Oscar Wilde once said that “Life imitates Art more than Art imitates Life”. The American Dream Factories in Hollywood and DC currently provide two opposing forces in this dialectic.
Hollywood has caught the zeitgeist with the remake of the Great Gatsby.
The Federal Reserve and the Federal Government (who produced and directed the recent real life Gatsby with a War on Terror deficit financed by an expanded Fed balance sheet), are currently trying to remake “It’s a Wonderful Life”, in which the good folks of the American Middle Class play the leading roll.
Ben Bernanke played a cameo role with his Valedictorian speech to the Princeton Class of 2013[i]. He has scripted a new social contract between young Americans and the Federal Reserve. Presumably this means that the Fed’s expanded balance sheet will also get stuffed with modified student loans repackaged by Sallie Mae as bonds! President Obama raised the curtain on Bernanke’s swansong in an interview with Charlie Rose, in which he made it clear that the monetary maestro’s career was over[ii]. Bernanke has been “Gatsbied”.
If the Fed Chairman walks and quacks like a Lame Duck, he must be……
In doing this, the President has made Bernanke a Lame Duck[iii]. The conduct of monetary policy, at this critical stage in the economic cycle, has just been made even more complicated. Fed communications and actions will lack the authority and legitimacy, now that Bernanke has been consigned to obscurity. Observers and speculators will now become distracted by the game of guessing who will be the next Fed Chairman; and then what this means for policy by default. When he finally quacked in the press conference after the June FOMC meeting, traders didn’t even try to be understanding. When the “Taper” word sounded audibly, the markets crashed. He made it clear that the “Taper” is still a form of easy monetary policy, but nobody cares any more. As Michael Woodford noted at Jackson Hole in 2012, when markets start to discount the end of QE all its benefits are lost[iv]. Bernanke made it clear, for anyone who would listen, that the Fed won’t be selling MBAS even when it finally ends QE. This confirms the underlying thesis in Terminal velocity of an indefinitely expanded balance sheet; and that the strategy is to let these assets mature. It hardly seems to matter however, since the spike in Treasury Bond yields will create as much damage in the underlying mortgage and housing markets as a Fed tightening.
The President is evidently working on a new production. The teaser for this latest blockbuster production from the White House was released online, rather than at cinemas, on June 12th. It was entitled “Rock and Roll, Economics, and Rebuilding the Middle Class” and was directed by Alan Krueger, Chairman of the Council of Economic Advisers (CEA)[v]. Some of the stills are worth reproducing (below) to understand the sublime message in the production.
The St. Louis Fed also added some CGI special effects with its latest report on the Flow of Funds[vi]. The “QE Tide” did not lift all American boats, as the general picture on the recovery of household wealth suggests. The headline figure suggests that household wealth is back at pre-crisis levels. This headline is heavily distorted by the financial assets of the 1% of Americans who have benefited directly from the impact of QE on their portfolios. Drilling down into the data shows that older Americans have similarly benefited from QE. The less wealthy and especially the young have not benefited at all. We think this is why Bernanke redirected his rhetoric towards the young demographic at Princeton.
The movie script is clear. It also politically eviscerates the Republicans; by destroying the credibility that their new strategy hoped to gain with a return to nostalgic “Reaganomics”. Republicans fondly remember “Reaganomics”. The CEA has presented Reagan as the datum at which the great decline of the American Middle Class began; without specifically naming him and committing heresy plus political suicide. For “Reaganomics” read “Rockonomics”. Since Reagan, income disparities have widened; and the wealthy have preserved the legacy for their children to perpetuate the system. The Middle Class have pretended to be wealthy, by taking on too much debt; and have now been overwhelmed because their debts are still bigger than their assets. QE has passed them by because they are long in debt and short in financial assets. The poor have been abandoned and criminalised. It’s all very fin de siècle, just like the Great Gatsby.
Great Britain and its iconic “Thatcherism” bride of “Reaganomics” also get framed in the same economic allegory.
The socially cohesive Europeans have their own less socially divisive genre of “Economic Cinema”. Their social cohesion however comes at the cost of a bloated welfare system, which is financed by sovereign deficits; so even their cosy polity is at risk.
The American solution opined by the CEA, seems to be another New Deal. Before readers assume that a new round of deficit spending to save the Anglo-Saxon Middle Class is coming, one should check the deficits of these countries however. They can’t afford it, especially Britain. Neither can the Europeans, as we know. So what can they do?
