Dead presidents

The global financial response to the slowdown in economic activity has been nothing short of extraordinary.  In the United States, over $3 trillion in money supply has been created, with a further $3 trillion in fiscal activity.  Overseas, in China, in the UK, in Canada, in the EU, similar levels of new money have flooded the money system, courtesy of central banking policies tailored to system: quantitative easing in open monetary systems, reduced capital requirements and increased access to money creation programs for banks in closed systems paired with aggressive foreign exchange management.  There is a lot more money in the system, but the implications of that are diverse, more so than the commentary one reads on Bloomberg or in the Financial Times or the Wall Street Journal. 

Quantitative easing has had the positive result of effectively eliminating any increase in debt service costs associated with government deficits.  When government spending goes up but taxes go down (in the form of tax forgiveness or citizen payouts), the result is an imbalance in the government books, which is funded by borrowing.  Anyone who lived through the Reagan deficits will remember that.

So far, however, the deficit expansion has been effectively funded by central banks, at least indirectly.  In the US, the Fed expanded their treasury purchases and instituted a small program buying high-grade corporate debt.  But the bulk of their $3 trillion monetary expansion, though, has focused on agency MBS, as it’s called, bonds backed by mortgages and guaranteed by the federal housing agencies.  These are normally the bread and butter of commercial and savings bank securities portfolios; when the Fed hoovers up 25-45% of any given issue, the banks have to look elsewhere to buy securities, and the yield of those mortgage securities goes down.  Banks most easily can switch into government debt – especially when the federal government is running huge deficits – and their new demand for that debt pushes down the cost to the government of financing the deficits.  

Of course, all investors are looking for attractive returns.  With the Fed inserting itself into the market, the extra money that otherwise would have bought the Fed’s bond purchases flows into lots of markets.  With equity markets dropping, for example, a decent chunk of inflows has purchased stocks, sending prices higher.  It should also flow into corporate bond and corporate lending markets, although on a net issuance basis, there has been much less of this than many, including the central bankers, expected, particularly for smaller borrowers – whether in Main Street or High Street lending or to the midsized companies that fuels much traditional employment growth and capital accumulation.

The goal of all of this capital markets activity, of course, is ultimately to stimulate the economy, by sending a powerful signal to everyone who might think about borrowing money to engage in micro-economic activity – by spending borrowed money to buy factory equipment or a new car or take a vacation – that money is cheap, and they should maybe accelerate their spending plans to take advantage of the relative reduction in the cost of money.  

For understandable reasons, though, in the midst of a pandemic, not many potential borrowers are feeling up to the challenge.  Risk appetite has dropped significantly, and we see it in borrowing markets across the financial landscape.  Mortgage borrowers are reducing the outstanding balance of mortgage debt in most developed markets; there is a lot of refinancing activity, but there’s actually a slow destruction of the credit stock in mortgage markets taking place.  Ditto in corporate markets: while corporate bond issuance is at all-time highs, much of the proceeds is being used to pay down riskier short-term commercial paper and revolving bank borrowings.  Commercial real estate markets are largely frozen, with the market already likely overbuilt prior to the pandemic, and uncertainty about how we will physically organize our spaces for business of all kinds sort of destroying any appetite for lenders to extend new credit in real estate.  Other issuance is more about capitalism eating itself: there’s been a raft of initial public offerings called “SPACs”, special-purpose vehicles designed to give corporate raiders capital to take over other companies.  No activity takes place via SPAC purchases – in fact in general, SPACs tend to destroy activity as they carve up companies perceived to be overvalued – but it gives hope to those searching for high returns that they can maybe beat the market.

So despite the massive creation of new money, very little new credit is being successfully created.  In a capitalist financial economy which employs credit money (as opposed to hard money like gold or silver), a reduction in credit leads inexorably over time to a reduction in economic activity.  This is because in such an economy, where money is a synthetic creation of the banking system, credit is an accelerant, or should normally act as such. 

