The Investor October 2019

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By Richard Cluver October 2019

1987 was an important year in my life. I married that year, notched up my first million, saw the value of my share portfolio decimated by the share market crash and launched the first version of the ShareFinder computer programme.

As assistant editor of The Daily News in Durban I considered myself to be quite well off on a salary of R3 450 a month that would not even pay my electricity bill today. Considering that my home was bond-free and that salary, after deducting income tax, medical; aid contributions and pension deductions, allowed me a take-home sum of R2 414.54 which well exceeded my living expenses and was massively more than the median salary at the time, I had good cause to feel happy about my situation.

And then it all went dramatically wrong heralding a significant change in the way our investment scene operated as I shall shortly explain.

That I had neglected to take my own widely-published advice and had gone out on a limb of investment risk that was wildly dangerous, had somehow escaped me. Most of all, however, I had failed to recognise that a major change was coming over the world and was not prepared for it. The change was deeply significant and it is important to understand what happened around that time to the global investment scene because similar change is in the wind once more!

What happened to the Johannesburg Stock Exchange that October 1987 is best understood by considering the following graph of the JSE Overall Index for the period. In a matter of days between October 19 and November 5, the market fell from an index of 28040 to 16820 loosing 40 percent of its value. It recovered briefly until November 30 and then slid down again to bottom on February 12 at a low of 15170 by which time the overall loss was 54.1 percent.

If South African investors could have foreseen what was to subsequently happen, we might not have felt as devastated as we all felt that November in 1987 for within 21 months the JSE had recovered all the ground it had lost and gone on to spectacular new heights. By February 1990 it had soared to a new high of 33940 meaning that those investors who had the confidence to have bought in at the bottom in February 1988 at 16820 had seen their investment more than double with an actual growth of 101.78 percent.

 It was an agonizing and extraordinary time when millions saw their lifetime savings disappear overnight; a time of sleepless nights and cold pan10 minute millionaire ad.pngic. Fortunately for me, I am both an optimist and a quick learner. You learn to become one when you are technically bankrupted overnight!

I had recently bought one of the first commercially-available computers, the famed Apple 2E, and was busy with a research project that in a remarkably short time led to the development of the ShareFinder programme which, for the first time ever, provided users with a reliable list of investment grade shares which could effectively guarantee one an assured growth portfolio and an equally effective timing mechanism which enabled them to buy at the most cost-effective price. I was on the way to restoring my own fortune and, as a newspaper columnist, fast becoming a beacon of hope to thousands of readers who saw in my writings the promised that by adopting my methods they might hope to be able to restore their own lost savings.

I was flying high. My investment columns were running in all of the then Argus Group’s major newspapers and I was enjoying a daily mailbag of readers’ letters which exceeded the sum of all other editorial letters. In recognition of this, I had just received a 28 percent pay increase of my monthly take home amount of R1 984 the previous year. The extent of that increase might appear exceptional today but then in the intervening year inflation had surged to 16.3 percent; a phenomenon that was considered normal for those times but one we have today nearly forgotten…and with it the understanding that investing money requires that you match the method to the times…and times are constantly changing.

That is why it is so interesting to look back to the 1980s; to a period of high monetary inflation and to understand the consequences of the phenomenon. If you care to refer to a useful web site at created by Renier Crause, you will determine that in 2020 money my gross 1987 salary of R3 450 was the inflation-adjusted equivalent of R32 516 today and it compared with the then median monthly salary of R2 737 for South African white-collar workers; a figure which in turn would represent R25 796 in the year 2020.

The median price of a house in South Africa that year was R76 895 which, inflation-corrected, represents a 2020 value of R724 735 while the latest figures supplied by FNB suggest that the current average house price in KZN is R1 025 000. That differential between the inflation-corrected value of a house represented a real increase in value which is best explained by the pressures of supply and demand and the consequence of very little home building having taken place in the intervening years.

But for now I want to focus upon the phenomenon of inflation which is at the heart of this narrative. Thus I mention all these numbers because most middle aged South Africans living today will still be alive 32 years from now and they are likely to experience even greater rates of monetary inflation between now and then and probably worse investment market volatility. To bring us up to the present, let’s consider some current pay averages provided by Stats SA:

If we leave out Eskom employees who we all know are massively overpaid, then we can see that the average pay across all work sectors in 2020 is around R21 850. If the same inflationary pressure are brought to bear on the buying power of the Rand during the next 32 years as happened over the previous 32, that salary average will represent R205 934 a month in the year 2052.

Why is that figure important? Well if you are just getting by as a middle-aged worker today, you need to recognize that in order to pay for your current lifestyle in your so-called golden years you will need to provide a pension for yourself at least ten times greater than your current earnings. And if I and a growing band of global economists are correct, it could be massively greater for we are on an economic cliff edge which is likely to radically re-shape how we currently view investment decisions.

To understand what is coming you need a little monetary history; to appreciate that during the 1970s and 80s the “Greenback Dollar” had been the world’s sole reserve currency. Most international trade agreements back then were written in US Dollars since the dollar was the only currency allegedly backed by reserve funds of gold bullion held by the US Federal Reserve in a massive series of underground vaults beneath Fort Knox and elsewhere in the USA. The dollar was presumed to be “as good as gold”…except that it was not.

Using their dollars, US investors had been buying up the assets of blue chip corporations across the globe. But economists had begun to wonder whether the US really held those reserves and whether the US Dollar was truly worth its stated value in relationship to gold. As early as February 1965 French President Charles de Gaulle began challenging the US to settle its debts with France in gold bar rather than in paper money. Economists had good reason to be concerned and their fears were reflected in a rapid rise of the US inflation rate which reached as high as 13.3 percent in 1979 which resulted in the sovereign bond rate soaring to a peak level of 18 percent the following year.

 If you consider the tables on this page, alongside each year I have listed the US inflation rate and in turn the sovereign bond rate, you can gain an understanding about the world environment at that time.

Contrast those figures with my second table below which lists the same figures in the US since 2008, when in the wake of the “sub prime financial crisis,” the bond rate fell to zero and inflation hovered at 0.1 percent for the year. This dramatic change was the result of financial engineering initially by the US Federal Reserve and in turn by most of the world’s central banks in the wake of the 2008 economic crisis which many at that time feared was likely to tip the world into another Great Depression. Employing a process known as “Quantative Easing” the world’s central banks massively distorted the global monetary system. Quantative Easing” a process in which the US Government issued massive quantities of debt which the Federal Reserve voraciously absorbed, the exercise was a vain effort to achieve the Keynesian economics objective of igniting inflation in order to promote economic growth. But it did not work and official inflation numbers have since remained stubbornly low…or so it seems.

However, the process simultaneously sowed the seeds for the next monetary crisis which is now about to unfold. The result of Quantative Easing, both in the US and everywhere else, has been a massive increase in global debt being run up both by governments and corporates taking advantage of the historically low-interest rates which resulted from the fact that the world’s money supply was quadrupled.

Of course, if you increase the money supply without a simultaneous increase in productivity the normal result is inflation but in this
case the effect was concealed. Stupidly, because governments wanted to punish the banking system which was perceived to have created the monetary crisis through their creative lending exercises leading up to the 2008 crisis, governments enacted policy to ensure that banks could no longer lend money so freely to the public. But money is like water. It flows around until it manages to find a resting place and in the post 2008 period, since it was blocked from being channeled to the ordinary public in the way it normally does in the form of hire purchase and mortgage loans, it flowed into the worlds’ share markets.

The result was the longest bull market both Wall Street and the rest of the world’s equity markets have ever seen. In my graph below you can see how Wall Street’s Standard and Poors 500 Index massively increased in value between March 2009 and the present by a total of four and a quarter times.

Simply stated, the world’s top ten percent who own most of the value locked up in global stock exchanges saw their wealth increase 440 percent from an index low of 69741 to 302097.

That red trend line on my graph represents a compound average increase in market value of Wall Street stocks of 15.4 percent a year at a time when US monetary inflation averaged 1.39 percent a year.

Now monetary inflation is conventionally measured by comparing a shopping basket of the same goods month by month. So inflation is a measure of the rise in some living costs which might or might not include home rentals, but not the rise in value of inflation-hedge items like property, antiques, corporate shares, precious metals and so forth.

However, over time all of the latter move more or less simultaneously. Thus, if property prices rise but you fail to take this into account you are saying that providing a home for yourself is not a living cost. Similarly, if the State subsidises some housing and some basic foodstuffs, it is wrong to argue that inflation is not taking place since it is not evident when you measure these items.

Inflation is in fact a measure of money supply rather than a measure of a change in cost of goods and services. To offer a crude example, a house that costs a million rands today should, unless you make significant changes and improvements to it, still be worth a million rands in ten years time. Its price might fluctuate if several people view it as particularly attractive and compete to purchase it, which introduces the concept of supply and demand pressures, but its value should not vary over time.

What in reality changes in the house price example is the buying power of money and that is a consequence of central bank monetary policy. Again, to offer a crude explanation, if central banks print only enough money annually to replace bank notes destroyed by wear and tear there should be no inflation. However, if they print more than so required, the result is inflation and if they print less the consequence is deflation.

Now, when central banks effectively print enormously greater amounts of money through the manipulation of credit, they inevitably distort the way we conduct our lives and the way we do business. So, as a consequent example, corporates now no longer resort to the stock exchanges of the world in order to raise money. Who would want to do so when the prevailing dividend yield is around three percent and money can be borrowed in the money market for less than one percent.

Governments meanwhile have been able to borrow at negative rates? Add to that the fact that most governments have long been unable to match their income from taxes etc to the sum of their spending and the result of all of this borrowing has been that most countries have long passed the point where they can afford to repay their debts by the conventional means of regular installments. With global interest rates at historic lows, most governments and corporate have resorted to simply rolling over their debts and borrowing ever greater sums merely to repay the interest.

The table on the right lists the most indebted nations by the ratio of their debt to Gross National Product. In all, 76 countries have debts exceeding 60 percent of their GDP, the level above which most economists accept that debts cannot be normally serviced. The world average debt level has now, in fact, passed the 60 percent level.

