetary machinations so dominated financial markets and economies. And as in Star Trek, they have gone boldly where no central banks have gone before—pushing interest rates below zero, once thought to be a practical impossibility.At the same time, central bankers have resumed their use of a tactic from an earlier, more primitive time that was supposed to be eschewed in this more enlightened age—currency wars.
The signal accomplishment of these policies can be encapsulated in this one result: The U.S. stock market reached a record high last week. That would be unremarkable if central bankers had created true prosperity.
But, according to the estimate of one major bank, the world’s economy will shrink in 2015, in the biggest contraction since 2009, during the aftermath of the financial crisis. That is, if it’s measured in current dollars, not after adjusting for inflation, which the central bankers have been trying desperately to create, and have failed to accomplish thus far.
Not since the 1930s have central banks of countries around the globe so actively, and desperately, tried to stimulate their domestic economies. Confronted by a lack of domestic demand, which has been constrained by a massive debt load taken on during the boom times, they instead have sought to grab a bigger slice of the global economic pie.Unfortunately, not everybody can gain a larger share of a whole that isn’t growing—or may even be shrinking. That was the lesson of the “beggar thy neighbor” policies of the Great Depression, which mainly served to export deflation and contraction across borders. For that reason, such policies were forsworn in the post–World War II order, which aimed for stable exchange rates to prevent competitive devaluations.

Almost three generations after the Great Depression, that lesson has been unlearned. In the years leading up to the Depression, and even after the contraction began, the Victorian and Edwardian propriety of the gold standard was maintained until the painful steps needed to deflate wages and prices to maintain exchange rates became politically untenable, as the eminent economic historian Barry Eichengreen of the University of California, Berkeley, has written. The countries that were the earliest to throw off what he dubbed “golden fetters” recovered the fastest, starting with Britain, which terminated sterling’s link to gold in 1931.

This, however, is the lesson being relearned. The last vestiges of fixed exchange rates died when the Nixon administration ended the dollar’s convertibility into gold at $35 an ounce in August 1971. Since then, the world has essentially had floating exchange rates. That means they have risen and fallen like a floating dock with the tides. But unlike tides that are determined by nature, the rise and fall of currencies has been driven largely by human policy makers.

Central banks have used flexible exchange rates, rather than more politically problematic structural, supply-side reforms, as the expedient means to stimulate their debt-burdened economies. In an insightful report last week, Morgan Stanley global strategists Manoj Pradhan, Chetan Ahya, and Patryk Drozdzik counted 12 central banks around the globe that recently eased policy, including the European Central Bank and its counterparts in Switzerland, Denmark, Canada, Australia, Russia, India, and Singapore. These were joined by Sweden after the note went to press.

In total, there have been some 514 monetary easing moves by central banks over the past three years, by Evercore ISI’s count. And that easy money has been supporting global stock markets (more of which later).

As for the real economy, the Morgan Stanley analysts write that while currency devaluation is a zero-sum game in a world that isn’t growing, the early movers are the biggest beneficiaries at the expense of the late movers.

The U.S. was the first mover with the Federal Reserve’s quantitative-easing program. Indeed, it was the initiation of QE2 in 2010 that provoked Brazil’s finance minister to make the first accusation that the U.S. was starting a currency war by driving down the value of the dollar—and by necessary extension, driving up exchange rates of other currencies, such as the real, thus hurting the competitiveness of export-dependent economies, such as Brazil.

Since then, the Morgan Stanley team continues, there has been a torrent of easings (as tallied by Evercore ISI) to pass the proverbial hot potato by exporting deflation. That has left just two importers of deflation—the U.S. and China.

The Fed ended QE last year and, according to conventional wisdom, is set to raise its federal-funds target from nearly nil (0% to 0.25%) some time this year. That has sent the dollar sharply higher, resulting in imported deflation. U.S. import prices plunged 2.8% in January, albeit largely because of petroleum. But over the past 12 months, overall import prices slid 8%, with nonpetroleum imports down 1.2%.

