Decades of unproductive monetary [and fiscal] policies have encouraged tremendous misallocation of capital, as evidenced by an estimated underinvestment gap of c.$400trn in the past half century.
Accomodative monetary policies across major econoomies, such as the USA, the UK and the EU, were in part necessary to mitigate the economic impact of the global financial crisis.
However, when interest rates fall to zero or near zero, it signals that we are approching the end of a long-term debt cycle (which usually lasts between 50-75 years). This also suggests that the economy is close to peak capital misallocation within the cycle.
The net result of capital misallocation due to [too] easy moentary policy is a distortion of the fundamental function of the economy – which is to facilitate progress through innovation and wealth creation.
Across developed countries, especially in the US, we now have for the most part a ‘monetised’ economy which is kept alive by historically low interest rates and ever more debt – in other words, economic growth has been subjugated to monetary expansion. This creates an illusion of prosperity and also prevents the economy from performing its fundamental function, which requires capital to be allocated productively over the long-term.
If we look at the US economy from a high level perspective, things don’t look too bad – for example, the US household and nonprofit orgarnisations’ net wealth in Q1 2019 was about 500% of nominal GDP.
However, as Ray Dalio suggests, we can get a better understanding of a situation when we look at it more granularly – and when we do that, we can see clear signs that the economic system is malfunctioning.
Going forward, it will soon become a non-viable option that economic progress ought to be scarified for political capital. In other words, our political leaders are running out of trade-offs – the economy needs to be cleared of unproductively allocated capital. If our leaders do not do it proactively, eventually the system itself will – indeed, this process has already begun: Brexit, the election of Donald Trump, as well as the “yellow vests” protests in France, Belgium and Netherlands are clear signs of this.
This paper was last updated in July 2019.
The economy and its function
In our world, different markets bring together buyers and sellers that exchange money and / or credit for goods, services or financial assets. The total number of transactions across all markets make up the economy.
Economic actors engage in transactions motivated by various self-interests (which can be rational, emotional or a combination of both). When these economic actors are free to make their own decisions, regardless of what the self-interests are, both buyers and sellers must believe that they will be better off as a result of completing the exchange (transaction), otherwise there will be no point in entering in one .
An aside: the fact that the government is an economic actor is self-evident – Keynes suggested that the government could stimulate economic growth by spending (i.e. pursuing an expansionary fiscal policy). Although it was an appropriate solution at the time when “The General Theory of Employment, Interest and Money” was published in 1936, over time it became a problem – the role of the government was and still is to set the rules of the ‘game’, not to play the ‘game’. If you have an institution that can both set the rules and also engage in the activities governed by these rules, there is a chance that the institution will tilt the rules towards its own interests of doing well in the game. However, we risk digressing too much and therefore, we will return to the main argument now.
It is from this intrinsic belief, namely that our lives will be improved as a result of completing a transaction, that we can deduce the function of the economy – over time, as economic actors seek to improve their living standards, they aim to do things better, i.e. more efficient.
Aiming for more efficiency eventually produces Schumpeter’s creative destruction, which ensures that complacency is removed by innovation and unproductive activities and enterprises are replaced by productive ones. As my favorite Red Hot Chilli Peppers song, Californication, goes on to say – “Destruction leads to a very rough road but it also breeds creation”. The net result of this is progress through innovation and wealth formation (i.e. more ownership / stake in the economy and the wider society). However, we need to acknowledge that there were, still are and will continue to be people that push our civilisation forward through their contributions, who are not necessarily motivated by a desire to better their own lives; rather these people are moved by sheer curiosity and creativity – the intellectual instinct to explore and the imaginative drive to create are powerful influences on human behaviour that can manifest at the expense of nearly all other motivations, including that of survival in some cases. That said, improving one’s living standards is what motivates most economic actors, as far as we can observe.
For the economy to ensure progress through innovation and wealth creation, it needs a production structure that efficiently employs resources (capital). ‘Efficiently’ means productively – in other words, using resources must [eventually] deliver to the economy a benefit larger than the cost of obtaining, manufacturing and utilising them.
