Cheap Money Is Not a Victimless Crime

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The financial world is meant to be directly linked to the real economic world. In the purist, philosophical sense, finance is supposed to not only reflect economic reality, but to foster productivity within the real world by productively allocating what should be scarce capital through price discovery and signaling. Six years of zero interest rates is not only a mistake, it compounds the destructive nature of low interest rates enacted in previous episodes of economic and financial engineering. Businesses of every type and size make real decisions based on their perceptions of the cost of money, i.e., interest rates, transmitting these interventions well into the real economy.

Part of that decision-making process comes from a differentiation of funding sources since not all types of funds or money has the same cost. In general, a business has access to three kinds of monetary resources: internally generated money or retained profits, debt, and equity. Business owners and corporate managers analyze, to the best of their abilities and often according to the textbook understanding of finance, the most productive mix of financing business operations. When interest rates are low, the textbooks say to rebalance the overall cost of financing in favor of debt, likely reducing equity outstanding to produce an "optimal" weighted average cost of capital, of which interest rates are the primary driver of that calculation.

In circumstances where money is in relatively short supply for a given demand (such as when demand for money rises), we should expect the cost of money, interest rates, to rise. This is true for both equity and debt given the expected shift in preferences of investors (stocks are less attractive in rising interest rate environments, meaning the cost or ability of a particular business to raise equity funds is high or limited). With external money relatively costly, business reliance and focus on internal funds rises as well. This means a sharper focus on managing the entire cost structure in order to generate profits, especially sustainable profits.

That means innovation, not in the laboratory, academic sense, but in the real world sense where operational, and thus profit, productivity is prized the most. This leads to not just small innovations in productive efficiency, but entirely new ways of thinking, including new products and advancements. While the world has been captured by the stories of seemingly lone wolf innovators working in their garage, or government grants stimulating the genius of academic researchers, the truth is the vast majority of innovation is done by existing businesses focused on maintaining and expanding profit growth.

Innovation and productivity are the hallmarks of economic success since they are the backbones of both broadening economic participation (through increasing labor specialization) and sustainability. Long-term economic success is really defined in terms of sustainability - recession and dislocation are, by definition, the lack or end of sustainability in a large proportion or segments of the economy. To ensure that the economic system continues on a sustainable path necessarily means that productive potential comes first and foremost to the thoughts of corporate and business managers. Therefore, the incentives for success should align with the creation, maintenance and expansion of productivity and productive potential.

The flipside to scarce money and market discipline is interest rate targeting by central banks. Modern economic theory holds fast to the idea that the economy is stimulated by low interest rates. In order to achieve low interest rates, the central bank has to increase the level of reserves in the banking system relative to demand by purchasing government bonds (though that is somewhat misleading since most monetary policy is not conducted as stand-alone purchases; essentially they are the cash-owner side of very short-term collateralized loans, reverse repos). No matter what happens on the demand side for money, the central bank will release "cash" in exchange for bonds, satiating any and all demand for money so that the short-term interest rate target is maintained (called the Fed funds rate).

Primary dealer banks, now flush with new reserve "cash", transmit these funds (when the system works) into the wholesale money markets for banks far and wide to use as "cash" to fund new loans (I use quotes around cash because none of it is in the physical, traditional sense; it is all just balance sheet entries). It is important to note again, that any and all demand is met for short-term money to maintain whatever target the central bank feels meets its perceptions, according to its textbook orthodoxy, of economic management. The quantity of money and its transmission are all that is needed to be "stimulative", conventional economics makes no other distinctions.

In 2001, the Fed funds rate target was brought all the way down to 1%. The economic recovery from the dot-com bust was sluggish, so that justified to the Greenspan Fed maintaining that then-record low target well into 2004. That meant that any increase in the demand for money, by, for example, banks needing cash to fund off balance sheet credit structures of mortgage bond products, was going to be met. The central bank did not care how the money was to be used, seeing this as nominally a free market, capitalist economy - the "market" would sort out all this "stimulus". For some reason, this is still thought of as capitalism even though the quantity and cost of money is set by a central mechanism for reasons other than individual market opinions (and often contrary to market opinions).

Most commentators (myself included) have focused on the financial fallout from this economic/financial schematic, but it is extremely important to not lose sight of the real economic context into which this intervention projected. Plentiful money meant companies were less constrained in their approach to operations. Market discipline was relaxed, meaning profitability fell in relative importance (this is not to say that profits were disregarded, but with plentiful funding the focus on sustainability gets muddied and papered). Easy access to cash can allow business lines and whole businesses to operate unprofitably longer than they really should, meaning the relative importance of innovation and/or productivity is diminished. Efficiency gets lost in the euphoria of asset prices, as stock prices reflect quantities of money rather than true expressions of value.