The figures, provided by the World Bank, highlight the fact that most of the world’s leading nations are so hopelessly mired in debt that it is impossible for them to repay by conventional means.

The United States debt comes in at 82.3 percent of its gross national product, Germany at 64.1 and South Africa at 50.1 while in terms of per capita debt, Japan leads the list at $91 768 per citizen, the United States at $46 645 and Britain at $35 320.

This massive card castle of debt now teeters on the edge of unsustainability. Were interest rates to return to their historic average of five per cent per annum, the entire global economy would collapse as it effectively did when the consequence of General de Gaulle’s challenge resulted in the then US President Richard Nixon agreeing in August 1971 to end the Bretton Woods system which had been established at the end of World War Two and which guaranteed dollar convertibility into gold.

The dollar/gold parity which had been fixed after the war at 35 dollars an ounce was then reset to an initial 44.60 dollars and this in turn led to a tacit admission that the US did not have adequate reserves of the metal which resulted in President Nixon officially ended the Bretton Woods relationship of the dollar to the price of gold.

That year the gold price rose to $63.48. Ten years later it had climbed to $400 and in 2012 it reached a peak of $1 664.

In this graph below, supplied by Wikipedia, you can see how closely the gold price in fact mirrored the US consumer price index and has continued to do so because gold is viewed as the ultimate store of value. And it is this fact that takes me back to the events of 1987.Image result for gold price history graph

From the 1960s through to the 1990s in South Africa things were very different from today. First of all we were taxed at a far higher rate. In 1987 a maximum personal tax rate of 45 percent was reached at an annual income of R60 000.

Dividend income was treated as additional to normal income which meant that if you earned more than R5 000 a month every cent of dividend income was taxed at 45 percent.

Contrast that with a current marginal rate of 36 percent which only kicks in at an income level of R423 300 a year and you can get an understanding of why such onerous taxation led to severe distortion of the financial system. And South Africa was by no means unique.

In Britain’s during World War Two personal income tax rose to 99.25 percent and was only reduced to 40 per cent under the Margaret Thatcher reforms which were bent on encouraging the wealthy to migrate their assets back to Britain and end a long period of economic stagnation.

Here again a brief bit of history; income taxes are a relatively new phenomenon first introduced by Britain to fund World War Two and so governments can perhaps be forgiven for initially not entirely understanding their consequences. We all now know there is a finite limit above which you cannot tax people without their taking evasive action. The higher governments raise tax levels the lower the net sums they are able to gather because high-income people consequently opt to spend more leisure time on the golf course or, worse, to emigrate to more favourable tax destinations while the general public simply resorts to avoidance and outright evasion.Image result for laffer curve south africa

My graph illustrates the now well understood Laffer Curve developed by economist Arthur Laffer to explain this phenomenon.

In Britain, the highest rate of income tax ever levied was during the Second World War at 99.25 percent. It was then slightly reduced to 90 percent through the 1950s and 60s. In 1971 the top rate of income tax on earned income was cut to 75 percent but a surcharge of 15 per cent kept the top rate on investment income at 90 percent. In 1974 this cut was partly reversed and the top rate on earned income was raised to 83 percent. With an investment income surcharge this raised the top rate on investment income to 98 percent on incomes over £20,000.

Reducing those rates formed a major part of the Margaret Thatcher era. Switching instead to indirect taxation such as VAT, her first budget after her election victory in 1979 reduced the top rate from 83% to 60% and the basic rate from 33% to 30%. The basic rate was also cut for three successive budgets – to 29% in the 1986 budget, 27% in 1987 and to 25% in 1988. The top rate of income tax was cut to 40% in the 1988 budget and the investment income surcharge was abolished in 1985.Under the subsequent government of John Major the basic rate was further reduced in stages to 23% by 1997.

Globally governments had discovered there was a limit to the taxes they could gather. The graph illustrates the practical effect this had upon total revenue raised by governments. As you can see total revenue raised flattened the graphs at around the 40 percent mark. And that was when the borrowing spree began. Unable to raise any more taxes, the graph on the right shows how America’s gross public debt soared from precisely the time when tax revenue gathering plateaued:

To sum up then, up until the 1980s we were living in a very high tax high inflation era. Importantly, however, there was no tax on capital gains back then. Capital Gains Tax was only introduced in South Africa from October 2001 at an effective rate of 10 percent upon individuals and at 20 percent upon trusts.

 As a result the most effective means of growing wealth then was to leverage assets. Rather than see the Receiver of Revenue stripping 45 percent of all dividend income, it made sense to raise a bank overdraft on one’s share portfolio. In such cases the interest costs of the loan were applied to offset dividend income which could accordingly not be taxed. It was thus practical to double the value of your share holdings and accordingly double your potential capital gain. And the reward for doing so was considerable. My graph below illustrates the growth of the JSE All Share Index in the year immediately ahead of the October 1987 market crash with the red trend line showing a compound annual average growth rate of 57.1 percent at that time.

Consider the numbers. A thousand Rands invested on the JSE would have on average yielded a dividend of R30 of which the Receiver would have collected R13.50 in tax leaving you with a net R16.50 income. Had you instead pledged your portfolio for a 100 percent overdraft the result would have been R2 000 invested which would have grown to R3 142. Your effective gain was thus R2 142 compared with the R13.50 you would otherwise have received in dividend…159 times greater.

Since there was no capital gains tax, and the interest costs of the loan were mostly covered by your dividend income, you got to pocket the entire sum.

Vacant land was similarly soaring in price at that time because smart investors had recognized the same potential and here the effective gearing was even greater.

A half-acre building plot could be had for R1 000 and the seller could usually be persuaded to let you have a private bond in return for a 10 percent deposit. So, if you had R1 000 to invest you could practically buy ten vacant plots which you immediately put back on the market at R2 000 each.

I can personally attest to the fact that such land speculation invariably led to a sale well within a year. So here the arithmetic of your transaction was an investment of R100 to buy a plot of land for R1 000 which you promptly sold for R2 000. To keep it simple I have ignored items like municipal rates, estate agents’ commission and interest on the loan. Thus the effect of such land speculation was that for your R100 outlay you got to pocket R1 000.

Now you can perhaps understand why in 1987 I became a millionaire. You can also understand why, when the market crashed I was left owing the bank more than the subsequent value of the shares I had pledged against my overdraft. Happily however, though the market fell, the dividends kept on coming and I was able to continue servicing the loan. The bank accordingly made no effort to liquidate my overdraft with the result that a year later I was again a wealthy, though somewhat chastened, investor.

Today we live in a very changed environment. The introduction of capital gains taxation killed off the possibility of such geared gains and, with inflation at global lows, you are likely to lose money on falling property and share prices within a sluggish economy. But change is imminent. If you have understood the narrative I have just provided you will understand that a tidal wave of inflation is virtually certain to be heading this way. Next month I will explain why and how you can avoid losing your shirt in the very scary times that lie ahead.

Global population shock!

By Richard Cluver

Contrary to widespread public opinion, one of the greatest threats to mankind might not be population increase but rather population collapse. This startling fact was highlighted in a televised discussion recently between two of the world’s visionary entrepreneurs, South Africa’s Elon Musk and Alibaba’s Jack Ma at the World AI conference in Shanghai .

Both believe Humanity is doomed by an impending population collapse. Elon Musk thinks we’re in a simulation and AI will destroy us. Jack Ma thinks we’re irreplaceable and AI will dramatically reduce our work. Both Ma and Musk think tech will transform education as we know it.

  • books ad.pngMa: “For the next 10, 20 years, every human being, country, government should focus on reforming the education system, making sure our kids can find a job, a job that only requires three days a week, four hours a day. ” Keep in mind, Ma endorses a grueling 996 work schedule (9am–9pm, six days a week). 
  • Musk: “The way education works right now, it’s really low bandwidth, it’s extremely slow, lectures are the worst…Down the road with Neuralink you can just upload any subject instantly, it will be like the Matrix.”

The future of work

Ma, the AI optimist, and Musk, the pessimist, revisited their long-held beliefs:

  • Ma: “I don’t worry about jobs…Computers only have chips, men have the heart. It’s the heart where the wisdom comes from.”
  • Musk: “AI will make jobs kind of pointless…Probably the last job that will remain will be writing AI, and then eventually, the AI will just write its own software.”

The one thing they agreed on…

  • Musk: “The biggest issue in 20 years will be population collapse, not explosion collapse.”
  • Ma: “I absolutely agree with that.”

“Now in China today, we have 18 [million] new babies born every year, which is not enough. We need to have much more than that,” said Ma.  “I think the best resources of the human beings, or the best resources on the earth are not the coal, not the oil, not the electricity, it’s the human brains.” (China had 15 million babies in 2018, the lowest number in half a century.)

Musk said he thought the coming population decline—or “collapse” as he called it—might well be the gravest problem facing us. That’s a view that might seem odd to many in a world of 7.7 billion, expected to grow to 11 billion before tapering off.

“I am worried about the birth rate, which you alluded to earlier. Most people think we have too many people on the planet. But actually this is an outdated view,” Musk said. “I think the biggest problem the world will face in 20 years is population collapse. Collapse, I want to emphasize this. The biggest issue in 20 years will be population collapse—not explosion, collapse.”

The conventional projection by the UN is that world population, currently 7.7 billion, will increase to 11.2 billion in 2100, then stabilise before slowly declining. However, current trends cast much doubt on this picture. Fertility rates are in dramatic decline worldwide and world population may peak below nine billion by 2050 and then decline.

In order for a human population to maintain its numbers, each woman must bear, on average, 2.1 children. If the birth rate exceeds 2.1, population numbers increase; if it is less than 2.1, population numbers decline. Birth rates below 2.1 have been common now since 1970. Ireland had a birth rate of 1.92 in 2016 but inward migration is contributing to population growth.

The following countries are examples where populations are in decline (fertility rates in brackets): Bulgaria (1.58), Greece (1.3), Hungary (1.39), Italy (1.49), Poland (1.29), Portugal (1.24), Russia (1.75), Japan (1.48) and South Korea (1.26).