There are various factors that determine whether capital is being employed efficiently or not, including fiscal policies (what the government does) and monetary policies (what the central bank does). Of course, there are other elements that influence capital allocation within the economy but these two factors in particular have the biggest impact on the behaviour of private economic actors that produce and consume – companies and households.
Although we will focus in this article primarily on monetary factors (interest rates and money supply), it is important to understand that monetary policy is not entirely a-political and it is indeed closely connected to fiscal policy.
There are many theories that try to explain what interest rates are. For example, the marginal productivity theory, developed by American economist John Bates Clark in The Distribution of Wealth (1899), implies that the interest is paid because capital is productive – the more productive the capital the higher the interest rate paid on it. Another explanation of interest rates comes from Knut Wicksell who, in his seminal work Interest Rates and Prices (1898), differentiated between the natural (real) interest rate, which is the by-product of supply and demand forces for goods (and services), and the rate that can be observed on credit, which is an entirely financial construct. Wicksell called this financial entity, the monetary (nominal) interest rate.
However, as Yogi Berra said: “In theory there is no difference between theory and practice. In practice it is.”
Therefore, in discussing interest rates we will look at their practical use, taking inspiration from Ray Dalio’s How the Economic Machine Works; as such, interest rates are the cost of servicing debt, the amount paid on cash deposits and the rate at which the future value of cash flows from assets such as stocks is discounted back to the present.
As a general rule, lowering interest rates makes servicing debt less costly, diminishes the amount savers get from cash deposits and boosts the present value of future cash flows. The converse is true when interest rates are increased.
Therefore, all else being equal, at a macroeconomic level, lower interest rates encourage more spending and less saving, stimulating demand and, as a result, uplifting economic growth – higher interest rates have the reverse impact.
We can think of interest rates as signals that direct the flow of money and credit across financial markets and different parts of an economy, both within mainland and cross-border.
Another important monetary factor that impacts economic development and growth is money supply or, more specifically, broad money supply. The relationship between GDP and money supply is expressed by the following equation: MV = PT (or the quantity theory of money, developed by Irving Fisher).
M is the quantity of money, V is the velocity of money in circulation, P is the price level and T is the volume of transactions. For practical purposes, the equivalence can be re-written as: Growth in money supply x Velocity of money (the speed at which one unit of currency changes hands in an economy) = Inflation x Growth in real GDP; or: Growth in money supply x Velocity of money = Growth in nominal GDP.
Research done by the Institute of International Monetary Research demonstrates “a clear link in the last 30 years […] between the rates of increase in money (broadly-defined, to include all or nearly all bank deposits) and in nominal gross domestic product across the G20 leading nations”. For the mathematically inclined readers, the relationship can be expressed
as: ∆% NGDP = 0.78 + 0.91(∆% Broad Money), with an R-squared of 0.98.
Consequently, if the money supply drops, nominal economic growth also suffers – this was also very clearly demonstrated by Milton Friedman and Anna J. Schwartz in A Monetary History of the United States 1867 – 1960, in which they showed that a key cause of the USA’s 1929-1933 Great Depression was a c.40% fall in broad money supply.
However, Friedrich Hayek argued that when money supply rises faster than potential nominal GDP, asset values rise in absolute terms and relative to income – this induces a boom as economic actors gear up to buy, build and service assets. The reverse happens when money supply grows slower than potential nominal GDP.
Therefore, taking inspiration from research produced by the MacroStrategy Partnership, the above equation can be re-written as: Asset velocity x Money velocity x Money supply growth = Asset inflation x Price inflation x real GDP.
The term ‘economic monetisation’ describes the shift in the drivers of economic growth, away from saving and investing and towards an approach to capital allocation dependent on debt growth and accommodative monetary policy.
In response to the 2008 global financial crisis (GFC), central banks across the world were required to act fast and prevent what could have been a far worse financial and economic outcome. Of crucial importance to our discussion is what the big 5 central banks have done, especially the Federal Reserve (Fed) – the reason for focusing on the Fed is based on the global status of the USD as reserve currency, as well as on the multi-trillion offshore USD economy that has grown over the past 50 years.
