If You Don't Know What's Wrong, You Won't Ever Know What's Right

If You Don't Know What's Wrong, You Won't Ever Know What's Right
The Economist
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In April 2009 during the absolute worst economic circumstances of at least four generations, the new Obama administration announced that its stimulus plans were coming along.  Keenly aware of Republican criticisms about profligacy, the President assured the country that projects were “ahead of schedule and under budget.” Economists like Paul Krugman were distressed, particularly about the second half of the pronouncement.

As Dr. Krugman wrote for the New York Times, “Yay – but boo.”  You can see his point.  There is nothing wrong with “under budget” on its own accord, but this was depression stuff.  Economists during these times preach waste, anything to get things moving. Being fiscally sound wasn’t the point.  If the government felt some duty in this area, then Krugman’s further advice was “that we need more projects.”

The goal is not to do X, but spend X on Y, Z, A, or L.  The enemy is not the budget it is the miserly, or so we are led to believe.

John Maynard Keynes, who Dr. Krugman predictably references, advocated mimicking gold mining left in such situations.  If it got all the way to L on the project list he proposed the Treasury Department printing banknotes (currency), filling old bottles with them, and then “burying them at suitable depths in disused coalmines which are then filled up to the surface with town rubbish.”  He meant it as a sarcastic critique on gold and true money adherents.

“The analogy between this expedient and the goldmines of the real world is complete. At periods when gold is available at suitable depths experience shows that the real wealth of the world increases rapidly; and when but little of it is so available our wealth suffers stagnation or decline.”

It is nothing less than Milton Friedman’s helicopter suitably, Keynes thought, cloaked in the façade of “well-tried principles of laissez-faire.”  If the private economy objects to government intervention on whatever grounds, then fool private business into believing private business is the answer.  Should the government have to waste resources to do so, all the better. 

In many ways, quantitative easing was just that.  Instead of newly minted banknotes buried in abandoned coalmines, the Federal Reserve virtually “printed” bank reserves buried on bank balance sheets (but only the largest).  It was Keynes and Friedman put together, and it failed miserably.

I don’t want to write that little thought was given to the second part of Keynes equation quoted above.  The first part is easy enough; there has always been a historical correlation between the availability of money and increasing economy.  It is through the latter, however, that wealth is created.  Money is not itself wealth, but often a temporary and tradable substitute for it. 

The whole point of gold at the base of the monetary pyramid was that it could never disappear.  It may be melted, smelted, and transformed, but what has ever been mined by all human endeavors is still with us today.  Thus, the “little of it is so available” part isn’t strictly about quantities.  

To the modern economist it is about confidence.  The government may waste and spend and print, but if what happens if it really is just waste?  If the Obama administration had followed Keynes and Krugman to the letter and had buried banknotes all over the land for private business to then dig up, we have a good idea of what might have happened. 

Many economists believe an actual recovery would have followed.  Actual experience with QE, however, suggests the currency would have been uncovered and then little else.  It likely would have been deposited on account for whomever found it and perhaps spent by that firm, but other than that in systemic terms it would have filled out a bank liability in exactly the same way as the bank reserve byproducts of QE.

The point of such efforts in terms of spending is the “pump priming”; to get some additional activity started so that it will spur confidence and bring with it more to follow.  When people see other people spending, when businesses experience that long awaited uptick in spending, the recovery is triggered. 

Or is it?

There has to be more than that, else the period following the Great “Recession” would have conformed to cyclical expectations. Economists have instead spent a great deal of the last ten years trying to figure why that didn’t happen; and not just here, but everywhere. 

The contraction did, in fact, end in 2009.  The uptick in general business did, in fact, occur.  The economy on the whole has expanded in the years since, but it hasn’t actually returned to meaningful expansion. 

All this economic theory predicts that it doesn’t matter why the contraction happened in the first place.  What is supposed to matter is what happens afterward.  So long as the government is willing, there is the answer in “aggregate demand.”  That it so clearly hasn’t happened in that way has left mainstream Economics to always see bigger numbers; as in the government no matter how many trillions it expends in whichever form is always several more trillions short.