The UN World Fertility Patterns 2015 Report details birth rates (children per woman) for the major world regions: Africa 4.7, Asia 2.2, Europe 1.6, Latin America/Caribbean 2.2, North America 1.9, Oceania 2.4. The overall world fertility rate is 2.5.

It will come as a surprise to many that South Africa’s birth rate is one of the lowest in Africa at 2.08 births as a result of one of the fastest rates of decline in the world and resulting from significant demographic change. The ending of the Pass Laws at the dawn of democracy brought about a flood of people from rural areas to the cities and with it the constraints of small housing units, legalised abortion and the economic pressure of competitive urban living.

Japan, meanwhile, averaged 1,230 more deaths than births a day in 2018, while South Korea had 326,900 newborns in 2018, its lowest number since at least 1960 and similar situations prevail in large swathes of Europe, as women increasingly remain single or marry but choose to have fewer children.

While most scenarios still predict continued growth into the 22nd century, there is a roughly 27% chance that the total population could stabilize or begin to fall before 2100. Longer-term speculative scenarios over the next two centuries can predict anything between runaway growth to radical decline (36.4 billion or 2.3 billion people in 2300), with the median projection showing a slight decrease followed by a stabilization around 9 billion people.Image result for global population decline

By 2070, the bulk of the world’s population growth is predicted to take place in Africa: of the additional 2.4 billion people projected between 2015 and 2050, 1.3 billion will be added in Africa, 0.9 billion in Asia and only 0.2 billion in the rest of the world.

Africa’s share of global population is projected to grow from 16% in 2015 to 25% in 2050 and 39% by 2100, while the share of Asia will fall from 60% in 2015 to 54% in 2050 and 44% in 2100.

The strong growth of the African population will happen regardless of the rate of decrease of fertility, because of the exceptional proportion of young people already living today. For example, the UN projects that the population of Nigeria will surpass that of the United States by 2050. The population of the more developed regions is slated to remain mostly unchanged, at 1.2 billion, as international migrations from high-growth regions compensate the fertility deficit of richer countries. In recent years rich -or mainly European countries – have been trying to increase the fertility rate by giving some type of incentives to increase their country population.

Taxing South Africa into recession

by Brian Kantor

We are well aware that slow economic growth depresses the growth in tax revenues. What is not widely recognised is the influence that tax rates and taxation have on economic growth. The burden of taxation on the SA economy, measured by the ratio of taxes collected to GDP, has been rising as GDP growth has slowed down, so adding to the forces that slow growth in incomes and taxes.

Trends in government revenue, expenditure and borrowing


 The GDP growth rate picked up in Q2 2019. But GDP is only up 1% on the year before while in current prices, it has increased by only 4.4%. That is slower nominal growth than at any time since the pre-inflationary 1960s, which is not at all helpful in reducing debt to GDP ratios (something of great concern to the credit rating agencies). This 4.4% growth is a mixture of the slow real growth and very low GDP inflation, now only about 3.5% a year.

Annual percentage growth in real and nominal GDP


GDP and CPI inflation


In the first four months of the current SA fiscal year (2019-2020) personal income tax collected grew by an imposing 9.7% or an extra R14bn compared to the same period of the previous financial year. Higher revenues from individual taxpayers were the result of effectively higher income tax rates, so-called bracket creeps, on pre-tax incomes that rise with inflation.

Income tax collected from companies, however, stagnated, while very little extra revenue was collected from taxes on expenditure.  Lower disposable incomes resulted in less spending by households and the firms that supply them. The confidence of most households in their prospects for higher (after-tax) incomes in the future has been understandably impaired.

Treasury informs us that total tax revenue this fiscal year, despite higher income tax collected, is up by only 4.8%, compared to the same period a year ago, while government spending has grown by 10.3%, or over R51bn.

The much wider Budget deficit of R33bn (Spending of R156.6bn and revenue of R123.6bn) represents anything but fiscal austerity. It has added to total spending in the economy, up by a welcome over 3% in Q2 2019 – after inflation.

But deficits of this order of magnitude are not sustainable. Nor can they be closed by higher income and other tax rates that would continue to bear down on the growth prospects of the economy and the tax revenues it generates. A sharp slowdown in the growth of spending by government, combined with the sale of loss-making and cash-absorbing government enterprises is urgently called for if a debt trap is to be avoided. Given that the debts SA has issued are mostly repayable in rand, rands that we can print an infinite amount of, a trip to the IMF and the “Ts and Cs” they might impose on our profligacy is unlikely.

More likely is a trip to the printing press of the central bank rather than the capital markets to fund expenditure. Such inflationary prospects are fully reflected in the interest we have to pay to fund our deficits. These interest payments add significantly to government spending. The spread between what the SA government has to offer lenders and those offered by other sovereign borrowers has been widening.

The SA government now has to pay 8.7 percentage points a year more in rands than the average developed market borrower, ex the US (Germany and Japan included) and 7.6 percentage points a year more than the US has to offer for long-term loans. We also have to pay 3.1 percentage points a year more than the average emerging market borrower has to pay to borrow in their own currencies.

The difference between RSA interest rates and other sovereign borrowers. Ten-year bonds in local currencies


You can’t play the long game when we are running out of time

By Dawie Roodt
Chief Economist of the Efficient Group

The astounding levels of corruption and plundering in the country are certainly a reason for most South Africans to experience a feeling of despair. And let us not be shy to point fingers to the most destructive force this country has ever seen: the ANC and its alliance partners.

Sure, there was a change of guard. Zuma was just the symbol of corruption, incompetence and state capture. We may have a new president, but it is still the same ANC. Judging from president Ramaphosa’s actions so far, he must either be weak, doesn’t appreciate the danger in which the South African economy is, or he simply doesn’t care.

I think we have a weak president that simply doesn’t have the political capital to implement unpopular structural changes. All that is left for him to do is to use (gutted) institutions, like the NPA, to do the heavy lifting for him. He is playing the “long-game”, but this economy doesn’t have a long time.

Even if we can somehow wave a magic wand and get rid of all the corruption and incompetence in the state and SOEs overnight, the perilous condition of the state’s finances will need an extraordinary attempt to save us from further economic collapse.

The fiscal deficit (“fiscal” is derived from the same Latin word that means basket in which money [tax collections] is kept) is the difference between what the state (usually defined as the “national government”) spends minus its revenue (taxes). This deficit is the amount of new money the state needs to borrow and is usually expressed as a percentage of GDP.

Here’s a party trick; take the fiscal deficit to the GDP of a country for a period (usually a fiscal year) and subtract the rate of economic growth from this number. What is left is roughly how many percentage points the state debt-to-GDP will increase.

For example, our fiscal models suggest that the fiscal deficit in the current fiscal year (2019/20) is probably going to be around 6%. Fiscal years start from 1 April every year. State debt as a percentage of GDP at the start of this fiscal year was 56.7%. We expect economic growth for the current fiscal year to be approximately 0.5%, but for simplicity’s sake, let’s call it 1%.

Now, the trick continues: 6% (the deficit: GDP) minus 1% (GDP-growth) gives you 5%, which is the rate at which the fiscal debt to GDP will increase this year. Add the 5% to the existing 56.7% of state debt and we will end the fiscal year with debt of approximately 62%. There are a few other variables that will also affect this ratio, but for a simple back-of-matchbox calculation this simple model will suffice.

Now, repeat this process for the next number of years. Not pretty… That is the reason why state finances find themselves in such a death-defying spiral; because, especially since 2009, state spending was increased relentlessly at a time when tax collections collapsed – mostly because of a faltering economy. At this rate of debt increase, it is very clear things will turn out very unhappy, very soon.

In order to fix the problem of collapsing fiscal accounts, a combination of three things must happen to stabilise the debt to GDP ratio. The first thing is that the economy should preferably start growing at a rate of 6%, at which rate the debt to GDP ratio will stabilise. Unfortunately, the ruling elite seems to be hell-bent on doing even more damage to the economy with all sorts of silly socialist ideas, like the suggested creation of yet another state bank, a new mandate for the SARB and the unaffordable NHI. Because of this, economic growth, believe me, will not save us from this fiscal cliff.

A second option is to increase taxes by the equivalent of 5% of GDP (current market price), which is approximately R250 bn! For example, VAT needs to increase by more than 11 percentage points to get this kind of money, or personal income taxes need to increase on average by nearly 10 percentage points! This is a meaningless argument because such an increase in taxes will have a huge adverse effect on growth and overburdened taxpayers will not be happy with this. But the magnitude of required tax increases is clear.

Preferably, and the only realistic option left, is to cut state spending with a similar amount: R250 bn. Percentage wise that is a real reduction in state spending of approximately 15%, or 20% in nominal terms! Now, show me the politician with the clackers to go and give COSATU the good news! But even if we could implement such austerity measures, the initial impact on the economy will be hugely negative – dammed if you do, dammed if you don’t.

But wait, there is more. We all know that SOE’s are make-believe creations that pretend to be companies, with boards, chairs and all the perks that go with that. When push comes to shove, then suddenly they have a “shareholder” (read the taxpayer) that needs to keep bailing them out, very un-company like!

If the debt of SOE’s are also added to that of the state, as it should be, then state debt to GDP will reach approximately 72% by the end of this fiscal year. And we haven’t even mentioned local authorities, the Road Accident Fund, the deficits at the GEPF …

Clearly, we are in trouble. The troughing of socialists like this always ends the same and here’s what happens next:

First you (read the government) run out of taxpayers. The taxpayers who haven’t emigrated yet, are carrying a huge tax burden and any further increases in taxes will likely have a detrimental effect on actual tax collections.

Then you turn your attention to those assets under your control, like the SOE’s. But eventually you also run out of assets to plunder, like Eskom, SAA, SABC…

Then you turn your attention to the next target, the few pots of gold left; the savers. Savers are those people that save for retirement, for example, and a glance towards the shenanigans at the PIC is proof of what happens to the assets of the savers. In the meantime, prescribed assets are also suggested, which will exacerbate the plight of our dwindling number of savers. Also keep in mind that any tax on capital is in a way also a confiscation of savings. Other measures are also typically taken by now, like forex controls. All this happens until you run out of savers.