In response to the crisis, the Fed lowered short-term interest rates to near zero. However, as Glenn Rudebush’s December 2018 Economic Letter tells us, this was not enough: “…during the global financial crisis and Great Recession, the Fed again cut the funds rate a bit more than 5 percentage points. However, given the much worse economic conditions, the usual response wasn’t nearly enough. With the unemployment rate reaching 10% in 2009, the simple policy rule would have prescribed much more monetary policy stimulus – indeed, an additional 7 percentage points of interest rate cuts…Unfortunately, the Fed was limited from lowering the funds rate further because of an effective lower bound on interest rates near zero…”.
He continues: “The shortfall between what the Fed could deliver with conventional policy and what seemed appropriate given the dire economic conditions prompted the Fed to employ unconventional monetary policy tools. While conventional policy employs a short-term interest rate to affect financial conditions and the economy, unconventional monetary policy uses other tools to do so. The Fed employed forward guidance and quantitative easing as these unconventional policy tools.”
The main reason why lowering interest rates did not work was because the mechanism of transmition between monetary policy and the real economy, i.e. the banking system, was insolvent – banks across Western economies were unable to lend to businesses and consumers and therefore, unable to support money supply growth. As we know from the quantitative theory of money, a declining money supply eventually means a declining nominal GDP.
Consequently, to prevent economic collapse, while also allowing the banks to recover by recognising bad loans and recapitalising their balance sheets, the Fed drastically eased monetary policy – not only by cutting short interest rates but also by expanding its balance sheet through the acquisition of Treasuries, Agency debt and Mortgage-backed securities from financial institutions (both banks and non-banks).
The Federal Reserve has done this through three rounds of QE (QE1 from December 2008 – March 2010, QE2 from November 2010 – June 2012 and QE3 from September 2012 – October 2014) and Operation Twist (September 2011 – December 2012).
To contextualise just how much liquidity has been pumped into the system via these actions, in 2008 the Federal Reserve’s balance sheet stood at c.$900bn, or 6% of the US GDP. In December 2017, it reached a peak of c.$4.5trn, or roughly 25% of the US GDP.
Although over the past 24 months the Fed has tightened monetary policy by both normalising its balance sheet and raising interest rates, the three QE programmes coupled with ultra-low interest rates represented huge injections of liquidity – and a much needed one. However, as we shall see it has had severe unintended consequences.
There are good reasons to suggest that the Fed kept its monetary policy accommodative for too long.
We can measure excesses caused by “too” easy monetary policy by taking money supply growth relative to potential nominal GDP. M2 money supply (the broadest measure on which data is available) has been above the potential nominal GDP for the best part of the last 10 years.
Keeping interest rates down artificially has severe negative consequences for the economy. Ludwig von Misses pointed out in Human Action – A Treaties on Economics that “the drop in interest rates falsifies the businessman’s calculations. Although the amount of capital goods available did not increase, the calculation employs figures which would be utilizable only if such an increase had taken place…They make some projects appear profitable and realizable which a correct calculation, based on interest rate not manipulated by credit expansion, would have shown as unrealizable.”
In other words, low interest rates can make unproductive businesses look like gold mines, creating a zombie economy.
These are a massive drag on productivity, meaning that future growth will be dependent on even more [cheap] debt.
Also, the bull runs in equity and credit markets that subdued interest rates fueled have helped the financial sector across the developed world to grow dramatically over the past 3 decades. This can be problematic for the economy as financial firms compete with the rest of the industries for resources: for example, a physicist whose R&D may improve efficiency of airplane engines, lured by higher wages in a growing financial sector, is now employed to develop systematic strategies for hedge funds. This can further drag on productivity in the long-term as human capital migrates more and more towards finance, depleting the talent pool for other R&D-focused sectors.