China is the other importer of deflation, they continue, owing to the renminbi’s relatively tight peg to the dollar. The RMB’s appreciation has been among the highest since 2005 and since the second quarter of last year. As a result, China has lagged the Bank of Japan, the ECB, and much of the developed and emerging-market economies in using currency depreciation to ease domestic deflation.

The bad news, according to the Morgan Stanley trio, is that not everyone can depreciate their currency at once. “Of particular concern is China, which has done less than others and hence stands to import deflation exactly when it doesn’t need to add to domestic deflationary pressures,” they write.

But they see central bankers around the globe being “fully engaged” in the battle against “lowflation,” generating monetary expansion at home and ultralow or even negative interest rates to generate growth.

The question is: When? Bank of America Merrill Lynch global economists Ethan Harris and Gustavo Reis estimate that global gross domestic product will shrink this year by some $2.3 trillion, which is a result of the dollar’s rise. To put that into perspective, they write, that’s equivalent to an economy somewhere between the size of Brazil’s and the United Kingdom’s having disappeared.

Real growth will actually increase to 3.5% in 2015 from 3.3% in 2014, the BofA ML economists project; but the nominal total will decline in terms of higher-valued dollars. The rub is that we live in a nominal world, with debts and expenses fixed in nominal terms. So, the world needs nominal dollars to meet these nominal obligations.

A drop in global nominal GDP is quite unusual by historical standards, they continue. Only the U.S. and emerging Asia are forecast to see growth in nominal-dollar terms.

The BofA ML economists also don’t expect China to devalue meaningfully, although that poses a major “tail” risk (that is, at the thin ends of the normal, bell-shaped distribution of possible outcomes). But, with China importing deflation, as the Morgan Stanley team notes, the chance remains that the country could join in the currency wars that it has thus far avoided.

WHILE ALL OF THE central bank efforts at lowering currencies and exchange rates won’t likely increase the world economy in dollar terms this year, they have been successful in boosting asset prices. The Standard & Poor’s 500 headed into the three-day Presidents’ Day holiday weekend at a record 2096.99, finally topping the high set just before the turn of the year.

The Wilshire 5000, the broadest measure of the U.S. stock market, surpassed its previous mark on Thursday and also ended at a record on Friday. By Wilshire Associates’ reckoning, the Wilshire 5000 has added some $8 trillion in value since the Fed announced plans for QE3 on Sept. 12, 2012. And since Aug. 26, 2010, when plans for QE2 were revealed, the index has doubled, an increase of $12.8 trillion in the value of U.S. stocks.

The Bubble Economy Redux

cartoon-bubble-v31

Good article. A little sunshine goes a long way. The reason QE hasn’t caused inflation is because of massive disinflationary forces around the world unleashed by excessive credit and debt creation. People won’t borrow at low interest rates if they already have too much debt, they merely refinance. Banks also do not want to lend in an uncertain monetary environment with distorted prices of collateral, so they leave their excess reserves idle or buy Treasury bonds and earn the difference.

But QE HAS generated much asset price inflation in real and financial assets, hence the booms in select housing, land, art, and financial markets. The Fed thus has caused relative price distortion that is greatly impeding long-term risk-taking, production, and job creation. Is this a secret? I think not. Time for a reckoning of monetary and fiscal policy.

From the National Review Online:

The Other Bubble

Some highly placed people don’t want a serious discussion of quantitative easing.

By Amity Shlaes

Back in the late 1990s and right up to 2007, journalists occasionally wondered about two big enterprises called Fannie Mae and Freddie Mac. Fannie had come out of an obscure period of American history, the New Deal. Freddie had been created more recently, but no one could explain quite how. The official job of the pair was to provide liquidity in the housing sector in various ways, including creating a secondary market in securities backed by mortgage loans. Whatever Fan and Fred did, their form seemed a contradictory hybrid: On the one hand they were “private.” On the other hand their bonds sold at a premium over other bonds, suggesting that the Treasury or the Fed would always bail them out. These “government-sponsored enterprises,” as they were known, were both growing. Logic suggested that the more they grew, the more bailing them out would rattle markets.