But none of this will prevent the inevitable: debt will continue to balloon, the economy will falter, poverty and unemployment will keep going up and those that are responsible for all the troubles will keep on blaming “the others” for their absurdities.

By then the only remaining alternative will be to inflate your debt away. But for that to happen you need to control the SARB and with Lesetja Kganyago at the helm, that is not going to be easy. But be assured, as we sink further into this debt chaos the pressure on the SARB will become relentless and eventually also the SARB will buckle under the pressure. And then, inflation!

But it can be different. What we must understand is that no structural adjustment, no new dawn, no fresh start can be taken seriously unless it includes an admittance that there are just too many trying to live off too few. Many tens of thousands of civil “servants”, including those at SOE’s, are simply not needed. They must go!

The question: Are our democratic institutions strong enough to confront our economic woes, even if it means confronting political ideologies and political allies? Will the president call on the police and the army, if necessary, to protect us from a marauding wave of sabotage and destruction when an overweight, overpaid and underworked civil “service” realise that the party is over? Or will we just become another socialist failure?

With these kinds of odds, can we blame the dwindling number of wealth creators to hedge their bets, to reduce their workforce, to expatriate their wealth and to “wait and see” before they commit to SA?

I don’t think so.

Timing the market is foolish

By Jared Dillian

If you wake up tomorrow morning and for some reason you want to blow up your portfolio, here’s the easiest way to do it: try and time the market.

Timing the market is something that should only be attempted by a handful of people. Trust me on this.

Actually, trust the math on this:

  • The S&P 500 has delivered a 5.6% compounded annual growth rate over the past 20 years, but
  • The average investor’s gains were just 1.96%, which is worse than a 100% bond portfolio (not that I’m recommending a 100% bond portfolio but I like being able to say out loud that the average investor’s gains over the last 20 years were much lower than a 100% bond portfolio).

Why are average investor returns so terrible versus the S&P 500? Because market timing is impossible and people who try to time the market by getting in or out at the right time almost always get it wrong. Spectacularly wrong.

So, what you’re meant to do is average into positions, even if you think the market is turning, because you’re probably wrong that the market is turning.

Trends Go On Longer than You Think

Your market timing instincts are probably off because trends go on much longer than you think.

People thought tech stocks were overvalued in 1996. The crash came four long years later.

So tell me now that bond prices can’t go any higher because interest rates can’t go any lower and that the rally is definitely over.

Interest rates have been falling for 30 years, you think they can’t go down any further?

The Point

The point of this email is to clear up this cognitive dissonance people have when they see a giant 30-year trend and think somehow that they can accurately pinpoint the end of that trend to the day.

Black Hole Investing

John Mauldin

By John Mauldin

Scientists say the rules change in a cosmic “black hole” at what astrophysicists call the event horizon. How do they know that? Not by observation, since what happens in there is, by definition, un-seeable. They infer it from the surroundings, which say that the mathematics of the universe as we understand them change at the event horizon.

Or maybe not. One theory says we are all inside a black hole right now. That could possibly explain a few things about central bank policy.

Recently I showed you Ray Dalio’s latest Three Big Issues article. To recap, Ray says we are now in a world where…

  • Central banks have limited ability to stimulate growth as we approach the end of a long-term debt cycle.
  • Wealth and political polarity are producing internal conflict between the rich and poor as well as between capitalists and socialist.
  • There is also external conflict between a rising power (China) and the existing world leader (the USA).

The world last saw this combination in the 1930s, which is not comforting, to say the least. But as I said, we can get through this together if we approach it wisely. That’s a big “if,” given the ways some investors behave at cyclical peaks, but people will do what they do. We can only control our own actions, and today I want to talk about some we can take.

We are approaching the black hole, which means we can’t rely on previously reliable strategies. Let’s start with a jolt of reality.

Realistic Forecasts

As investors we have to make assumptions about the future. We know they will likely prove wrong, but something has to guide our asset allocation decisions.

Many long-term investors assume stocks will give them 6–8% real annual returns if they simply buy and hold long enough. Pension fund trustees hire consultants to reassure them of this “fact,” along with similar interest rate and bond forecasts, and then make investment and benefit decisions.

Those reassurances are increasingly hollow, thanks to both low rates and inflated stock valuations, yet people running massive piles of money behave as if they are unquestionably correct.

You can, however, find more realistic forecasts from reliable, conflict-free sources. One of my favorites is Grantham Mayo Van Otterloo, or GMO. Here are their latest 7-year asset class forecasts, as of July 31, 2019.
Source: GMO

These are bleak numbers if you hope to earn any positive return at all, much less 6% or more. If GMO is right, the only answer is a large allocation to emerging markets which, because they are emerging, are also riskier. The more typical 60/40 domestic stock/bond portfolio is a certain loss, according to GMO. (Note these are all “real” returns, which means the amount by which they exceed the inflation rate).

Others like my friends at Research Affiliates (Rob Arnott), Crestmont Research (Ed Easterling), or John Hussman (Hussman Funds) have similar forecasts. They differ in their methodologies but the basic direction is the same. The point is that returns in the next 7 or 10 years will not look anything like the past.

If you think these are reasonable forecasts (I do), then one reaction is to keep most of your assets in cash for at least a fractionally positive, low-risk return. That’s simple to do. But it probably won’t get you to your financial goals.

Remember, though, this forecast is what GMO expects if you buy and hold those asset classes for the next seven years. Nothing requires most of us to do that. We are free to move between them and use other asset classes, too… which is exactly what I think we should do.

Profound Technological Change

I mentioned recently that technology will bring profound changes. It has major investment implications. Companies small and large, all over the world, are right now inventing new technologies that are going to change our lives.

I’ve used this example before, but think of the now-ubiquitous smartphone. Apple launched that category with the iPhone in 2007. Many who saw them as expensive toys at first now can’t live without them. That shows you how fast, and how deeply, a technology we didn’t even know we needed can change everyday life. Not always for the better, but the change is real.

The iPhone ecosystem around it spawned other successful companies. The productivity gains it gave users led to growth in seemingly unrelated fields. We have a radically different (and, on balance, better) economy now than we would have without it.

Note also, the iPhone launched just months before the Great Recession began, and proved indispensable anyway. So our macro challenges, serious though they may be, won’t necessarily stop progress. They may even accelerate it.

I expect to see fortunes made in biotechnology, and particularly life extension and age reversal drugs, but that will only be the beginning. Autonomous vehicle technology is going to restructure our cities and enhance our productivity as we put those traffic jam hours to better use. AI and Big Data will enable quantum leaps in many fields.

I could go on with more examples, but here’s the point: Innovation will continue in almost any economic scenario you can imagine. Recession will, at most, delay it a bit. Not every innovative company will succeed but some will, and the rewards will be huge. If you want capital gains, the opportunities will be there… but not in a passive index strategy. You will need active management and expert managers.

Owning index funds won’t help much because by definition most of these companies will start out small and not have meaningful presence in the indexes. By the time they are big enough to be meaningful, the really massive gains will have already been made. That means you will want to find active managers who focus on particular fields and allocate them some of your risk (not core!) capital. These will not be sure things.

Income Challenges

Now, capital gains aren’t (and shouldn’t be) everyone’s goal. Many of my Baby Boomer peers have assets but need current income, which is scarce and getting scarcer in this low-yield world. The way central banks are going, conventional debt instruments probably won’t do it.

This week the ECB lowered its base rate to -0.50% and announced it will stay there for a long time. I think it is increasingly obvious we are headed back to the zero bound on short-term US government debt. That will drag down interest rates on most fixed income instruments.

Here again, I think the market will provide solutions but they won’t be what once was thought of as “normal.” Our parents and grandparents could count on 5% or better yields in safe, predictable CDs and Treasury bills. That’s fantasy now. So, what do you do?

The first thing, if you’re not already fully retired, is to maximize your job income and increase your savings. Watch your spending, too. Now is not the time for frivolity. Be the ant, not the grasshopper.

That still won’t be enough for most income-seeking investors. We will need higher yields from our portfolios. Right now, this is more than a minor challenge unless you want to take significant principal risk. Government bonds yield nothing (or less) and corporate bonds are headed that way. High-yield bonds indeed have higher yields but also higher risk. What to do?

I think interest rates are going lower and will stay lower for a very long time, just as I and my fellow Boomers are hitting retirement age. (I’ll start getting Social Security when I turn 70 next month. I remember reading somewhere that I’ll earn something like 1 to 2% compound returns on my Social Security “investment.” Ouch.)

The good news is that markets eventually respond to demand. More and more companies will concentrate on returning investor capital. As businesses stabilize into steady cash flow, they will be able to pay increasingly higher dividends, and may find it is a good way to maintain their share prices. In addition, I think many old-fashioned value companies are getting ready to come back into favor as their steady dividends become attractive to a retiring generation.

Remember, there are different ways to slice this pie. It doesn’t have to be standard dividends. I expect innovative structures will emerge to offer yield with controlled risk—new kinds of preferred shares, convertible securities, etc. Some exist right now, but legal barriers restrict them only to the wealthiest investors. Here again, if the demand exists, elected officials will respond by relaxing those barriers.

Higher yields come with higher risk, of course. That’s why you should spread your capital across more than one and not risk too much on any one strategy. A strategy I have seen used with great success is simple high-yield bond timing. While those trading algorithms can be complex, even simple ones can sometimes yield above-market returns over a full cycle.

As my dad would tell me when I was growing up, “Son, betteth not thy whole wad on one horse.” That was as close to biblical language as he could get.

Central banks and politicians are the problem, not the solution. Last week President Trump openly told the Federal Reserve to reduce interest rates to zero or lower.

Seriously? What business activity will that encourage? The latest National Federation of Independent Business survey (by my good friend Bill “Dunk” Dunkelberg) clearly shows that small businesses aren’t worried about interest rates. What they need is more customers and predictable government policies. In a world of trade wars and potential currency wars brought on by central bank manipulation, predictable is not a word that comes to mind.

Further, do the president and his economic advisors understand the realities facing the average retiree? In this zero-interest-rate world, exactly how are retirees supposed to survive without taking much more risk than they should?

