Inequality Outbursts Are a Consequence of Bad Money

Speaking at an investor forum in Southern China earlier in April, Zhou Xiaochuan was asked about China's unique monetary framework. Anyone who is not familiar with that name is likely to become more so over the course of this year. As Governor and highest government official of the People's Bank of China (PBOC), the monetary intonation there has reached something of lofty (depending on your perspective) disfigurement. At least as it relates to the Western architecture, the PBOC is alone in its placement within the Chinese government. More "traditional" central banks are conferred independent status.

That places Zhou in more than a bit of a quandary, given the astronomical rise in credit over the past few years, a more reform-minded government has softened certain priorities and re-arranged others. Against that, the credit and banking dominance has become vastly more inefficient toward actual economic growth. Furthermore, sustaining that trend inside these inefficient constraints is likely to push the limits on operational consistency - all of which Zhou acknowledged.

"If the central bank is not a part of the government, it is not efficient in coordinating policies to push forward reforms," he said.

"Our choice has its own rational reasons behind it. But this choice also has its costs. For example, whether we can efficiently cope with asset bubbles and inflation is questionable."

That was an amazingly candid statement for a central banker, of any taxonomy, to make. In the context of the growing Chinese imbalance, it amounted to a sly warning about the downslope of government influence. They built the mess but may not be able to contain its inevitable washout. Once reform begins, the chips will fall where they may.

That is about as far from the carefully crafted sentiment that adheres to most commentary about the PBOC. Any and all mainstream assessment of the recent yuan devaluation, for example, anchors itself on the idea that Zhou and his comrades (let's remember what they are) control even the smallest of "market" changes. If the yuan suddenly and starkly devalues, it must be a planned "program" of the PBOC. It certainly cannot be a widening dollar shortage as that would directly contradict their omniscience.

If the devaluation is something far more close to what I describe, and it ends badly, there is another certainty. Zhou's warning will be lost amidst the memory hole of public statements, replaced with something far more sanitized and conforming. The reforms or "efficiently cope with asset bubbles" will be totally replaced in culpability by "the market."

If China is about to run the course that Japan did in 1989-90, then it is highly unlikely that anything other than its embrace of a "market" economy will garner scorn. The peaceful and beautiful embrace of a stable and growing economy by leaders of the last generation will be seen as having been undone by allowing too much "market" influence and deference. The problem was not the command side, but too much freedom and, of course, greed.

This is all conjecture on my part, but all the signs are there already. Zhou's warning was only the latest. The bubble itself will be blamed on the "market", as will the failure of the pansophical PBOC to contain it. Freedom is messy and commands are order.

We see it every day in every imaginable fashion. In the latest GDP report, the utterly "unexpected" egg of Q1, Obamacare is being fashioned as the government-led savior even to the point of contradicting its established role as government-led savior. As Reuters "helpfully" points out under the headline "Obamacare Just Saved The US Economy From Contraction", without spending on health insurance and healthcare in general GDP would have been significantly negative in this latest report.

And that is true, up to a point. But first, that is not what we were told about Obamacare closer to its inception. In June 2009, before the law became law, the White House issued a report that purportedly showed legislation like that which they were advancing would increase the economy by reducing health care expenditures.

That might be far more likely the case than what is being preached now about current GDP (assuming any such legislation could). Apart from spending on healthcare and rent, consumers spent very little on goods, including both durable goods and nondurable goods. The pace of durable goods spending was actually the lowest Y/Y since 2009; about half the pace of the previous quarter and at levels closely associated with recession. In other words, it is far more likely that spending on healthcare "crowded out" spending on other more useful (in terms of both household consumption and economic efficiency) items.

As much as that and the sudden carnage caused by Old Man Winter is being blamed for this shameful economy, this current state simply does not match previous rhetoric. How can it be that snow can unsettle a $17 trillion economy? We keep hearing that recovery is near but if it can be so derailed by a season then the premise is false on its face. For five years now, we have been told over and over this same tale, or nearly so. Treasury Secretary Geithner's warm, and ultimately false, invitation of welcome to the recovery will turn four in just three months' time. The Federal Reserve itself has overstated economic expectations from the time they were issued, with the actual economy falling short by between 50-75% in almost every instance.