The primary example of this dangerous imbalance was the massive surges in stock repurchase plans and leveraged merger activity during the middle part of the last decade, right up until the wholesale repo markets first froze in 2007. So much of overall marginal business resources in the last decade (and really for the past twenty-five to thirty years, such as the junk bond bubble in the mid-1980's that used an outsized proportion of business resources on leverage buyouts) were focused on financial schemes to boost share prices. Share repurchases and mergers, particularly leveraged takeovers, are nothing more than ownership changes conducted at premiums to current prices, competing with real productive endeavors for monetary resources. Since the price effects of ownership changes are instantaneous, whereas productive projects are a net cost up front and often take many years to bear fruit, the systematic skew toward the short-run favors asset manipulation over operational innovation and improvement. True investment is discarded in favor of financial "investment".

Proponents argue that the marketplace was simply undervaluing the ownership of such firms, and so companies are simply taking advantage of an opportunity. But that is true only in the context of rapidly rising stock prices, there is no other way for so many diverse companies to be undervalued at exactly the same time. And since share prices are rapidly rising due to plentiful money (remember that this kind of equity extraction is typically done at a hefty premium while actively and dramatically reducing the absolute supply of stocks), we have a self-sustaining feedback where cheap-money financed equity extraction pushes share prices higher, meaning more companies are likely to perceive that their own share price "undervalues" the ownership of the company, inducing even more equity repurchases away from other uses. So how much is this "undervaluing" ownership, and how much is just the feedback loop of asset price inflation. Since the three largest periods of equity extraction (1983-86, 1997-2000, 2003-2007) were all followed by price "corrections", I tend to believe that no under-valuation existed in the first place since this was all just reflecting massive financial imbalances.

Of course, the fact that so much of corporate management pay is directly tied to share prices only enhances the incentives for this kind of financial activity. That, again, is short-term thinking due to easy credit terms. In fact, during the last decade companies often borrowed cheap money in order to directly finance these kinds of equity extractions (the weighted average cost of capital calculation at work). How much of that financing would have flown to more real economy, productive endeavors will never be known, but I certainly believe it is non-trivial. In other words, this focus on short-term financial manipulation likely, in my opinion, crowded out both market discipline (and its focus on innovation and productivity) and real productive expansion, the very purpose of the Fed's cheap credit initiatives in the first place.

Since it is capital expenditures on real projects that increase economic participation through labor, the preference for ownership transfers was problematic, meaning the marginal circulation of credit money had to be achieved by other means (in this case asset prices and debt). Increasingly, marginal economic activity moved away from production and productivity-based to consumption and debt-based. This imbalance was pushed further along by unilateral trading mechanisms whereby production increasingly moved overseas in exchange not for additional domestic production, but for U.S.-based financial assets (particularly U.S. government and U.S. government agency debt). So the "free market" that closed the artificial loop of the circulation of new quantities of money in unsustainable patterns conformed to the central bank goal of achieving some quantity of activity, meaning the Fed and its cohorts believed they had largely succeeded.

The marginal balance of economic circulation increasingly moved away from domestic production, yet asset prices and debt accumulation were not alerted to these imbalances by the systemic price of risk. Because that price of risk was embedded within the central bank pegging of the cost of money, the fundamental balance between the economy's ability to service all that money and debt skewed so heavily in the wrong direction. If long-term economic health is built on sustainable enterprises adhering to market discipline, there is little wonder this consumption-debt economy was doomed to fail. The neglect of the fundamental basis for production (including both goods and services) eroded the long-term trajectory of the economy. Without a consistent attention to innovation there is no long-term prosperity.

Of course large corporations made money, record profits. But those profits do no good if they are used in the ponzi-like schematic of constant repurchasing instead of direct circulation into the hands of workers and the construction of real wealth. At least during the dot-com episode, these kinds of equity extractions were balanced by IPO's - the allocation of stock prices into new businesses and thus workers. Though, again, there was too much money flowing and sustainability was not prized. In the 2000's, however, there was no counterbalance to equity extraction, meaning it is no surprise that wage growth was weak.