Yet if a reporter took a stab at explaining these mystery entities in a story, or even merely spotlighted them, that reporter paid for it. Fannie and Freddie’s big executives, credentialed power brokers from both parties, hopped on the Shuttle and came to New York to bully the newspaper into shutting up. The executives suggested the journalists weren’t bright enough to appreciate the financial mechanics of Fannie or Freddie. This brazen effort at intimidation was unusual. Even senior editors could recall nothing like it — unless they were old enough to have met with a Teamster.

Those writers who experienced this finger-wagging and strong-arming in the conference room will never forget the queasy feeling they engendered. Fannie and Freddie’s lobbyists did not succeed in muzzling big news. From time to time, even after such a visit, editors ordered up and reporters wrote articles probing the GSEs. But when it came to big, sustained investigations, most newspapers turned to easier topics. When, much later, Fannie and Freddie proved to have been ticking time bombs and set off the financial crisis, the reporters told themselves that the very blatancy of the effort to intimidate should have tipped them off. They vowed to respond differently should that queasy feeling ever return.

Well, queasy is back. And this time, the strong arm belongs not to the boss of the company, Janet Yellen of the Fed, but to a media supporter, Paul Krugman of the New York Times. Unlike the old Fan and Fred execs, Krugman isn’t administering his punishment in the privacy of a conference room but rather in his columns and blogs. Example: This week, the professor’s target was actually another man qualified to be a professor, Cliff Asness, a University of Chicago Ph.D. who does his own academic work. Asness also runs tens of billions at a hedge fund, a fact that suggests he has thought about interest rates and the Fed quite a bit. To Asness Krugman wrote: “But if you’re one of those people who don’t have time to understand the monetary debate, I have a simple piece of advice: Don’t lecture the chairman of the Fed on monetary policy.”

What triggered Krugman’s pulling some kind of imagined rank on Asness was that Asness, along with me and others, signed a letter a few years ago suggesting that Fed policy might be off, and that inflation might result. Well, inflation hasn’t come on a big scale, apparently. Or not yet. Still, a lot of us remain comfortable with that letter, since we figure someone in the world ought always to warn about the possibility of inflation. Even if what the Fed is doing is not inflationary, the arbitrary fashion in which our central bank responds to markets betrays a lack of concern about inflation. And that behavior by monetary authorities is enough to make markets expect inflation in future.

Besides, the Fed cannot keep interest rates this low forever. As former Fed governor Larry Lindsey notes, the cycle of quantitative easing has become predictable: “QE1 ends. Stock market sells off. QE2 begins. Then, QE2 ends. Stock market sells off. Operation Twist starts to be soon followed by a full-blown start of QE3. Now here we are in October and QE3 is finally winding down. This time it was ‘tapered’ rather than abruptly ended. Still, stock market sells off.” Concludes Lindsey: “Whenever the Fed withdraws a stimulus it is going to be painful. Whenever officials flinch and ease because of the pain it just becomes harder next time.”

Given all the confusion, it would surely be useful have a vigorous debate on the Federal Reserve law and Fed policy — one that includes all kinds of arguments, and in which nobody calls anybody a “wing nut.” One that asks whether stock prices or, for that matter, housing prices may reflect inflation or deflation, or whether the dollar will always behave the way it does now. The authorities’ response — “We’re smart, so be quiet” — suggests that the greatest bubble of all bubbles may be the bubble of credibility of central bankers. Whenever that one pops, the whole world will feel queasy.

This Wild Market

stock-market-the-ride

This Wild Market

Perhaps we can figure out what’s going on in the markets today if we read between the lines.  Prof. Shiller explains that “…the value of the earnings depends on people’s perception of what they can sell it again for” to other investors. Which means that CAPE today is largely a reflection of the Greater Fool Theory of investment.

Then Mr. Shiller states that “[t]oday’s level “might be high relative to history, but how do we know that history hasn’t changed?”

I would guess that history has changed. Starting when the dollar and all other currencies became free floating in 1971, empowering central banks to create credit at will according to political dictates. This credit creation has occurred simultaneously with the expansion of the global labor supply in concert with new technology, both of which have depressed inflationary price signals, permitting central banks to continue their credit expansion at little apparent cost. It’s all good, as the shadow bankers might say.