The financial repression emanating from central banks all over the world borders on criminal, and that they think they are “helping” us is risible. They are on the verge of destroying a generation come the next recession. They have encouraged retirees to seek yield and riskier investments precisely when they should not be.

They are robbing savers and asking us to say thank you because they are so wise.

Crazy Numbers

Many financial advisors, apparently unaware the event horizon is near, continue to recommend old solutions like the “60/40” portfolio. That strategy does have a compelling history. Those who adopted and actually stuck with it (which is very hard) had several good decades. That doesn’t guarantee them several more, though. I believe times have changed.

But those decades basically started in the late 40s and went up until 2000. After 2000, the stock market (the S&P 500) has basically doubled, mostly in the last few years, which is less than a 4% return. When (not if) we have a recession and the stock market drops 40% or more, index investors will have spent 20 years with a less than 1% compound annual return. A 50% drop, which could certainly happen in a recession, would wipe out all their gains, even without inflation.

And yes, there have been historical periods where stock market returns have been negative for 20 years. 1930s anyone? Yes, it is an uncomfortable parallel.

The “logic” of 60/40 is that it gives you diversification. The bonds should perform well when the stocks run into difficulty, and vice versa. You might even get lucky and have both components rise together. But you can also be unlucky and see them both fall, an outcome I think increasingly likely. Louis Gave wrote about this last week.

Historically, the optimized portfolio of choice, and the one beloved of quant analysts everywhere, has been a balanced portfolio comprising 60% growth stocks and 40% long-dated bonds. Yet recently, this has come to look less and less like an optimized portfolio, and more and more like a “dumbbell portfolio,” in which investors hedge overvalued growth stocks with overvalued bonds.

At current valuations, such a portfolio no longer offers diversification. Instead, it is a portfolio betting outright on continued central bank intervention and ever-lower interest rates. Given some of the rhetoric coming from central bankers recently, this is a bet which could now be getting increasingly dangerous.

We are rapidly approaching the event horizon where central bank intervention and ever-lower interest rates will not help your bond portfolio. That is already the case in Europe and Japan. Stocks are at historically high valuations and subject to a severe bear market brought on by a recession.

“Diversification” is not simply owning different asset classes. They have to be uncorrelated to each other and, more important, stay uncorrelated. That was a problem in 2008 when lots of previously disconnected categories suddenly started moving in lockstep.

For the moment, I still think long-term yields will keep falling, helping the bond side of a 60/40 portfolio. Meanwhile, negative or nearly negative yields will push more money into stocks, driving up that side of the ledger. So 60/40 could keep firing on all cylinders for a while. But it won’t do so forever, and the ending will probably be sudden and spectacular.

Which brings us to my final point. The primary investment goal as we approach the black hole should be “Hold on to what you have.” Or, in other words, capital preservation. But you may not realize that capital preservation can be better than growth, if the growth comes with too much risk. Here’s the math.

  • Recovering from a 20% loss requires a 25% gain
  • Recovering from a 30% loss requires a 43% gain
  • Recovering from a 40% loss requires a 67% gain
  • Recovering from a 50% loss requires a 100% gain
  • Recovering from a 60% loss requires a 150% gain

If you fall in one of these deep holes you will spend valuable time just getting out of it before you can even start booking any gains. Once you start to fall, the black hole won’t let go. Far better not to get too close.

Friends don’t let friends buy and hold. I can’t say that strongly enough. You must have a well thought out hedging strategy if you’re going to be long the stock market. If your investment advisor simply has you in a 60/40 portfolio and tells you that “we are invested for the long term and the market will come back,” pick up your capital and walk away. I can’t be any more blunt than that.

Every investment advisor, including me, uses these words in their disclosure documents: Past Performance Is Not Indicative of Future Results. I think that has never been more true than for the coming decade. The 2020s will be more volatile and difficult for the typical buy-and-hold index fund investor than anything we have seen in my lifetime.

Active investment management is not particularly popular right now since passive strategies have outperformed. But I think that is getting ready to change. You should start, if you’re not already, investigating active management and more proactive investment styles. You will be much happier if you do.

Personally, I am still happily invested in a number of hedge funds but the strategies I select are limited, as many hedge fund styles have seen great challenges in producing acceptable risk/reward returns.

That is getting ready to change. I believe some hedge fund styles like the distressed debt, fixed income and event driven spaces are going to be very attractive. Who knows? Maybe even long/short funds will eventually find their former mojo.

At the economic event horizon, we all need to become black hole investors. Relying on past performance as the tectonic plates shift underneath us, as the central bank black holes begin to suck historical performance into their maws, we must look forward rather than backwards to design our portfolios.

At the event horizon, as the Jefferson Airplane song of my youth says, logic and proportion are fallen sloppy dead. You better feed your head with much more forward-looking strategies.

Keynes had a point

By John Mauldin

“Practical men, who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back.” John Maynard Keynes

I begin with this Keynes quote because, while true, it doesn’t go far enough. The problem isn’t simply defunct economists or “scribblers of a few years back.” We are in the grip of economists who, far from being defunct, hold great power. Whether they hear voices in the air (or Twitter), I can’t say, but they are indeed madmen in authority.

Not all economists are in that category. Many provide valuable insight or are at worst harmless. They don’t pretend they can change human nature or prevent the inevitable. Unfortunately, some economists do believe those things. Worse, they are in places from which they can wreak havoc, and they are.

Last weekend I received two emails referring me to articles about the economics profession. They came within minutes of each other, from two different associates who don’t know each other. That seemed like an odd coincidence but it stirred my writing juices.

Please note, I don’t agree with everything in the articles I’ll describe today. They are nonetheless important because they try, at least, to describe and possibly fix the problem Keynes identified. We have to address them, not just economically but politically. We can’t just put our heads in the sand and think this will go away.

The whole debt bubble, the income and wealth inequality angst, a growing deficit which will get worse after the next recession, and lack of economic understanding among voters is all coming home to roost. Better to think about that now, while we can still act and maybe even change things.

The first item is a July 2019 TED talk by Nick Hanauer, a self-described Seattle “plutocrat” who founded and sold several companies. He is now a venture capital investor. Hanauer is far to my left politically, but his thinking reminds me a bit of Ray Dalio, and as we will see, some of the proponents of neo-Keynesian “new economics.”

Hanauer’s latest TED talk is titled “The dirty secret of capitalism—and a new way forward.” You can read the transcript. He begins by describing the widening inequality problem we have discussed before, then quickly zeroes in on what he thinks is the problem: neoliberal economics.

Economics has been described as the dismal science, and for good reason, because as much as it is taught today, it isn’t a science at all, in spite of all of the dazzling mathematics. In fact, a growing number of academics and practitioners have concluded that neoliberal economic theory is dangerously wrong and that today’s growing crises of rising inequality and growing political instability are the direct result of decades of bad economic theory.

What we now know is that the economics that made me so rich isn’t just wrong, it’s backwards, because it turns out it isn’t capital that creates economic growth, it’s people; and it isn’t self-interest that promotes the public good, it’s reciprocity; and it isn’t competition that produces our prosperity, it’s cooperation.

What we can now see is that an economics that is neither just nor inclusive can never sustain the high levels of social cooperation necessary to enable a modern society to thrive.

I know, those are fighting words to most free-market defenders, but hear this out. Hanauer blames the sad state of modern economics on three false assumptions.

First, it isn’t true the market is an efficient equilibrium system. You may have read my “sandpile” letter that is one of my most popular ever. I reprint it every so often, most recently here. It describes how our astronomically complex modern economy is anything but an equilibrium. It is a growing sandpile whose collapse is certain. As Hyman Minsky wrote, stability breeds instability.

If, as too many economists believe, you think you can manage an economy toward equilibrium, you simply help the sandpile grow bigger so its eventual collapse is even more violent. That’s how we get crises like 2008, and the one we will have again in due course.

The second false assumption is that price always equals value. That’s the heart of the efficient market hypothesis, that stock prices always reflect all available information. Clearly, they don’t, since we have all seen both overvalued and undervalued markets.

In fact, we have economist-run institutions like the Federal Reserve working to make sure prices don’t equal value. They intentionally distort prices, starting with the most important one: the price of money, what we call “interest rates,” with all kinds of harmful effects (and often benefits to those who already own assets).

The third false assumption is that humans are rational, utility-maximizing machines who look out for our own interests first. It’s just not true. Humans are social animals, and we will, in the right conditions, sacrifice our own interests for others. Soldiers don’t heroically jump on grenades because they’re selfish. Parents and friends often sacrifice for their children and their friends. People accept lower returns to invest in ways they think improve the world, or pursue behaviors they feel are in the common and general interest but not their own individual interests. Happens all the time.

If we were all so naturally self-maximizing, there would be no such thing as love, which is a choice to place someone else’s good ahead of your own. If you have some hidden selfish motive, it’s not really love, is it? Not in the way any religion I know describes it.

Yet many economists persist in believing we are all competitive, all the time, and this somehow leads to equilibrium and prosperity. That is false and if it is your base assumption, all your other answers are going to be wrong. This is not an embrace of human nature, but a denial of it.

Meanwhile, another Seattle billionaire had some words on the same subject recently. Bill Gates didn’t say exactly “economists know nothing,” but that’s clearly what he meant.

“Too bad economists don’t actually understand macroeconomics,” the Microsoft co-founder said. Asked what he meant by that, Gates continued:

“It’s not like physics where you take certain inputs and you predict certain outputs. Will interest rates ever return to normal, and why aren’t they returning to normal? You won’t get a consensus between economists quite the way that if you dropped a ball out your window and called up physicists and asked, ‘What the hell happened?’ There’s so many factors including what [economist John Maynard] Keynes called ‘animal spirits’ in the economic equation that we don’t have predictability.

Even today, people are still arguing about what happened in 2008. So it’s even harder to look forward. [Look at] the role of the bond rating agencies in 2008, which is completely unreformed. Why would that be? Well, there must be a lack of consensus.”

Both Hanauer and Gates make a point. Economists began assuming equilibrium must exist early in the 20th century. General equilibrium was wonderful because it let them model the economy on paper (and later, computers). Economists have physics envy. In essence, they assume away whatever doesn’t fit the model. Unsurprisingly, the models don’t work when put to the test, because the assumptions are not anchored in reality.