Another issue posed by low interest rates is that they distort the consumption preference of economic actors – consumption is an inter-temporal decision: subdued interest rates discourage deferred consumption (savings) and encourage present consumption, likely fuelled by cheap credit. This kind of economic behaviour can create all sorts of problems, such as bubbles across asset classes and speculative capital allocation at the expense of disciplined, wealth-creating investment.
This is exactly what has happened since the financial crisis of 2008 – the US corporate sector’s debt reached $6.4trn in Q1 2019, up from $3.3trn in Q4 2007, while America’s public debt stood at $22trn in Q1 2019 vs. $9.2trn in Q4 2017. Also, credit card liabilities reached $1.04trn in September 2018, surpassing the $1.02trn level of 2008.
However, debt in itself is not an issue – as Ray Dalio argued in A Template for Understanding Debt Crises, whether debt becomes a problem or not hinges on a) what that debt produces and b) how it is serviced. In other words, it depends how debt is allocated – productively or not. This will ultimately dictate if the return on debt is high enough to service it or if new debt needs to be issued to service the old one, a process which eventually hits a wall and defaults start to unfold, marking the start of the end of the debt cycle.
There are several ways we can assess whether or not credit was productively allocated. One of them is to look at how fast the debt has been growing relative to a measure of income (such as GDP, at a national level). The chart below is for the US.
Additionally, looking at the total debt in the US (public plus private debt) it stood at 1.3x its GDP in Q1 2019.
As research from the MacroStrategy Partnership suggests, another way to look at whether debt resulted in misallocation of capital is to look at the Wicksell spread – Knut Wicksell argued that when the borrowing costs for the average business are 2% above nominal GDP (to compensate for a) the risks of the investment and b) unproductive government spending) monetary policy is neutral. When borrowing costs fall below the 2% figure, funding becomes cheap and it induces a boom – but it also incentivises misallocation of capital.
We can see from the chart below that the spread has been below the neutral line for monetary policy for quite some years now.
This accommodative interest rate environment has manifested while the Fed was also injecting massive amounts of liquidity into the system. However, QE was necessary as the golden rule for a central bank when dealing with an insolvent banking system is to provide liquidity so that the banks recognise losses and then recapitalise their balance sheets – eventually, the banks will recover and will start lending to the economy.
However, banks got ‘repaired’ back in early 2014 and we know this because they started lending again. A quick gander at US bank lending data shows that loan charge-offs lowered close to a pre-crisis level, while bank lending picked up (between January 2014 – September 2018, loans issued by US banks to corporates and consumers grew by c.$983bn).
That means that the Fed’s QT was about 3 years overdue. However, we need to give credit where credit is due! In the words of Ray Dalio: “…investors only have to understand how the economic machine works and anticipate what will happen next. Policy makers have to do that, plus make everything turn out well—i.e., they have to know what should be done while navigating through all the political impediments that make it so hard to get it done. To do that requires a lot of smarts, a willingness to fight, and political savvy—i.e., skills and heroism—and sometimes even with all those things, the constraints under which they work still prevent them from being successful.”
The injection of USD into the system through QE was not only a saving potion for the US markets (and economy) but for the rest of the world economy as well. When USD liquidity is abundant, the greenback weakens, boosting international trade and commodity prices and supporting financial assets rallies.
That said, if policymakers keep these accommodative conditions for longer than needed excesses start to form across the financial system and the economy. Remember that QE was there primarily to ensure that money gets injected into the economy while the banks repaired their balance sheets and started lending again – bank lending is the ‘natural’ way for money supply to grow. As the data above points out, US banks reclaimed their economic function in 2014.
Nevertheless, we can see several signs of excesses across financial markets and economies that can be attributed primarily to easy monetary policy. The first one was mentioned above – money supply has been running above nominal GDP for a while: this provides excess liquidity to support overvalued assets and / or unproductive ventures. Another sign of misallocation of capital can be seen in the US corporate sector that geared up and bought back shares like there was no tomorrow.