But the less obvious result has been volatility of asset prices that we see reflected in the 30 year transition of financial markets toward trading away from new productive capital investment. This is how the hedge fund industry has blossomed.

The value of financial assets has departed from cash flow fundamentals and the result is markets that pop one day and deflate the next, depending on the sentiment of the moment, rather than underlying economic fundamentals. We’ve created greater price uncertainty in the economy that hampers productive long-term investment and concentrates the rewards in a shrinking cohort of lucky asset holders. This violates the most basic theory of financial management under uncertainty, which is stability through diversification.

This history was not inevitable, it was deliberately pursued under faulty intellectual models of our market society.

From the WSJ’s MoneyBeat:

Robert Shiller on What to Watch in This Wild Market

By Jason Zweig

You would have to be crazy to think the stock market isn’t crazy.

In three tumultuous days this week, the Dow Jones Industrial Average dived 273 points, then jumped up 275 points, then dropped 335 points.

But you might be even crazier if you think you know exactly when to get out of the market.

Few people understand that better than Robert Shiller, the Yale University finance professor who shared the Nobel Prize in economics last year for his research documenting that stock prices fluctuate far more than logic can justify—and who is renowned for telling people when to get out of the market.

Prof. Shiller predicted the collapse of both the technology-stock bubble in 2000 and the real-estate boom in the late 2000s. And he developed a measure of long-term stock valuation that many professional investors rely on.

Yet the central message that emerges from three conversations with Prof. Shiller over the past few weeks isn’t a cocksure forecast; it is a deep humility in the face of irreducible uncertainty.

Many analysts have warned lately that Prof. Shiller’s long-term stock-pricing indicator is dangerously high by historical standards.

Known as the “cyclically adjusted price/earnings ratio,” or CAPE, Prof. Shiller’s measure is based on the current market price of the S&P 500-stock index, divided by its average earnings over the past 10 years, both adjusted for inflation. It stands at nearly 26, well above the long-term average of about 16.

If only things were that simple, Prof. Shiller says.

“The market is supposed to estimate the value of earnings,” he explains, “but the value of the earnings depends on people’s perception of what they can sell it again for” to other investors. So the long-term average is “highly psychological,” he says. “You can’t derive what it should be.”

Even though the CAPE measure looks back to 1871, using data that predates the S&P 500, it is unstable. Over the 30 years ending in 1910, CAPE averaged 17; over the next three decades, 12.7; over the 30 years after that, 15.7. For the past three decades it has averaged 23.4.

Today’s level “might be high relative to history,” Prof. Shiller says, “but how do we know that history hasn’t changed?”

So, he says, CAPE “has more probability of predicting actual declines or dramatic increases” when the measure is at an “extreme high or extreme low.” For instance, CAPE exceeded 32 in September 1929, right before the Great Crash, and 44 in December 1999, just before the technology bubble burst. And it sank below 7 in the summer of 1982, on the eve of a 17-year bull market.

Today’s level, Prof. Shiller argues, isn’t extreme enough to justify a strong conclusion. So, he says, he and his wife still have about 50% of their portfolio in stocks.

On Thursday, as the Dow fell more than 300 points, Prof. Shiller told me, “The market has gone up for five years now and has gotten quite high, but I’m not selling yet.” He advises investors to monitor not just the level of the market, but the “stories that people tell” about the market. If a sudden consensus about economic stagnation forms, that could be a dangerous “turning point,” he says.

Based on new research he has done into industry sectors, he says, he is “slightly overweight” in health-care and industrial stocks.

The third edition of Prof. Shiller’s book “Irrational Exuberance,” coming out in February, will feature a chapter on bonds.

Is the bond market, as some investors have suggested, a bubble bound to burst?

“A bubble is a product of feedback from positive price changes that create a ‘new era’ ambience in which people think increasingly that prices will go up forever,” Prof. Shiller says.

Today’s bond market, he adds, “is just the opposite of a new-era ambience.” Instead, the demand for bonds is driven by “an underlying angst” about the slow recovery and pessimism about the future. “That’s not a bubble,” he says.