The entire premise of equilibrium economics is false. The world is a complex system. To model it requires complexity mathematics and theory. Sadly, but not unsurprisingly, we are decades away (if ever) from actually being able to model the economy as long as one continues to assume equilibrium at some point.

Of course we can make observations and theories and propose policies. But we shouldn’t do so under the illusion that some mathematical model allows us to know what we’re doing. “Lies, damn lies and models” should have been the quote. So when Gates and Hanauer and others, including me, say that economists don’t understand economics, our real point is that they rely on incorrect models and assumptions.

It gets worse when the politicians get economists to create models for them. These economists are every bit as trained as any circus animal and they don’t even need a whip. The economists’ assumptions inevitably lead to the conclusions the politician wants. Of course, they all have “neutral data and facts.” What would a model be without facts and data?

The second article came to me from a person who thought it ridiculous. He sent it along with a lengthy preface warning about its (in his view, false) claims. I appreciated the thought but I am also trying very hard to break out of the tribal box. I now often say that I’m neither Republican nor Democrat, but American. I don’t automatically reject ideas simply because of their origin. If I reject them, it’s because I have studied them and concluded they are wrong.

That said, this one has a lot of problems but is still worth reading. The author is Jared Bernstein, an economist who once advised Vice President Joe Biden. In this piece he describes what he calls a “new economics” that will create a more “just” America.

Like Dalio and Hanauer, I think Bernstein correctly identifies many of our problems. It is not the case that everything would be peachy if government just got out of the way; we have deeper issues. I completely endorse Bernstein’s first sentence: “The American economy has some serious, structural problems—and the economists are partly to blame.” He goes on:

It is not a coincidence that the new economics is in ascendency at this moment. Though by some measures, inequality has not grown much in recent years, it remains at levels as high as the late 1920s, which, for the record, didn’t end well. In one of the most disturbing developments emerging from recent research, the inequality of income and wealth is increasingly associated with the inequality of life expectancy.

The assumption that self-interested firms would self-regulate gave rise to repeated rounds of deregulation that gave us what I call the “shampoo economy”: bubble, bust, repeat. The old economics wrongly claimed we couldn’t have persistently low unemployment without spiraling inflation, yet that’s precisely what we’ve enjoyed in recent years.

In other words, the new economics isn’t arising just because we want “better” outcomes from our markets. It’s also arising because a lot of the old stuff has turned out to be just plain wrong.

That is mostly true but I think it’s because deregulation hasn’t gone far enough. Large companies use political influence to have government protect them from competition. The result is a bunch of “zombies” engaged in counterproductive activities that market discipline would quickly send to the graveyard, were it allowed to work.

The solution, in my opinion, is not for government to further regulate private business, but for it to stop picking winners and losers. Consumers could then decide what works. Of course, there’s room for reasonable regulation; we all want safe vehicles, clean food, etc. But regulations should promote competition, not suppress it.

I think many of Bernstein’s policy ideas won’t have the desired results, and some would be disastrous, but these are debates we need to have. We will achieve better results if we engage in them civilly and sincerely. That is hard in today’s polarized environment… but avoiding it will be even harder.

That brings us back to Lord Keynes. Many now regard him as one of the “defunct economists” he himself blamed for the problems of his time. In certain quarters, “Keynesianism” is as unpalatable as socialism. In fact, while Keynes was a leftist by today’s standards, he wasn’t against capitalism.

Recently I ran across a 2009 article by Bruce Bartlett with the provocative headline, Keynes Was Really a Conservative. That overstates it, but Keynes was more conservative than you might think. Here’s Bartlett.

Keynes completely understood the central role of profit in the capitalist system. This is one reason why he was so strongly opposed to deflation and why, at the end of the day, his cure for unemployment was to restore profits to employers. He also appreciated the importance of entrepreneurship: “If the animal spirits are dimmed and the spontaneous optimism falters… enterprise will fade and die.” And he knew that the general business environment was critical for growth; hence business confidence was an important economic factor. As Keynes acknowledged, “Economic prosperity is… dependent on a political and social atmosphere which is congenial to the average businessman.”

Indeed, the whole point of The General Theory was about preserving what was good and necessary in capitalism, as well as protecting it against authoritarian attacks, by separating microeconomics, the economics of prices and the firm, from macroeconomics, the economics of the economy as a whole. In order to preserve economic freedom in the former, which Keynes thought was critical for efficiency, increased government intervention in the latter was unavoidable [at least to him]. While pure free marketers lament this development, the alternative, as Keynes saw it, was the complete destruction of capitalism and its replacement by some form of socialism.

“It is certain,” Keynes wrote, “that the world will not much longer tolerate the unemployment which… is associated—and, in my opinion, inevitably associated—with present-day capitalistic individualism. But it may be possible by a right analysis of the problem to cure the disease whilst preserving efficiency and freedom.”

In Keynes’ view, it was sufficient for government intervention to be limited to the macroeconomy—that is, to use monetary and fiscal policy to maintain total spending (effective demand), which would both sustain growth and eliminate political pressure for radical actions to reduce unemployment. “It is not the ownership of the instruments of production which is important for the State to assume,” Keynes wrote. “If the State is able to determine the aggregate amount of resources devoted to augmenting the instruments and the basic rate of reward to those who own them, it will have accomplished all that is necessary.”

One of Keynes’ students, Arthur Plumptre, explained Keynes’ philosophy this way. In his view, Hayek’s “road to serfdom” could as easily come from a lack of government as from too much. If high unemployment was allowed to continue for too long, Keynes thought the inevitable result would be socialism—total government control—and the destruction of political freedom. This highly undesirable result had to be resisted and could only be held at bay if rigid adherence to laissez-faire gave way, but not too much. As Plumptre put it, Keynes “tried to devise the minimum government controls that would allow free enterprise to work.”

There’s actually a lot to like here. A government that focuses on keeping the “macro” playing field level while letting producers and consumers control the “micro” economy would be a vast improvement over what we have now.

That last quote from Plumptre is well said. Keynes wanted “the minimum government controls that would allow free enterprise to work.” He sought a balance between central planning and anarchy. He saw a lot of room between the extremes.

Likewise, by establishing conditions in which market forces could work, Keynes sought to prevent the kind of radical policies some of his modern followers want. The crazy ideas we now fear—negative rates, MMT and the rest—didn’t appear spontaneously. Their proponents see them as solutions to real problems. These ideas would go nowhere if the economy functioned better.

Today we’re still seeking the balance Keynes wanted. We need an economics profession with clear thinkers. They’re out there. We have to amplify their voices.

Quantum Economics

By John Mauldin

Keynes is still provocative 73 years after his death, no matter what you say about him. But my real point was about the twisted economic thought that is having dangerous effects on us all. And we can’t blame it just on Keynes.

This economic dispute is, at its core, a very old argument about how we understand reality. The ancient Greek philosopher Aristotle might agree with some of today’s economists. He taught deductive reasoning with the classic syllogism:

  • All men are mortal
  • Socrates is a man
  • Therefore, Socrates is mortal

In other words, Aristotle said to move from general principles to specific conclusions. That’s what the bulk of modern macroeconomics does, using their (much more elaborate) models to deduce the “best” policy choices.

Centuries later, Sir Francis Bacon turned Aristotle upside down when he advocated inductive reasoning. Rather than start with broad principles and apply them everywhere, he said to presuppose nothing, observe events and move from specific to general as you gather more observations… what we now call the “scientific method.”

Today’s economists may think that’s what they are doing, but they often aren’t. They begin with models that purport to include all the important variables, then fit facts into the model. When the facts don’t fit, they look for new ones, never considering that the model itself may be flawed.

Furthermore, as I have shown time and time again, they assume away reality in order to construct models that are in “equilibrium” with themselves. This is supposed to give us insight into the reality that has been assumed away.

That process isn’t necessarily wrong, but it’s not science. It is the opposite of science. Bacon would be horrified to see this. He tried to show the world a better way and now, centuries later, some of our most learned professors still don’t get it.

This is sadly not just a philosophical argument. It has real consequences for real people, including you and me.

Speaking of science, I received this note from an actual scientist (i.e., not an economist).

Dear John, having been an avid reader of your articles for many years now I wanted to write to say how much I tend to agree with your commentary, and in particular how much I enjoyed this week’s article. I’d like to make a couple of comments about this week’s material.

Firstly, reference was made to comparing economics with physics, and how economists suffer from “physics envy” (I should say that I have a PhD in physics from Oxford and subsequently worked as a physicist at the European Centre for Nuclear Physics Research (CERN) in Geneva, Switzerland, although I left behind my career as a physicist a long time ago.)

Economies and financial markets are much more like the world of quantum mechanics than the world of classical physics. In classical physics there is complete independence between the observer and the system under observation. However, in the realms of quantum mechanics, the systems under observation are so small that the act of observation disturbs the system itself, described by Heisenberg’s Uncertainty Principle.

This situation is similar to that of financial markets, where the actions of market players is not separate from market outcomes; rather the actions of market players PRODUCE the market outcomes.

Betting on financial markets is different from betting on the outcome of an independent event, such as the outcome of a horse race or a football match. The latter are akin to classical physics where there is independence between observer and observed. Whilst actions in the betting market change the odds on which horse/team is favoured to win, they don’t impact the outcome of the event, which is rather determined by the best horse/team on the day. —Paul Shotton

Thank you, Paul, for pointing out this important distinction. I can’t pretend to understand quantum mechanics but your point about independent observation is profound. Economists don’t just build models; they (and all of us) are parts of the model. We are the economy and the economy is us. While discussing it, we also affect it.

George Soros calls this the principle of reflexivity, the idea that a two-way feedback loop exists in which investors’ perceptions affect that environment, which in turn changes investor perceptions. (Here’s his essay explaining more.)

That means these macroeconomic models, which with their Greek letters and complex equations look very scientific to a layperson, are often at odds with the scientific method. You can’t conduct independent observations and experiments on an entire economy. That doesn’t render the models completely useless, but greatly limits them.

