My last piece “The Matrix Exposed” generated a bit of a stir. And as per usual the PhD’s had some fairly colourful things to say to me regarding the notion that more money and more credit may actually stall an economy. But look I’m not trying to be offensive to anyone. I’m simply making a case that when consumer credit becomes the basis of growth, well you have a real problem. And that is a pretty reasonable argument even without the hoards of data backing it up.
But so allow me an attempt to mend some bridges. Let’s start by looking at the various existing frameworks that drive economic policy. We have Monetary policy (the banks), Fiscal policy (Congress), Microeconomic policy (Corporations). So let’s look at each.
Let’s begin with Fiscal policy.
The very first issue that should jump out to everyone is that Congress has been utterly ineffective for almost 2 decades now. That is because the partisanship has become so intense that there simply seems no room for compromise in an effort to get any reasonable piece of legislation done. What we are left with is a slew of outdated fiscal policies. Perhaps most detrimental is a corporate tax rate nearly twice that of many other developed nations.
The problem with relatively (to other nations) high corporate tax rates is it means that any domestic investment, everything else equal, has a significantly longer breakeven point. Said another way, the return on domestic investment is much lower than the return on foreign capital investment (ceteris paribus). This is a very intuitive concept, easily digestible by all. The implication is that the relative level of corporate tax rates here in the US incentivize corporations to invest elsewhere.
And corporate tax is now a catch 22 because government transfers have become such a robust part of the societal fabric. We need the high corporate tax level for the transfers but the transfers are in part a result of the high corporate tax level. This quickly becomes a highly sensitive political point of dispute. And again with Congress completely locked down by partisanship there is essentially zero probability of any significant legislation (either tax cuts or spending initiatives) being passed anytime soon. And so Fiscal policy is off the table.
Now let’s look at Monetary policy and the Fed.
If you follow my research and writing you’ll know that I’m not the Fed’s biggest fan. That said, if we are going to have a Fed it should do what it can to be beneficial to the economy. But so how does the Fed affect the economy? Well it does so through interest rates and money supply. Now the major problem with monetary policy is that it attempts to stimulate economies by incentivizing capital allocators (corporations) to be productive. It does so by essentially dictating the cost to borrow, which flows through to breakeven point and thus return on investment. It also increases the effective money supply in the economy (through credit i.e. fractional reserve) in an effort to kickstart a demand side that then incentivizes capital allocators (corporations) to be productive.
By being productive I mean initiating domestic capital investment, which should lead to jobs and thus demand via improved incomes; and the boom cycle begins. And the Fed had some success historically. But Fed/Monetary policy has been ineffective during its latest recovery program post financial crisis. Why? Well when we look at things like corporate debt levels we see that Fed easing did incentivize corporations to borrow but what they did with that capital countered the Fed’s objective and this is the main problem with monetary policy. It is indirect and requires allocators to play along and this time they didn’t.
And so when we look at what corporations did with that money we find the broken mechanism of monetary policy.
Rather than initiating productive domestic investments a significant amount of those funds went to dividends, buyback and foreign capital investment. None of which hit on the Fed’s objective for easing monetary policy. And so while the Fed may have been genuine in its attempt to stimulate the domestic economy, it was reliant on corporate microeconomic policy to follow suit. And that simply didn’t happen. Let’s visualize this story with real data.
Here’s the Fed’s implemented monetary easing post financial crisis.
Next chart shows that Fed policy did incentivize capital allocators (corporations) to borrow.
Next chart shows that corporations have been increasing dividends as their borrowing increased.
Next chart shows that corporations have taken buybacks to record levels as borrowing increased. If you summate divs and buybacks you’ll note it is more than 100% of net income.
Next chart shows the increased debt is used almost exclusively to buy back shares (cash distribution – the most inefficient use of capital).
Next chart shows that real private domestic business investment peaked in Q1 ’15 at a much lower level than where it was in the late 1990s and has again been contracting for the past year despite the most extreme monetary easing in the history of the Fed.
This means that the significant increase to borrowing that was incentivized by Fed policy in order to stimulate productive domestic investment actually went to the most inefficient use of capital, i.e. cash distributions. And that means the Fed’s monetary policy objectives failed to be realized.
Notice in the above chart that a recession (grey verticals) immediately followed every sharp drop in real net domestic business investment (recession was delayed in the 80’s but we ultimately succumbed to recession before increasing). However, today we are asked to believe record equity valuations are warranted based on near/medium term expectations despite an 88% probability that we have just entered a recession? Well that’s a topic for another day. Now what happens at the microeconomic level when capital is misallocated?
Next chart tells us exactly what happens. Return on investment and balance sheets deteriorate. So we add risk while reducing return. An investing 101 No – No.
The result of perpetually misallocating capital is that everyone dies in the end. And look I have sympathy for CEOs. In fact, I’ve given CEOs a pass on criticism. It is because CEOs are simply pawns in the system. They are beholden to what investors demand. And investors want returns.
Investors today, with median holding periods now less than 60 days, don’t care if a CEO can provide return through expansion of operations or contraction (raiding the balance sheet). For the past 8 years CEO’s have only been able to provide investors a return through contraction (as a result of a damaged demand function) and so they have done so. The problem is that while this is generally ok on a short term basis as an individual firm awaits its demand universe to correct, things are different this time. Demand isn’t coming back because all firms have implemented the same survival policies, which become destructive to both demand and productivity on the macro level.
The result is that these corporate microeconomic policies of capital misallocation (implemented in an attempt to appease investors) are negating all of the intended benefits of Fed policy. This means we are fully reliant then on fiscal policy which, as we already discussed, is off the table for as far as the eye can see.
And so even if we accept that all existing economic policy frameworks (fiscal, monetary, microeconomic) really do have the very best of intentions we are still effectively dead in the water.
So then what in the hell do we do? Well there is a real and viable solution that would require no central banker, legislator or CEO involvement by creating a fourth policy framework. Let me know if you’re interested in hearing more.