It also is worth considering where Prof. Shiller gets his knack for seeing what others overlook—the kind of gift that the renowned hedge-fund manager Michael Steinhardt has called “variant perception.”

Prof. Shiller is an unconventional thinker who relishes investigating ideas that other people regard as eccentric or unrewarding. “I don’t fit in so well,” he says, shrugging. “I’m socialized differently somehow.”

Prof. Shiller—and his wife, Ginny, a clinical psychologist—suspect that he has “a touch” of attention deficit hyperactivity disorder. “I’m very distractible, although I can be highly focused on tasks that interest me,” he says.

It is that intensity of thinking that leads to rare big insights—and to the recognition that, as he puts it, “a lot of fundamental problems aren’t really soluble.”

One friend recalls meeting him for lunch in New Haven; afterward, Prof. Shiller offered to give him a lift to the train station. But, the friend recalls, “Bob couldn’t find his car. He couldn’t remember where he had parked it.”

“Bob came into my office one day in the early 2000s,” his colleague, Yale finance professor William Goetzmann, told me. “He said, ‘I think we are in a real-estate bubble.’ I listened to him and said, ‘Hmm, that’s interesting,’ and when he left, I went right back to whatever research I was doing.” Prof. Shiller went on to produce the first serious warnings that the housing market would collapse.

Prof. Shiller says both stories sound right to him.

I reached him by phone earlier this month after he had missed an earlier appointment to speak. “I was awaiting your call,” he said, “but somehow never heard the phone ring.” Later he clarified that he might have left his cellphone in the next room but wasn’t sure.

It isn’t hard to imagine him sitting there, oblivious to the ringing phone and every other sight and sound, lost in contemplation of big ideas.

Creative Capitalism: Gates & Buffett

CreativeCapBook Review:

A noble effort that fails to converge on ideas…

There are basically two teams in this match of ideas, with several participants trying to referee. On one side are the economists by trade, who are very skeptical about non-market criteria in economics. On the other side are the non-economists who believe the art and science of economics needs to be broadened, but are unclear on how this can be accomplished. Notably, I found the most refreshing approach of the many experts participating in the blog offered by perhaps its youngest contributor – the student Kyle Chauvin – who argued how we need to expand the reach of traditional, or profit, capitalism, not only around the world but to the overlooked corners of the developed world as well.

Unfortunately, the two sides never really converge in this debate and I suppose that may be why the conversation has disappeared from public discourse. Both sides accept some common premises that need to be challenged in order to break out of the box we find ourselves in on these issues.

These premises derive from the neoclassical school of economic theory that laid the foundation for general equilibrium theory in macroeconomics. Specifically, actors within the economy are classified according to a loose application of factor analysis, so we have workers, entrepreneurs and small business owners, corporate firms and managers, investors, savers, lenders, borrowers, consumers, and political actors. Then we lump these categories into producers, savers, and investors on one side versus consumers, workers, and borrowers on the other. The consensus seems to settle on the idea that some people produce and so policy should empower this production. Then successful producers can be taxed by political actors, and/or encouraged by philanthropy, to redistribute the wealth to non-producers for reasons that range from compassion to demand stimulus.

Capital accumulation and equity ownership in capitalist enterprise is an essential form of participation in the modern global market economy. Concomitant with ownership is the question of control in governance and risk management as the flip side of profit. But instead of focusing on how wealth is created and distributed through these market structures and institutions, we insist on dividing capital from labor and then try to redistribute the outcomes by political calculus, or by corporate largess. This is industrial age capitalism and such a mode of production will never accomplish what we hope to through creative capitalism. (I do agree with Clive Cook that we need a better term—maybe Inclusive Capitalism or the Singularity, to borrow from Ray Kurzweil.)

The problems that corporate social responsibility (CSR) seeks to address are rooted in the skewed distribution of productive resources across society, widening the gap between the haves and the have-nots. But taxing the haves to give to the have-nots is a self-defeating form of compassion. We should try to adhere to the Chinese proverb about teaching a hungry man to fish so that he eats for a lifetime. This can be put most plainly by asking the following question: If corporations work solely to enrich shareholders, then why aren’t we all shareholders? To widen the economic net even more, why aren’t all enterprise stakeholders shareholders?