Borrowing from Clint Eastwood, this might be fine if those who use these models would respect the limitations. All too often, they don’t. And this is where it gets a little complicated. I confess that I use models. I build them and work with others who build even better ones. Models can help inform us of potential outcomes and better understand risk and reward, but there are clearly inherent limitations on using historical or theoretical observations to predict future results.

(Dis) Equilibrium

Here are a couple more letters, taking issue with my comments on equilibrium.

Just to clarify… Even if the economy can be modelled in some sense by a sand pile that will ultimately collapse, that does not mean that the economy is, at any point in time, not in equilibrium. In fact, it must be in equilibrium in order to form the sand pile! You could argue that the equilibrium is “unstable,” perhaps, but it is certainly a (possibly unstable) equilibrium. —John Bruch


John, I’ve been a reader for years and love your letter. But your comment today is over the top; “The entire premise of equilibrium economics is false.” Efficient market hypothesis is over the top but the premise of equilibrium is perfectly modelled in your sand pile letter. Cycles have always existed and always will exist.

Natural market forces will always move markets towards equilibrium but government interference slows the process making the sand pile grow in size and magnitude. To say that the principle of equilibrium is false is just ignoring reality.

The economy is like our forests. When a fire starts in the forest you let it burn so that nature’s cycle can run its course. If you keep putting out the fire you build excess fuel and then at some point you have a catastrophic fire that no humans can control. Mother Nature eventually steps in and puts out the fire and puts life back into equilibrium.

I agree that we need to rethink economics. But the principle of equilibrium, however short lived that moment in time is, is a sure reality. —Dennis Carver

John and Dennis raise an interesting question. The mere fact that the “sand pile” exists intact for some period of time means that equilibrium exists for that interval. Fair enough. The grains of sand do, in fact, line up so that they don’t collapse.

But we are constantly adding more sand and each additional grain changes the equilibrium. The previous equilibrium ends at that point, having been so brief as to be meaningless.

Eventually a grain of sand will create an unstable equilibrium, causing the pile to partially or completely collapse (and then be in equilibrium once again). So if no single state of equilibrium can exist for more than an instant, I would argue it’s not really “equilibrium” for any practical purpose. We can’t rely on it to continue. Every moment brings a new, unknown situation.

Let’s look at it another way. The sandpile model assumes there will be moments of instability. In economic terms, we are experiencing transitory equilibrium. The sandpile model is inherently unstable, a perfect example of Minsky’s Financial Instability Hypothesis: Stability leads to instability and the longer the period of stability, the greater the instability will be at the end.

(Nassim Taleb’s Antifragility Principle is important to understand when we think about equilibrium, or rather the lack of it. His book Antifragile is important and you should at least read the first half.)

My old friend and early economics mentor Dr. Gary North sees this idea of “equilibrium” as not just wrong, but downright evil.

In his 1963 textbook for upper division economics students, [Israel] Kirzner wrote about the assumptions of economists regarding the use of equilibrium as an explanatory model. They use it to describe the system of feedback that the price system provides the market place. “The state of equilibrium should be looked upon as an imaginary situation where there is a complete dovetailing of the decisions made by all the participating individuals.”

This means not only perfect knowledge of available economic opportunities, but also men’s universal willingness to cooperate with each other. In short, it conceives of men as angels in heaven, with fallen angels having conveniently departed for hell and its constant disequilibrium, where totalitarian central power is needed to co-ordinate their efforts. “A market that is not in equilibrium should be looked upon as reflecting a discordancy between the various decisions being made.”

The heart of free market economic analysis is the concept of monetary profits and losses as feedback devices that persuade people to cooperate with each other in order to increase their wealth. “But the theorist knows that the very fact of disequilibrium itself sets into motion forces that tend to bring about equilibrium (with respect to current market attitudes)” (Market Theory and the Price System, p. 23). Presumably, even devils cooperate on this basis. They, too, prefer profits to losses.

Biblically speaking, this theory of equilibrium is wrong. It is not just wrong; it is evil. It adopts the idea of man as God as its foremost conceptual tool to explain people’s economic behaviour. It explains the market process as man’s move in the direction of divinity. Economists are not content to explain the price system as a useful arrangement that rewards people with accurate knowledge who voluntary cooperate with each other. They explain the economic progress of man and the improvement of man’s knowledge as a pathway to divinity, however hypothetical. The science of economics in its humanist framework rests on the divinization of man as a conceptual ideal.

Setting aside the theology, the point here is that economists assume human beings are perfectly rational and consistent, or at least wish to be. That’s what makes equilibrium possible. But we know humans aren’t perfect or consistent. So how can we have equilibrium? We can’t, unless we assume markets are in equilibrium because they act in a manner we deem appropriate or ideal.

Insane Ideas

Again, this isn’t an academic argument. People who believe these ideas either hold seats of power or have influence on those who do. They truly think they can twist some knobs on their models and make everything better. If we just had better monetary or fiscal policy, if the government could tax the right people and distribute the money correctly, everyone would be so much better off. And of course, their highly complex models and theories will conveniently lead to their desired political conclusions.

It is increasingly obvious that conventional monetary policy is useless now that rates have been so low for so long, and everyone believes they will remain low. Nothing the central banks do incentivizes anyone to make immediate growth-generating decisions. If you need to borrow money, you likely did it long ago.

 A new Deutsche Bank analysis says the major world economies now have government debt, on average, exceeding 70% of GDP, the highest peacetime level of the past 150 years.

Source: Financial Times

This is obviously unsustainable but the economics profession (and the bankers) desperately want to sustain it. With monetary tools no longer useful, they are turning to fiscal policy. Serious people are mapping strategies like helicopter money, debt monetization, MMT, and worse.

These all, in various ways, essentially say that government debt doesn’t matter, and in some cases we actually need more of it. Historically, the only way that can be right is if we are on the cusp of another WW2-like crisis.

This horrifying but well-researched Bloomberg article is chock full of links to insane ideas. Some look superficially attractive, especially to those unfamiliar with even basic economics. Many have familiar, heavyweight names attached to them. All have, to me at least, a whiff of desperation. They are frantic attempts to make the world stop spinning.

I don’t think these ideas will work. I think we are beyond the black hole’s event horizon. Bad things are going to happen, culminating in some kind of globally coordinated debt liquidation I have dubbed the Great Reset. I really see no other way out.

Every day brings more signs of the impending crisis. Duke University’s latest quarterly CFO survey found more than half of finance chiefs foresee a US recession before the 2020 election. Possibly worse, they project only a 1% increase in capital spending over the next 12 months.

An economy in which near-zero interest rates can’t spur more investment than that is an economy with serious problems. And I expect them to get worse, not better.

Furthermore, an increasing body of evidence says that increasing sovereign debt is a slow but inexorable drag on GDP. It is like the frog being boiled in water, but so slowly that we as citizens don’t really understand what is happening to us. We do sense something is wrong, though. Hence today’s worldwide populist movements.

The driver for 1930s populism was the Great Depression and unemployment. Now the impetus is rising debt and underemployment, with people unable to improve their lives as past generations did. Millions no longer expect to be better off economically than their parents. That frustration is sparking unproductive political partisanship and has the potential to bring political chaos as governments try to protect their own technology and businesses.

The world in general has clearly benefited from globalization and automation, but that is a hard argument to make as jobs disappear. And more jobs will disappear as technology increasingly lets businesses replace expensive humans with cheap robotics and algorithms. Sigh… I wish I had answers. Well, I do, but I don’t think they’ll going to get a great deal of traction.

This won’t be the end of the world. I really do think there are ways that you can properly position your portfolio and your personal life to not just survive but to thrive. We will get through it and be better on the other side. But it’s going to be a bumpy ride.

The IMF should take over Libra

By Yanis Varoufakis, former finance minister of Greece, is leader of the MeRA25 party and Professor of Economics at the University of Athens.

It is a good thing Libra is unravelling, along with Mark Zuckerberg’s dream of a private global payments monopoly. But we should not throw the technological baby out with the monopolistic bathwater.

The Libra Association is fragmenting. Visa, Mastercard, PayPal, Stripe, Mercado Pago, and eBay have abandoned the Facebook-led corporate alliance underpinning Libra, the asset-backed cryptocurrency meant to revolutionise international money. More corporations are likely to follow as pressure upon them mounts from worried governments determined to stop Libra dead in its tracks.

This is a good thing. Humanity would have suffered had Facebook been allowed to use Libra to privatise the international payments system. But the authorities that are now strangling Libra should look to the future and do with it something innovative, useful, and visionary: hand Libra, or its core concept, over to the International Monetary Fund (IMF) so that it can be used to reduce global trade imbalances and rebalance financial flows. Indeed, a Libra-like cryptocurrency could help the IMF fulfil its original purpose.

When Facebook CEO Mark Zuckerberg announced Libra amid great fanfare, the idea sounded interesting and innocuous. Anyone with a mobile phone would be able to buy Libra tokens with domestic currency and by standard methods such as debit cards and online banking. Those tokens could then be used to make payments to other Libra users, whether to purchase goods and services or repay debts. To ensure full transparency, all transactions would be handled by blockchain technology. In sharp contrast to Bitcoin, however, Libra tokens would be fully backed by copper-bottomed assets.

To anchor Libra to tangible assets, the association backing it promised to use its revenues, along with the seed capital contributed by its member companies (at least $10-million each), to buy highly liquid, highly rated financial assets (such as US Treasuries).

Given Facebook’s leading role, it was not hard to envisage a moment when half of the planet’s adult population, represented by 2.4-billion monthly active Facebook users, would suddenly have a new currency allowing them to transact with one another and bypass the rest of the financial system.

The authorities’ initial reaction was awkwardly negative. By highlighting the potential criminal uses of Libra, they only succeeded in confirming the libertarian suspicion that, faced with the threat of losing control over money, regulators, politicians, and central bankers prefer to smother liberating monetary innovations. This is a pity, because the greatest enabler of illicit activity is old-fashioned cash, and, more important, because Libra would pose a systemic threat to our political economies even if it were never used to finance terrorism or criminality.