If one looks back at the slide that shows that all Americans prospered in-line after the World War II up until Jimmy Carter, we think that there is a clue.
The first phase of prosperity until the 1960’s came with a return of sound money and balanced budgets. Real incomes rose as inflation fell. The economy nurtured back to health by Bill Clinton is a contemporary example of this return to sound money and balanced budgets. If history rhymes again, a return of the strong US Dollar, low inflation and low growth are in place. This will be the multi-decade trend, which was called the “Lost Decades” when it occurred in Japan. The fiscal discipline never lasts though. Once the budget surpluses are visible, “Big Government” and Wall Street become covetous; so the President and his sound economics soon vanish. When policy makers started to get frustrated with the slow nominal GDP growth inherent in this strategy during the post-War period, inflation strategies culminating with the abandonment of the Gold Standard followed. Military adventures, such as Vietnam also occurred; so the budget constrained Pentagon also has large role to play in the future.
For those policy makers who are not satisfied with the “Lost Decades”, there is the solution that was applied at the end of this sound money period; which coincidentally Japan is trying right now. Monetary inflation was seen as the cure for the “Lost Decades”. In America, when it was applied from the 1960’s to the 1980’s it ended with the collapse of the US Dollar and the suspension of the convertibility of Dollars into Gold. These American “Lost Decades” ended with the removal of Jimmy Carter during a period of hyperinflation. America is now watching Japan’s in vivo experiment with inflation, to see if it can be applied.
We believe that we are now at a branch in the road. Currently, the American economy is on its way back to sound money, because of slow growth and enforced deficit cuts. There are however some economists, like Michael Woodford and Adair Turner, who believe that the application of “Helicopter Money” can avoid the full deflationary effects of the return to sound money and balanced budgets. The “Helicopter” thesis is seductive; however the spike in interest rates, recently witnessed in Japan, suggests that the volatility in capital markets created by “Helicopter Money” may destroy its efficacy.
In Terminal Velocity “Goldilocks Economy and the Three Bear Markets” it was suggested that Bernanke had moved to focus on the Employment Mandate. Having understood that QE has only boosted what we term the “Leverage Cycle”, rather than the Business Cycle, he has decided to scale back. To stimulate the Business Cycle, capital investment must be encouraged through the creation of a term structure of interest rates that rewards this form of risk taking. The “Taper” was observed as one of the tools to Normalize the Yield Curve to create this favourable interest rate environment for capital investment. It was therefore with great interest that we read the legendary investor John Hussman’s views on the shortcomings of QE[vii].
Mr. Hussman has named this study “The Price of Distortion”. His thesis is that QE has caused bubbles in asset prices that bear no relation to the economic indicators in the real economy. Real corporate profits are now at a turning point, after four years of recovery. In addition, fiscal austerity and private sector deleveraging are creating headwinds that will drive corporate profits even lower. Equities, normally valued by these metrics are however valued in relation to the high levels of liquidity in the financial sector as a consequence of QE. Mr. Hussman sees a wide disconnect, which is clearly bearish for equity prices. His observation supports the thesis that QE has been ineffective in stimulating the real economy, because it has been used for financial speculation rather than capital investment. The legendary Hedge Fund Manager, Stanley Druckenmiller was even more critical of QE[viii]. In the same spirit as Hussman’s “Price Distortion”, Mr. Druckenmiller opined that such distortions had effectively broken his dashboard as a trader; by distorting the values of trading signals that he would normally have used. Observers may shed no tears for these legendary investors losing their edge, however there is a more profound message. The Fed prides itself on being one of the more market savvy central banks. The Fed therefore also bases its own policy decisions on the feedback through asset prices from the markets. What Mr. Druckenmiller and Mr. Hussman are saying is that all current market indicators are distorted. If the Fed has also been using this distorted data, to make policy decisions, then it has been fooling itself. The big rally in equities therefore does not portend a strong economic recovery. On the contrary, it portends a huge crisis if and when the stimulus ends.
Kit Juckes at SocGen has come to this same conclusion already[ix]. His chart (above) illustrates what we called the “Leverage Cycle” in Terminal Velocity “Goldilocks Economy and the Three Bear Markets”; and the Fed’s predictable (and successful!) attempts to stimulate it each time it collapses.
We would like to combine these disturbing charts (below) of Capacity Utilization with this data.