Take for example Apple, which repurchased $43.5 billion of its own stock during the first six months of 2018 (according to The New York Times). But Apple is not alone – data from Goldman Sachs reported in August 2018, shows how companies in the US technology sector have accounted for 40% of authorized spending on buybacks so far in 2018. To contextualise this, US corporates have authorised $1trn of buybacks for this year (if executed, this would represent a 46% rise on the previous year). Importantly, companies have been doing this at the expense of investing in their own businesses.
Additionally, Morgan Stanley reported in May 2018 that the amount of leveraged loans in the US reached $1trn (this represents 102% increase from the amount seen in 2010). Meanwhile, a more recent report from the Bank of England suggests that there are as much as $2.2trn of leveraged loans globally.
Leveraged buyouts (LBOs) levered over 6x are now at a similar level (52.3%) as a percentage of new LBO loans as they were in 2007 (50.7%), based on the same research note from Morgan Stanley. These excesses are a by-product of the ultra-easy monetary policies pursued by central banks for longer than necessary.
These are just a few pockets of excesses – not to mention bitcoin (not blockchain) and the red hot housing markets in Canada, Australia, Norway, Honk Kong and London.
For all of this to be sustainable, i.e. for things to continue as before without major shocks, the Fed needs to keep monetary policy accommodative. However, this subjugates real economic growth to monetary expansion.
Under these conditions, wealth is increasingly an illusion of prosperity.
(US household) wealth is an illusion
There is a lot of discussion of what precisely constitutes wealth. Our interpretation is that wealth is synonymous to having a stake in the economy and society – the larger the stake, the wealthier you are. For example, owning a house will give you a stake in the broader economy, in your neighbourhood, in the city you live in, in the country you are residing and so on.
Therefore, viewed from this perspective, wealth consists of property, equity (shares in companies), bonds (money you lend to others that put it at work for the economy to develop and grow), real estate and relationships (personal and professional). The latter element is not quantifiable but is, in our view, a catalyst for acquiring the other three elements of wealth, which are calculable.
An alternative way of thinking about this is to view wealth as claims on future income streams (dividends from stocks, interest payments from bonds and rents from properties).
In the US, the households’ net wealth was c.500% of nominal GDP as of Q1 2019 – way above the long-term trend of this ratio.
As Niels Jensen of Absolute Return Partners notes in his December 2018 letter, “the US long-term mean value is around 380%; i.e. total US household wealth is on average about 3.8 times US GDP. The mean value varies somewhat from country to country, but it is long-term stable everywhere. Think of the ratio as a measure of capital efficiency, i.e. how much capital does it take to produce one unit of output? The lower the mean value, the more efficient a country is at utilizing the capital at its disposal…it must drop 25-30% to re-establish the long-term mean value. That can happen in two ways. Either GDP grows faster than wealth for an extended period of time, or 25-30% of all US household wealth is destroyed.”
Why is the household wealth so elevated? We think that expansionary monetary policy increases and supports inflated asset prices. The reason behind this observation was accurately underlined by Murray Rothbard in Man, Economy and State: “The individuals who receive the new money first are the greatest gainers from the increased money; those who receive it last are the greatest losers.”
The first to receive money were banks and asset managers. When the Fed bought securities from the banks, it increased the banks’ excess reserves at the central bank – these cannot be used to issue loans to the economy and therefore, these purchases do not increase money supply in a direct manner. But they can do so if these excess reserves are used to satisfy demand for cash. However, when the Fed bought securities from non-banks, like pension funds and money managers, it increased these institution’s deposits at their respective banks and, as a result, it boosted money supply. With this additional purchasing power, these economic actors bought more financial assets, bidding up asset prices.
The last to receive the cheap money was labour: the share that workers take home, as a % of GDP, has been declining since the 1970s. However, it has fallen of a cliff after the 2008 financial crisis and, nearly ten years later, it barely improved – up a mere 1.1 percentage point in 2017 from the lows of 2014.
Therefore, Rothbard’s observation points to another problematic outcome as a result of easy monetary policy – it widens the wealth gap: those that can make use of cheap money earlier in the process have bought goods and services, thereby increasing their stake in the economy (i.e. their wealth). As they buy more, prices start to rise across the economy.