In January 2011, when the Fed first started to publish its economic expectations, the "central tendency" of GDP for 2013 was thought to be about 4.2%. Over the course of those two years between original forecast and final tabulation, that prediction eroded to what we now know of 2013 GDP: 1.87%. That was down from 2.78% in 2012, the opposite direction from where these prophecies have us heading. Of course, 2013 saw GDP disappoint in its first quarter, "unexpectedly" weak at just 1.14% as winter was cold then too.

The results of these denouements are not just academic, as they display the very reason for the ultimate and primary fact of this "recovery": there were 138.36 million jobs in January 2008 and, not including today's report for April 2014, 137.9 million jobs currently. Even worse, there were 121.88 million full-time jobs in November 2007 and just 118.0 million now. The civilian non-institutional population (potential workforce) has grown by 14.6 million in that time. That's not a major problem; it is an unmitigated catastrophe.

Yet, not everyone is facing such difficulties. Stock prices are near or at record highs, though there is some fade evident of late. The Russell 2000 index of small cap stocks ran up just under 30% between April 25, 2013, and April 25, 2014, but the PE (price to earnings ratio) jumped from 34.16 to 101.65. Without doing too much math, we can estimate that the accumulated earnings on those companies in the index fell from about $27 to $11 at the same time prices were surging. That is a serious incongruence there, where prices rise 30% concurrent to earnings collapsing something close to 60%.

Of course, to those that embrace the narrative, there is no inconsistency there at all. One of these days the Fed is bound to get it right and the recovery will show up, so such extreme valuations in stocks are only a blip, a temporary delusion of angry bear projection. And those very same people, concentrated narrowly within finance, are exactly those that see little problem with the economy or markets.

Into that discrepancy has flowed all manner of neo-Marxism. Thomas Piketty is but the latest, though he has gained far more attention because he presents an argument, not new, that is seemingly rational and coherent. When Occupy Wall Street covered the exact same ground two years back they faded to obscurity only because they were comically unprepared and ill-suited to take up this mantle of economic dysfunction. Inequality is the child of asset inflation.

There is nothing wrong at all with rising stock prices, but there are times when such is beyond misleading. The Venezuelan stock exchange in Caracas continues to lead in global "performance" at exactly the same time its form of command economy decrees 30% wage increases. Not all stock markets are the same, nor are all periods of rising asset prices homogenous.

To brace this economic discontent with populist appeals to socializing and sharing is itself nothing new. And its message is incredibly powerful in these particular times when employment so lags against the seemingly endless tide of Wall Street. Such discontent is not so souring in ages where banks are left to their own devices and responsible for their own stupidity, where the government is not in the business of saving every last one. The obvious cronyism and sidestep around perceptions of fairness color the collective mood. This is not just OWS, as it captures the Tea Party as well.

There is more than just money at stake here, as the lack of economic progress lies in direct contradiction to our sense of fair distribution on the basis of merit. The inability of the economy to create a wider circulation of jobs and earned income results in inefficiency and malaise, and that is a commentary against financialism, including stock prices that benefit only a narrow segment. That disconnect between prices and economic function reveals this because its source becomes fully apparent - monetarism. It is so very evident even in the governing and basic philosophy there, as these orthodox zealots even claim directly that we must place finance first before economy; that we need to stimulate lending above all else or the economy suffers. It is credit and debt and nothing more.

So the fairness narrative that fosters disconnect with bailed out banks is extended to all of finance. Banks and "market" players are given an advantage because of the pedestal they occupy in the modern hierarchy of governing over the economy. That violates everything we hold dear about what should take place and how it should work. The game appears rigged against the little guy, where only those well-connected to asset inflation or cronyism can survive and prosper - because that is what is actually taking place to a large degree in a broad sweep of the US. Those that want to simply earn a living or run a small business (same thing, different means) are left with only Geithner's distinct brand of aged condescension, Bernanke's endless equivocation and evasion or now Yellen's seeming bewilderment.

Through all of this free markets are blamed.

Since the beginning of 2010, S&P 500 companies have repurchased $1.45 trillion worth of their own shares. The common argument in favor of such massive resource misallocation is that these CFO's are uncovering undervalued assets. They see their own stock as being unappreciated by the "markets" and simply wish to give them a boost toward fair value. Yet for all that bluster, stock repurchases are highly cyclical, rising greatly as market prices do. If repurchases were actually related to valuation, then there would have been exponentially more of them in 2009 than 2013 (or in 2003 rather than the $550 billion or so in 2007 alone).