The Capacity Utilization Chart shows that each Fed stimulated recovery in the “Leverage Cycle” leads to smaller recoveries in the real economy, especially manufacturing. As we suggested in Terminal Velocity “Goldilocks Economy and the Three Bear Markets” the “Leverage Cycle” is pro-Cyclical to the Business Cycle. This means that each collapse in the Business Cycle is exaggerated by the pro-Cyclical collapse of the “Leverage Cycle”. The chart of Capacity Utilization supports this view. On the upside however, the pro-Cyclicality is asymmetric; and less Capacity is utilized. We have suggested that each upswing in the “Leverage Cycle” is associated with more liquidity going into financial assets than into the real economy. This would explain why each recovery uses less Capacity. This also explains why equity markets have followed a historic uptrend, even though Capacity Utilization has fallen.
There is also another reason why each recovery is associated with less Capacity Utilization. In Terminal Velocity “Flying Blind, On Fumes, With No Pilot” we suggested that each Fed stimulus pulled economic activity forwards from the future[x]. Observers talk in terms of Over-Capacity; but we prefer to look at this more as demand being pulled forward from the future, so that there is less aggregate demand available in the future for subsequent economic recoveries. Out there on the historic timeline continuum there is a Black Hole, where growth should be. In the absence of some real growth multiplier such as the modern equivalent of the discovery of fire, the wheel and the internal combustion engine there is no real growth associated with any economic recovery. Growth has simply been borrowed from the future. We suspect that policy makers have been coming to this conclusion, from their observations of the diminishing returns to monetary stimulus since the 1990’s in the Developed World. In “Goldilocks Economy and the Three Bear Markets” we said that:
“Fundamentally speaking, the policy makers have reached the point at which they have conceptually understood that monetary stimulus has pulled forward the valuation of future economic growth to the present in asset prices.”
The valuation of equities is therefore predicated on future growth that is not there. The efficacy of the equity market as the predictor and valuer of future economic growth has gone. Based on what Mr. Druckenmiller is saying, this would seem to be the case. The equity market has become an indicator of the level of liquidity and not of future growth. If the Fed has pulled growth from the future therefore, there is some point in time at which the future meets the present and growth stops. The more the Fed pulls forward growth, the higher equity markets go; and the more painful the correction when this convergence occurs. It is also more probable that the greater the stimulus the sooner the convergence comes. QE simply brings this point of convergence closer, by increasing how much growth is borrowed from the future. When it is understood that the “Leverage Cycle” is pro-Cyclical, one can understand that this convergence point becomes even more painful when the declining “Leverage Cycle” kicks in. This why each recession is more painful and each recovery is more shallow.
It is our suggestion that the “Helicopter” will be an attempt to stimulate growth in the present rather than take it from the future. There is always a price to be paid in the future however; since all financial ledgers must balance over time. Payment for today’s “Helicopter” ride will come from the erosion of future purchasing power by inflation. The “Helicopter” is therefore not a panacea; it is simply a form of wealth redistribution that appears to be more politically progressive. It is economically regressive for the holders of financial wealth; however these are the 1%. The 1% will therefore have to move fast to exchange this financial wealth for real wealth when they see the “Helicopter”. Real wealth can be found in many places, both in the ground and manufactured above it, so equity investors should pick their stocks carefully to make sure that they have pricing power. The 1% has a choice. They can stay in financial assets and get wiped out when the convergence occurs, or they can turn their financial assets into real assets which have pricing power.
The most interesting highlight of the June FOMC announcement was the dissenting voice of James Bullard[xi]. Having seen the Chairman turned into a Lame Duck, he wasted no time in sticking the knife in. In his first act of dissention, he opined that he was taking a stand because inflation is too low. He then used his own homepage to elaborate upon his dissent. In his opinion, the Fed totally mishandled the June announcement[xii]. Not only is inflation too low, but the Fed has also committed a fundamental error by being timetable rather than data conditional. The Fed Timeline is “Taper” in September, end QE in June 2014 and Retire Bernanke in July 2014. Bullard feels that this is way out of touch with the economic reality in the data. It is also too forward looking. Not enough is known about the economy to communicate with certainty out to 2014. He offered an olive branch to his colleagues with the message that:
“While President Bullard found much to disagree with in this decision, he does feel that the Committee can conduct an appropriate and effective monetary policy going forward, and he looks forward to working with his colleagues to achieve this outcome.”
One suspects that he may be the first Fed President to resign on principle. Having failed to get the Chair this time around, he is clearly marking his run for the job when the next occupier of the seat is “Gatsbied”. He will need to make the early call that Inflation is the problem by then, if and when the “Helicopter” is in flight; to make it clear that he has still got the touch.