The fundamental processes that create real wealth, the productive exchange of labor and capital within production (or services), are the fundamental foundation of debt service and repayment. As bad as it was that the debt-fueled growth of the bubble periods was really just borrowed prosperity, the systemic and intentional mispricing of risk and the cost of money assured that payment for that borrowed growth would occur during a period where the ability to pay was significantly diminished. The key to keeping this impoverishing cycle going was the artificial alternative to direct/wage economic circulation - asset inflation and debt. Remove those and the high degree of unsustainability became obvious.

I don't believe it is coincidence that the rate of innovation has fallen off, especially the dramatic and revolutionary innovation that marked previous periods of economic success. The amount of financial resources diverted to financial management was simply immense, growing to unbelievable proportions in the 2000's, and that represented a huge opportunity cost to the economy as a whole. Expanding consumption under these kinds of conditions (the quantity of activity without regard to quality) is a net cost to the economy since there is no foundation of productive, sustainable activities to support it.

In almost every manner, the Federal Reserve and global central banks engaged in policies that were the exact opposite of what was needed. You cannot simultaneously borrow from the future while eroding the basis for that future. That is the definition of impoverishment, adding the weight of growing obligations on top of diminishing ability.

This is a global problem, conducted under the auspices of modern monetary thought. Since debt and asset price-based activity more easily responded to "stimulative" inputs of policymakers, that is logically where it all ended up - to defeat the business cycle necessarily meant marginally moving away from true productive capacity, and thereby perverting the foundations of real capitalism. The economy was easier to control when marginal activity flowed directly from intentionally mispriced interventions than when the free market economy charted its own course, caring more about market discipline than financial interchanges.

The travails of Greece are a stark warning to the large imbalances of finance over the real economy. Without any form of artificially induced economic circulation, the logic is simple. There is no way to pay all the debt that has accumulated because incentives were skewed away from building the economic infrastructure (sustainable enterprises) that would be necessary to pay it all back (or at least service all that debt reasonably). To build that economic infrastructure necessarily required unfettered pricing of incentives, and thus a longer-term focus on real investment that is the opposite of borrowing activity from the future - productive investment often requires deferring success.

That was the monetary trap that was laid back at the moment central banks embraced the idea that they could manage marginal economic activity through these means. In order to maintain artificial circulation, it was necessary to move away from productive capacity. Productive investment is a long-term prospect. Central banks are singularly focused on economic activity today. In that important regard, it makes little sense to have such an entity set the systemic price of risk, controlling the ripples such artificial prices produce across the whole of both the financial and real economies.

The economic dislocation of these past three-plus years is a belated recognition of that monetary trap. In order to manage the present, central banks sacrificed the future. They thought creating growth through debt would lead to longer-term prosperity because modern economics makes no distinction about the quality of economic activity. But there is a world of difference that plays out in the drama of sustainability and eventual market discipline. Once the artificial channels of circulation inevitably fell apart, the distinction between quantity and quality produced the astounding magnitude of the Great Recession.

What we are left with is the diminished capacity to even service the accumulated debt loads. Asset prices started to reflect this in 2008, but again central banks have intervened to preserve their ability to manage economic affairs through debt creation (their Wall Street tool). The process has yet to come to a successful conclusion since asset prices, especially in certain credit markets, only reflect central bank largesse and not fundamental values, again quantity of money. Greece is not alone in its economic imbalance and dysfunction (see Illinois or California).

Central banks cannot solve the problems because they are the problems. They are simply not equipped to manage the long-term affairs of the real economy (or even the financial economy). They continually seek short-term quantities of activity without regard to quality and long-term sustainability. All activity is the same to them, so they do not allow the financial system to sort out what is productive and what is not. The price discovery mechanism of free markets is disabled, meaning unproductive activity goes forward without discernment (which is what intermediation is supposed to accomplish).

We cannot keep sacrificing the future for the present. We cannot borrow any more future prosperity for today, that card is maxed out. Money is not in short supply, productive capacity is. Fiscal authorities have tried to fill the gap, but government is not equipped to pick winning projects or to foster long-term, sustainable growth either. Political interference will always be short-term in nature.

The market must be allowed to clear imbalances, to sort out quality from quantity, and refocus on productive capacity. Therein lie innovation and the potential beneficial revolution. Most of all, someone in a position of authority has to realize (and have the guts to proclaim) that policy has been backwards for far too long, that short-term sacrifice is needed for long-term success, not the other way around. Conditions should be normalized so that companies prize production over share prices, that conducting sustainable business creates true value, not by the quantity and circulation of cheap money by any and all means necessary. Cheap money is not a victimless crime.


Jeffrey Snider is the Chief Investment Strategist of Alhambra Investment Partners, a registered investment advisor. 

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