In 1999, the NBER published a study that directly linked stock repurchase behavior with management holdings of stock options. While it doesn't seem like such effort was really needed to confirm what common sense has suspected all along, it is somewhat helpful in setting the "science" on the matter.

"This paper has offered a new explanation for the dramatic increase in stock repurchases since the late 1970's. Managers holding stock options have substantial personal wealth at stake in the choice between repurchase and dividend distributions. My empirical results suggest that stock options factor importantly in firms' observed repurchase behavior. Controlling for other observable factors, firms in which managers have large stock option holdings are significantly more likely to choose the repurchase route than firms in which managers have small stock option holdings."

While the study only observed correlation with payout mode preference rather than gross amounts, I don't think it too much of a leap to believe that management pay based on stock prices factors into decisions about how much in shares are to be acquired. That itself leads one into actively seeking to influence share price, and you don't have to look very far to see this regular behavior.

It has become laughably common to see companies stumble in their quarterly earnings reports only to announce not a redoubling of efforts toward productivity but rather a new or boosted stock repurchase. And where are these businesses gaining resources for such financialism? Credit and debt.

Since the onset of the Great Recession, corporate debt has expanded by $3.6 trillion, second only to the federal government's $7.3 trillion. The cost of such debt is a direct monetarism, and, in fact, is a major consideration in the setting of such policy. The monetary commissariat that controls the systemic cost and pricing of risk posits that "stimulating" credit is, as I mentioned above, the key to the economy. This Keynesian belief of "pump-priming" has yet to be expunged despite the massive and growing empirical contradictions (including the disaster in Japan). It requires the assumption of homogeneity.

Just like all demand is thought equivalent under the tenet of aggregate demand, all credit is deemed equally or positively useful. They simply believe that if somebody somewhere borrows money, particularly if that agent was not going to before central planners reduced its cost, that it is an unqualified economic benefit every time and in every manner. However, the financial world is much more complex than that. A company that borrows money may not have any interest in expanding production, obtaining inventory or hiring more workers, management may simply be taking that low cost opportunity to raise their own pay even if that is a direct and hidden (opportunity) cost to productive capacity in the long run. That is not irrational exuberance at all, but rather rational adherence to unexpected and unintended consequences of too much simplicity.

While it is dangerous to assume too much of a counterfactual, it is at least reasonable to suggest that Apple itself may have never crossed into the repurchase realm (twice) had debt prices been far more closer to normal. But financialism receives priority across all time from "independent" central banks.

"Greedy" CEO's and CFO's bear the brunt of inequality's critical sting when they are simply reacting to the incentives that actually exist. Those incentives are not those of the free market, but of the intrusion of central banks.

"The aim which the Americans are pursuing arose out of the economic troubles, out of the economic crisis. The Americans want to rid themselves of the crisis on the basis of private capitalist activity, without changing the economic basis...Even if the Americans you mention partly achieve their aim, ie, reduce these losses to a minimum, they will not destroy the roots of the anarchy which is inherent in the existing capitalist system. They are preserving the economic system which must inevitably lead, and cannot but lead, to anarchy in production."

History repeats because it is cyclical and not linear (as central banks have to believe). The quote immediately above was Josef Stalin talking to HG Wells http://www.newstatesman.com/politics/2014/04/h-g-wells-it-seems-me-i-am-more-left-you-mr-stalin in 1934 about the "failure" of capitalism. Some things never change, as economic disfavor, then as now, opens the door to these kinds of criticisms leading to more command policy. Yet then, as now, capitalism itself was never the culprit, thus that prophecy was never fulfilled. Straying from sound money via early attempts at monetarism in the 1920's more than echoes the same vanity in the age of interest rate targeting.

That they ended up in the same exact kind of disaster is unsurprising. I suppose on the count of rising Marxism, that too is predictable given the stifling command and central planning that still exists during the "recovery" period - also in common with that age. That capitalism never failed should be a warning to those that reach for it now. So, too, should the timing of all these pieces - where sound money was reinstituted, at least partially, and then removed. That the inequality that so disturbs these intellectuals of both eras coincides exactly with unsound money. Therefore, empirically speaking, sound money and inequality is thus inversely correlated. However, central planning, even of the softer variety on display here, is positively and highly correlated.