In the case of Keynes’ missing money, however, there is every reason to believe that what triggered the matter is relevant to ending it. Gold never disappeared during depressions, it was instead “hoarded” by rational people fearing loss over a variety of potential causes.  Thus, it is more appropriate to say that the willingness to trade money is what disappeared.  These are liquidity preferences.

Replacing hoarded gold or banknotes with those newly dug up from the ground does what?  It doesn’t necessarily replace or alleviate those fears.  It may just be that people hoarding money end up hoarding more money even after some of it is spent.  On this point economists are correct; there has to be some threshold of confidence that inspires economic participants to give up those concerns and go back to normal.  Only then may added money or “under budget” projects contribute. There are prerequisites to such possible stimulus.

That is what all this really is about, the desperate attempt to find that transformative point between normal and hoarding (of whatever resources, monetary and economic).  The last ten years have shown that officials haven’t been able to.  No matter what they do, it doesn’t create the flashpoint pump priming effect.  Quantities are changed about them, but overall the search remains to find the kickstart of confidence.

To that end, we have to question whether “stimulus” efforts truly are the best way to go about it.  Recent experience again shows that doubts are well-founded.  Even in places like China where “stimulus” was immense there has only been deceleration and further misgivings.  The Chinese economy only the first time (2009) and only for a short time appeared as if it was to roar all the way back, but after the second (2012) it has only gotten worse. 

In 2009, Chinese authorities routed ~RMB 960 billion in additional investments (Fixed Asset Investment, or FAI) through its network of State-owned Enterprises (SOE).  That worked out to a massive 2.7% of GDP.  In 2012, a repeat of the same textbook impulse pushed ~RMB 1.06 trillion through the same channel (about 2.0% of GDP).  Once more in 2016, this time the level was ~RMB 1.45 trillion, or about 1.9% of GDP. 

Following each incidence there has been a rebound.  In this latest episode, there has been a measured uptick in activity within China’s economy. Industrial Production, the bedrock of China’s still mercantilist system, after being stuck for two years around 6%-6.5% growth finally hit close to 8% once in March and again in June.  Retail sales reached 11% expansion for the first time since 2015.  Private FAI, which is what urbanizes and modernizes China inside out, had actually contracted in the middle of last year but now is positive.

These results, however, are not nearly as impressive as they may sound.  Growth in IP should be running closer to 20% rather than a longshot for 10%; Retail Sales need to be 25% for the talked about rebalancing toward consumers and services to be anything more than the same useless conjecture; and FAI had been 30% growth up until the last few years, so single-digit pluses are not any real difference from very slight minuses.

Worse than that contextual reality, it increasingly appears as if the best is already over.  Whatever Chinese “stimulus” was going to accomplish may have already been accomplished.  It appears China’s economy is slowing yet again, or at best slipping back to the same condition as it was in early last year before the government stepped forward to waste so much more.  Economic stats released this week were uniformly bad (again): IP back at 6% again; Retail Sales barely 10% and right around the lows of the last fifteen years; FAI clearly decelerating especially on the private side after having fallen so short of an actual rebound.

What is truly important to note about Chinese economics is not how much the authorities do at any one time but when they do it.  The pattern is immediately recognizable to our own economic circumstances: 2009, 2012, 2016.  As the Chinese economy has confronted economic challenges in those years, so, too, has ours.  Both systems slowed at all of those points.  It’s not supposed to be that way where the two largest economies in the world are subjected to the same outside forces at the same time. 

Yet, here we are facing the consequences of a third round being completed with the same frightening results.  No matter what “stimulus” is done the global economy is worse off for the reason governments acted in the first place.  As I have written before, it isn’t actually stimulus but a signal that authorities finally see what we see, something wrong in the real economy they must react to.  It is more of an alarm bell than effective solution.

And what does repeated failure do in terms of confidence? It’s a rhetorical exercise, for the answer is innate and might only need to be spelled out for economists.