Equity participation may also be the most viable way to promote “recognition” as a complement to profit maximization, as stakeholders have a broader range of interests, of which immediate profits is only one. This idea also focuses our attention on the real problem of free societies: agency failures and governance. Market economies depend on a multiplicity of agent-principal relationships in economic enterprises and political institutions. The abuse of these relationships is the mark of cronyism that dominates public attitudes toward “undemocratic” capitalism these days. This is not an easy problem to solve, but suffice to say equity ownership, control, and risk management must be as open, transparent, and competitive as possible. This is the only way to confirm that these relationships are accepted as just.

The only sustainable solution to world poverty and the skewed distribution of resources is the creation of a worldwide, self-sufficient, productive middle class. This is as necessary for democratic politics as it is for economics. For the middle class to grow, it needs access to resources, mostly financial capital and technology these days.

We can point to the history of land homesteading that built the American Midwest, and just recently, the idea floated by Michigan’s governor to promote homesteading in Detroit for foreigners. Society’s resources need to be spread far and wide in order to reap the benefits of innovation and adaptation, while maximizing the utilization of these resources. The financial imperative of capital is to maximize return, but the socioeconomic objective seeks to do so by combining capital with labor. This flies a bit in the face of the efficiency argument that some people are better at managing risk and creating wealth, so specialization of function should favor the risk managers on Wall Street. The problem is that we never know where to find the successful entrepreneurs and job creating small businesses of the future, only those of the past. And Wall St. only considers those who manage to squeeze through the narrow access door.

Without angel capital provided by family relations who merely saved and accumulated their personal wealth, many enterprises would never see the light of day. At the early stages, venture capital money is too costly or unavailable. This story is repeated across the economy, yet today’s concentration of capital in venture firms, hedge funds, private equity, buyout firms, major bank holding companies, etc. narrows capital access to those who already have it. The proliferation of ideas must be forced through this bottleneck, to what end? Better that individuals, families, small group networks, etc. are empowered by policy to accumulate their own capital to put at risk in entrepreneurial ventures. After all, sometimes the idea is not so sexy and may be nothing more than a new restaurant idea or a better mousetrap. In a world where the future is unknown, we can’t lock ourselves into narrow investment models built on the past. Likewise, we should not underestimate the ancillary growth Microsoft seeded by enriching its own shareholders.

The key point, which cannot be overemphasized, is that broad capital accumulation achieves double the impact of other policy options. First, it helps finance ideas, innovation and entrepreneurial risk-taking that will increase labor utilization, spreading the risks and benefits of economic growth. Second, accumulated financial assets, or savings, help mitigate economic risks of unemployment, health, and retirement through self-insurance. This reduces political demands on the state’s safety-nets and the tax and redistributive policies on productive effort that hampers economic growth. Essentially, policies that promote broad-based capital accumulation are a win-win for all citizens of a democratic capitalist society.

Free People, Free Markets

freedomQuote from the WSJ celebrating its 125th anniversary:

The answer to our current slow growth and self-doubt isn’t a set of magical “new ideas” or some unknown orator from the provinces. The answer is to rediscover the eternal truths that have helped America escape malaise and turmoil in the past.

These lessons include that markets—the mind of free millions—allocate scarce resources more efficiently and fairly than do committees in Congress; that the collusion of government with either big business or big labor stifles competition and leads to political cynicism; that government will be respected more when it does a few things well rather than too many poorly; and that innovation and human progress spring not from bureaucratic elites but from the genius of individuals.

Above all, the lesson of 125 years is that whatever our periodic blunders Americans have always used the blessings of liberty to restore prosperity and national confidence. A free people have their fate in their own hands.

The Anti-Political Blues

LittleFeat

Back in the 1970s Lowell George of the band Little Feat penned a tune he called “Apolitical Blues,” which inspired the title of this post. If anything has changed politically since the Seventies, it’s that most Americans have become even more jaded with party politics and governing dysfunction. Blame who you will.