However, those who received the cheap money later on (or never) have seen their wealth stagnate or even decrease, as they couldn’t keep up with the overall price increases. Some might be sceptical of such inflation as we’ve only started to see inflation, in the traditional sense, emerge over the past few 18 months or so in the US – but that’s because the typical measures of inflation like CPI do not include financial assets. In fact, if we look at the NY Fed’s inflation gauge, which includes financial variables, it has been above 2% for some time now!
Inflation can occur in relatively isolated pockets of the economy, such as its financial sector or the housing market – indeed, if we look at the general increase of prices in the sphere of financial assets, inflationary forces are clear: this cycle has seen the longest bull market in recorded financial history – the S&P 500 has delivered a c.287% total return from July 2009 to July 2019 (with dividends reinvested); fixed income products also delivered good results, with the 10-year US Treasury yield being in decline for more than 3 decades, while commercial and residential real estate have recovered nicely since the financial crisis. These three assets – property, stocks and bonds – are the most common ones on US households’ balance sheets.
As such, we argue that the 500% of wealth to GDP ratio is primarily due to inflated asset prices as a result of accommodative monetary policy. The link between changes in money supply and national income and wealth are very well documented by Professor Tim Congdon in his video “Can monetary policy became ‘exhausted’?”.
Another way to think about wealth-to-GDP is to change wealth for capital and GDP for output. By doing that we arrive at the capital-to-output ratio first expressed by Paul Douglas and Charles Cobb in the 1920s: a capital-to-output ratio of 500% means that in order to produce $1 of output, the economy requires $5 of capital (up from the long-term norm of $3.8). This is another sign of weak productivity caused by capital misallocation.
The situation is more worrying when we consider the massive underinvestment gap which the MacroStrategy Partnership estimates to be about $400 trillion globally (or about 5 years of global GDP) – this is the amount of money that is needed to take GDP growth back to levels seen in 1950s and 1960s.
Easy monetary policy coupled with underinvestment means that economic growth is supported by debt and, when this debt will no longer be sustainable, capital consumption will required to sustain GDP growth in absence of a boost in productivity. In time, if these conditions are allowed to prevail, they will cause GDP not only to slow but to eventually turn negative.
We are now living under an illusion of prosperity – too many economic actors are focused on short-term consumption and have become accustomed to cheap debt funding.
Indeed, we have many goods around us that we can buy; but what about their utility? What about the costs in making these goods? Have they paid for themselves? An economy with chronically low productivity, depended on low interest rates to serve a titanic amount of debt and with a labour force that has taken home less pay over the years would suggest that the answer the these questions is a clear “No”.
The unrest in France, which is spreading to Belgium and the Netherlands are the latest signs that the economic system is no longer delivering for people – the first indications of this were Brexit and the election of Donald Trump. We believe that tensions will only increase from here until the large amounts of misallocated capital are cleared.
What does it mean to investors?
No imbalance can prevail forever – sooner or later the system will correct it, either proactively, i.e. through political and economic action or forcefully, i.e. through social unrest, forced debt restructuring and abrupt changes in political leadership.
There are many factors at play that can see a correction of economic imbalances in a chaotic manner. That said, investors can hedge against these events.
Given the recent capitaluation of the Fed to market pressure and to President Trump’s tweets, shorting the USD while going long Emerging Markets also has potential to deliver over the next 6 months.
We also think that long UK domestically-focused equities has potential to deliver over the next 12 – 18 months. Brexit uncertainty is likely to diminish from October. However, being selective here is important to avoid value traps.
Gold will do well in an uncertain environment. A trade which we believe has solid potential is long gold in Chinese Yuans – further analysis for this can be accessed here. We believe that gold is poised for a multi-year bull run.
Another longer-term play is to directly fund early-stage businesses that aim to revitalise productivity through innovation. As such, long low-levered VC-type structures that lock in capital for 5-10 years in concept-proven, privately-held busiensses in fields of energy, healthcare and information processing has potential to deliver great returns.
Disclaimer: This is not investment advice. Image from https://hunaari.co.uk/.