That’s the part that neither Keynes nor any of his modern disciples ever factor.  They merely assume that wasting trillions is enough; they spend more time on the number than any time on how any number actually makes its way from waste to growth. It doesn’t appear near enough to know that something happened (repeatedly) to cause hoarding, there may actually be a requirement to understand that something first.

To get money right, you have to figure out what went wrong.  Why are banks in particular hoarding liquidity all over the world after ten years and so many trillions?  It stands to reason that on time alone some level of normalcy would have returned by now, even if by accident or mean reversion.  It suggests an active factor in the money equation, one still active today.

The only policymaker I have seen who has come close to piecing together an answer was Fed Governor Lael Brainard.

“Of course, other developments may be affecting liquidity in financial markets. For example, market participants have indicated that changes in participants’ risk-management practices may be contributing to reduced market liquidity. In particular, the experience of the financial crisis may have led many participants to reevaluate the risk of their market-making activities and either reduce their exposure to that risk, become more selective, or charge more for it, thereby reducing liquidity.”

In reality, that was all an understatement.  For a Federal Reserve official, it could have been a giant step in the right theoretical direction. Dr. Brainard’s remarks were given, ironically, in early July 2015 just six weeks before China’s currency would point everyone in that same direction; not that many would see it.

After all, the topic of Governor Brainard speech was itself about global liquidity conditions.  There was some urgency to the matter given what had happened in the months before it: an oil price crash, a ruble crisis, then one for the Swiss franc, and bond rates worldwide that were doing the opposite of recovery and “rate hikes.”  Textbook money problems all. 

That last one in particular should have been a forceful clue, but as rates fell economists somehow convinced themselves that wasn’t further and heavier liquidity preferences being pessimistically practiced, but the positive attributes of monetary “stimulus.”

All the signs for monetary shortage and illiquidity were there.  But if all that wasn’t enough, the crash of China’s yuan in early August 2015 should have been the final piece to the puzzle. That the stock market (globally) nearly crashed two weeks after was simply the most obvious repercussion along those lines.

Keynes coalmine parable is incomplete.  The Treasury Department can print and bury a whole lot of banknotes in the ground, have private businesses extract them from under the town refuse, and then watch as they are hoarded, too, along with money and cash already in and then out of circulation.  The addition of new money is pointless unless it addresses the reason or reasons existing money has failed in the first place. 

Three times that has happened in the world since 2007, and three times the answer has been the same.  The global economy is reduced by each of these, and then never really comes back from them. No matter how much or in what form, “stimulus” at best provides a small and temporary reprieve (if that) that ends up instead proving how little governments can actually achieve and influence.  It inspires the opposite of confidence because why should it do otherwise? 

In reality, the monetary situation is even more bizarre than that.  The Fed thought it was burying money in those virtual coalmines but instead it printed worthless pieces of paper (how’s that for monetary sarcasm).  The private businesses that did dig them up (large banks) found them (bank reserves) totally useless and then told the government so; who then buried even more of the same unworkable paper again and again and again. 

And every time private businesses went through the effort to uncover these “stimulus bottles”, they found the same thing in them and therefore reached the totally rational conclusion that government authorities were never going to do anything different, so therefore nothing would be different.  You can’t eat gold, but you also can’t do a single thing with virtual bank reserves.  The only confidence that is affected is further confidence not to trust stimulus, of any kind.

As Lael Brainard observed in another speech given less than a month before the one referenced above, “it would not be the first time this recovery has proceeded in fits and starts. The underlying momentum of the recovery has proven relatively susceptible to successive headwinds, which have kept overall economic growth well below the average pace of previous upturns.”  

And what were those headwinds? In what other discipline is it where the cause of a disaster is believed immaterial to its aftermath? If you don’t know what’s wrong, you won’t ever know what’s right.  Once is random, twice may be coincidence, but three times is all the proof anyone should ever require. Unfortunately, all the signals are again starting to align for a fourth. 

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

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