I’ll make a case here why our politics has become dysfunctional. First, I’ll argue this is a non-partisan issue (though I do have my ideological biases). If one is intellectually committed to one party or the other, I doubt I can do much to change your mind, but I will caution that partisan explanations are incomplete and largely inaccurate.

Before I begin, let’s get a temperature reading on the mood of the electorate. In a (very) recent Gallup poll, only 29% of those polled expressed any confidence in our current executive branch and only a piddling 7% have confidence in Congress (that would be both Houses of Congress – the House controlled by Republicans and the Senate controlled by Democrats). The Supreme Court only garners confidence from 30%.

As for party identification among voters, only 24% identify as Republicans, 28% as Democrats and 46% as Independents. So roughly half the country is not impressed with either party or their candidates. Ideology is different than partisanship, but are mostly coterminous for this exposition. Frankly, I can identify with the anti-party Independents, but will explain here why I mostly favor the Republican/conservative side.

My general contention is that the Republicans are a bit lost in the more recent past of Ronald Reagan. Reagan was the right man at the right time, but his legacy is probably due as much to Nixon’s and Carter’s failures than to the efficacy of his policies. If government destroys growth incentives long enough, any policy that reverses that is going to yield positive results. In this light, instead of blaming Bush, Obama should probably be thanking him for delivering the presidency to the Left. However, Republicans are not as lost as their opposition.

Democrats are trapped in a postwar world that no longer exists, exemplified by FDR’s New Deal and JFK’s unrealized promise. Not only are they lost, they are convinced they are found and filled with certitude regarding their policy preferences. But they are wrong, and being certain of their follies makes them dangerous.

Now, let’s explain.

Both parties are rooted in the past and are failing because the economic landscape has changed. Republicans (and Reaganomics) are wedded to an economic truth that wealth is created by productive investment and hard work, with resources allocated by accurate market price signals. With these conditions, one can expect positive economic growth. But again, the economic landscape has changed and the most significant changes are technology, globalization, and demographics. These changes have tilted the playing field so that most of the gains to economic growth accrue to those who own productive assets or for some other reason have landed in the winners’ circle in a winner-take-all economy. (Say, like Michael Jordan or Cher – this is not to say they don’t deserve their lucrative fame.)

It also means that those whose incomes are dependent on their labor have lost ground. This is reflected in the unequal distributions of income and wealth. The growth mantra is meant to drown out the politics of inequality, but it never will. In our present policy configuration, we have widened the inequality gaps. For example, in seeking to reignite real growth, Fed policy has greatly enriched the “haves” vs. the “have-nots,” and there is nothing in economic or moral theory that justifies this. It is a matter of power and influence over policy.

The redeeming factor of all this is that we can learn and compensate for these policies without abandoning the principles of free markets and free peoples. In fact, these policies violate these principles. At some point the Republican Party will learn that what matters as much as economic growth is managing creative destruction in a dynamic society.

Things are not so encouraging across the ideological divide. Democrats focus almost exclusively on the politics of inequality and state redistribution. Punished for ignoring the imperatives of economic growth, they have turned to the postwar European model of state corporatism, at a time when this model is failing in Europe. In order to tax and redistribute according to political “fairness” (there is no such thing), there must be something to tax. (Thankfully, it was the Soviets who taught us this – unfortunately for the Russians.) So Democrats have decided they must corral big business, big labor, and big government to support their policy agenda. Thus, Obama’s main partners in policy, besides national labor organizations, have been big healthcare, big insurance, and big financial/banking corporations. With fewer players at the negotiating table (and no messy democracy), the state can manage society and insure “fairness” (again, there is no such thing in politics). The result is a society that grows gradually poorer as regulations, government intervention, tax policy, and political redistribution hampers the real economy and leads to gross distortions in the allocation of resources. The changing landscape of technology, globalization, and demographics will turn this policy strategy into a disaster.

To summarize, Republican policies lead to start and stop growth cycles, while Democratic policies lead to gradual stagnation and arbitrariness of results. The first goes in the right direction, but needs better calibration; the latter goes in the wrong direction and needs to be reversed.

So, anti-political blues, yes. But insanity, please no.

apoliticalblues

 

 

 

 

 

 

 

 

 

 

 

 

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