Starting with Libra’s ill effects on individuals, recall the great effort most countries have invested in minimising the volatility of the purchasing power of domestic money. As a result of those efforts, one hundred euros or dollars buy today more or less the same goods that they will buy next month. But the same could not be said of one hundred euros or dollars converted into Libra.

To the extent that Libra would be backed by assets denominated in several currencies, a Libra token’s purchasing power in any given country would fluctuate a great deal more than the domestic currency. Libra would, in fact, resemble the IMF’s internal accounting unit, known as Special Drawing Rights (SDRs), which reflect a weighted average of the world’s leading currencies.

To see what this means, consider that in 2015, the exchange rate between the US dollar and the SDR fluctuated by up to 20%. Had a US consumer converted $100 into Libra back then, they would be subjected to the agony of watching the tokens’ domestic purchasing power move up and down like a yo-yo. As for residents of developing countries, whose currencies are prone to depreciation, Libra’s facilitation of money changing would accelerate the depreciation, boost domestic inflation, and make capital flight both likelier and more pronounced.

Since the 2008 financial crash, authorities have struggled to manage inflation, employment, and investment with the fiscal and monetary levers that, prior to the crisis, seemed to work reasonably well. Libra would further diminish our states’ capacity to smooth the business cycle. Fiscal policy’s efficacy would suffer as the tax base shrunk, with every payment shifting to a global payments system residing within Facebook. An even greater shock would await monetary policy.

For better or worse, our central banks manage the quantity and flow of money by withdrawing or adding paper assets to the stock held by private banks. When they want to stimulate economic activity, central banks buy from private banks commercial loans, mortgages, deposits, and other assets. The banks then have more cash to lend. And vice versa when the authorities want to cool down the economy. But the more successful Libra becomes, the more money people will transfer from their bank account to their Libra wallet and the less able central banks will be to stabilise the economy. In other words, the greater the flight to Libra, the deeper the volatility and crises afflicting people and states.

The sole beneficiary would be the Libra Association, which would collect tremendous interest income on the assets from around the world that it would accumulate using the large portion of global savings attracted to its payment platform. Soon, the association would yield to the temptation to advance credit to individuals and corporations, graduating from a payments system to a gargantuan global bank that no government could ever bailout, regulate, or resolve.

That is why it is a good thing that Libra is unravelling, along with Zuckerberg’s dream of a private global payments monopoly. But we should not throw the technological baby out with the monopolistic bathwater. The trick is to entrust implementation of the idea to the IMF, on behalf of its member states, with a view to reinventing the international monetary system in a manner reflecting John Maynard Keynes’ rejected proposal at the 1944 Bretton Woods Conference for an International Clearing Union.

To bring about this new Bretton Woods, the IMF would issue a blockchain-based, Libra-like token – let’s call it the Kosmos – whose exchange rate with domestic currencies floats freely. People continue to use their domestic currency, but all cross-border trade and capital transfers are denominated in Kosmos and pass through their central bank’s account held at the IMF. Trade deficits and surpluses incur a trade-imbalance levy, while private financial institutions pay a fee in proportion to any surge of outward capital flows. These penalties accrue in a Kosmos-denominated IMF account that operates as a global sovereign wealth fund. Suddenly, all international transactions become frictionless and fully transparent, while small but significant penalties keep trade and capital imbalances in check and fund green investment and remedial North-South wealth redistribution.1

Brilliant ideas that would be catastrophic in the hands of buccaneering privateers should be pressed into public service. That way, we can benefit from their ingenuity without falling prey to their designs. BM

Copyright: Project Syndicate, 2019.

Slowing Money Supply Growth May Trigger a Recession

By Frank Shostak

falling1.PNGA slight strengthening in the momentum of consumer expenditure has prompted many commentators to suggest that as long as the US consumer continues to spend there is no risk of a recession ahead. The yearly growth rate of consumer expenditure at current prices stood at 4.1% in July against 4% in June.

Notwithstanding still buoyant consumer expenditure, commentators have expressed concern due to a fall in the consumer sentiment index as compiled by the University of Michigan. The sentiment index fell to 89.8 in August from 98.4 in July and 96.2 in August last year.

In this framework of thinking, economic activity is depicted as a circular flow of money. Spending by one individual becomes part of the earnings of another individual, and spending by another individual becomes part of the first individual’s earnings.

It is held that if people become less confident about the future they will cut back on their outlays and hoard more money. Therefore, once an individual spends less, this worsens the situation for some other individual, who in turn also cuts his spending.

A vicious circle then emerges — the decline in people’s confidence causes them to spend less and to hoard more money. This lowers economic activity further, thereby causing people to hoard more, etc.

The cure for this, it is argued, is for the central bank to pump money. By putting more cash in people’s hands, consumer confidence will increase, people will then spend more and the circular flow of money will reassert itself.

All this sounds very appealing, and various surveys of business activity show that during a recession businesses emphasize the lack of consumer demand as the major factor behind their poor performances.

It would appear that what impedes economic prosperity is the scarcity of demand. However, is it possible for the general demand for goods and services to be scarce?

Most people want as many things as they can think of. However, what weakens their demand is the availability of means. Hence, there can never be a problem with demand as such, but with the means to accommodate demand. In the real world, one has to become a producer before one can demand goods and services. It is necessary to produce some useful goods that can be exchanged for other goods.

Demand cannot stand by itself and be independent, it is limited by prior production. What limits the production growth of goods is the introduction of better tools and machinery (i.e. capital goods), which raises workers productivity. Tools and machinery, are not readily available, they must be made.

In order to make them, people must allocate consumer goods that will sustain those individuals engaged in the production of tools and machinery. The allocation of consumer goods is what real savings is all about.

Note that real savings become possible once some individuals agree to transfer some of their consumer goods to individuals that are engaged in the production of tools and machinery. Obviously, they do not transfer these goods for free, but in return for a greater quantity of consumer goods in the future. Since real savings enable the production of capital goods, obviously real savings are at the heart of the economic growth that raises people’s living standards.

Money Printing and Economic Growth

When money is printed (i.e. created “out of thin air”) by the central bank and the fractional reserve system it sets in motion an exchange of nothing for money and then money for something (i.e. an exchange of nothing for something).

An exchange of nothing for something amounts to consumption that is not supported by production. Since every activity has to be funded, it follows that an increase in consumption that is not supported by production must divert funding from wealth generating activities. This in turn diminishes the flow of real savings to the producers of wealth, which weakens the flow of production (i.e., sets in motion an economic recession).

For instance, when money “out of thin air” gives rise to consumption that is not supported by a preceding production, it lowers the amount of real savings that supports the production of goods and services of the first wealth producer. This in turn undermines his production of goods, thereby weakening his effective demand for the goods of another wealth producer.

The other producer is in turn forced to curtail his production of goods thereby weakening his effective demand for the goods of a third wealth producer. In this way money “out of thin air” destroys real savings and sets up the dynamics of the consequent shrinkage of the production flow.

Observe that what has weakened the demand for goods is not the sudden capricious behaviour of consumers, but the monetary injections of the central bank that has weakened effective demand. Every dollar created “out of thin air” amounts to a corresponding dissaving by that amount.

At the heart of a recession is the liquidation of various activities, which emerged on the back of a rising trend in the growth rate of money supply. These activities, which we label as bubble activities are bad news for the process of wealth generation.

They weaken the wellbeing of the economy, so to speak. What triggers the recessionary process is the decline in the trend of the growth rate of money supply.

 Slowdowns in money supply appear to have a real effect. In fact, the downtrend in the yearly growth rate in the adjusted money supply (AMS) during 2002 to 2007 was responsible for the economic slump of 2008. An uptrend in the growth rate of AMS during 2008 to 2011 provided a support for the strengthening in economic activity until very recently. A visible decline in the annual growth rate in AMS since 2012 has set in motion an economic slump. This slump is likely to strengthen as time goes by.


Note again that by popular thinking, a recession is associated with the so-called strength and weakness of various key economic indicators. Consequently, policies that can strengthen these indicators are most welcomed. The key variable that most commentators pay attention beside consumer expenditure is gross domestic product (GDP). Given that this indicator is monetary turnover, obviously then, changes in money supply after a time lag are followed by changes in the GDP. Given that most macro indicators are derived from GDP it is not surprising that changes in monetary policy of the Fed supposedly can navigate the economy.

Meanwhile, policies that are aiming at preventing the emergence of a recession make things much worse. These policies not only provide support to bubble activities but allow the emergence of new bubbles thereby undermining the wealth generating process further.

Note that by means of loose monetary policy, the Fed does not help the economy. The central bank only sets in motion a further diversion of real wealth from wealth generators to various bubble activities thereby making things much worse for wealth generators.

As long as wealth generators can still generate sufficient amount of real savings to support all the activities in the economy, then loose monetary policy of the Fed which appears to strengthen GDP seems to be a success. Observe that the increase in GDP just reflects monetary pumping and the weakening of the wealth generation process. Once the ability of wealth generators to support overall economic activity i.e. bubble activities and wealth generating activities weakens significantly central bank pumping cannot lift the economy even in terms of GDP.

One of the channels for monetary pumping is the fractional reserve banking. Once banks realise that various loans issued by them are likely to become bad assets, then banks begin curtailing the expansion of lending out of thin air. This result in a decline in the growth rate of money supply and after a time lag, the growth rate of GDP follows suit.

The best way to revive the economy is to allow wealth generators to run the show without any intervention by the central bank or the government. Those commentators that demand that the central bank and government should interfere in order to help the economy must realise that neither the central bank nor the government are wealth generators. All that they can do is to redistribute real wealth from one individual to another individual. As a rule, this results in the diversion of real wealth from wealth generators to various inefficient bubble activities.

If policies of the central bank and the government could grow an economy by now then most third world economies would have eliminated poverty and would now be classified as wealthy economies. Whenever various commentators argue in favour of central bank and government policies to provide support to the economy what they imply is a support for bubbles. The question that these commentators ought to ask is at whose expense will these bubbles be supported?

Frank Shostak‘s consulting firm, Applied Austrian School Economics, provides in-depth assessments of financial markets and global economies.

Contact: email.

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