Think of it this way: let’s say today, Bank A lends 100 units of money to Person X.  The first thing Person X does is put their newly borrowed money back in the bank – they’ll withdraw it later to buy that sweet new machine lathe, but their initial act is to put it back in the money system temporarily.  If they put it at Bank A, then we observe something simple: Bank A’s balance sheet has just grown by 100 units – indeed, Bank A just created money.  Even if Person X immediately bought that lathe from Industrial Conglomerate Q, the result would be the same – Q would take the proceeds from selling the QuadraLathe 3000Z and deposit it in their bank.  Eventually, of course, Bank A will expect to be repaid by Person X, and in theory the banking system will shrink back by its 100 units….

… but actually it won’t.  In the meantime, Bank A would collect, say, 10 units of interest from Person X, and depositors (in today’s world) would receive nothing.  Those 10 units have to come from somewhere, and what the come from is the ongoing continuing spin of economic activity that is enabled by the slow increase in the money supply affected by the central bank.  They supply extra money to allow for the float to be paid and keep the system afloat.  In the meantime, the QuadraLathe 3000Z adds value – not money per se, but value – to the overall system by spinning out really highly sought after sprockets and widgets.  Those sprockets and widgets cost a little to make but are worth a lot, and can be used as collateral to support other people borrowing, who then buy more QuadraLathes or sprockets, etc etc etc.

As a brief historical aside, note that in a hard money economy, the profit earned by the bank actually does, ultimately, have to come from one of the participants in the system (barring the economy finding more gold in the ground). It can be financed through credit creation for a period of time, but one of the reasons that gold standard economies in the 19th and early 20th century inevitably experienced long and painful depressions on a regular basis is that at some point, some lender decided to cash out and ask for repayment of that float in gold, and the gold couldn’t magically get created. Well it could – the central bank could yank the economy off the gold standard – but that had other consequences on trade flow and investment and government borrowing ability – but assuming the government did not do that, the only way get the original lender their gold was to drastically and violently reset all valuation of all assets – including inputs like labor. Fiat money – credit money – allows the central bank to avoid such hard resets by simply allowing the financing float to get paid for by slow, moderate expansion of the monetary base through time.

Back to our exciting machine tool example: This is a simple three-participant (four if you count the customer who assigns a market value to the sprockets and widgets) representation of our money system.  Of course in reality, there are hundreds of millions of participants, consumers, producers, and plenty of participants which are simultaneously both.  The aggregate activity of everyone is what makes the system self-sustaining.  It’s also what makes it so sensitive to increases or decreases in the speed and activity of the credit process.  If credit is being destroyed on the margin, the system will lead to less microeconomic activity; if the system doesn’t have the dollars, it won’t have anything to spend.  Similarly, if the system creates too much credit at the margin, it will have too much to spend, and at a certain point, the signaling power of money – in terms of its relative change in value through time, otherwise known as inflation – breaks down.

We’re seeing this right now but for most of us, sitting at home, ordering more delivery pizza than usual but taking far fewer vacations, it’s invisible.  The inflation signaling that’s breaking down is taking place in capitalmarkets, not in markets for goods and services.  Equity markets hitting new highs when economic activity is still cratering is not a signal that the market is expecting better days ahead: it’s a sign that the credit money that has been created through Fed actions has nowhere else to go except to buy financial assets.  This in turn reduces the signaled cost of capital to the market, which should then lead financiers to create additional credit money, which will also have no real economic activity to support, and will then drive up the value of financial assets.

Until they crash.  But a crash of financial asset values when the microeconomic valuation of goods and services have already slowed down due to the pandemic will not clearly collapse the economy; far from it.  More likely there will simply be a compressed period where those who lent money see their financial value destroyed, and those who borrowed money lose the wealth that they had used to justify their borrowing.

In the Great Depression, this was a problem.  Essentially the 1920s was a period of unabashed credit creation, during a period when the US was experimenting with a hybrid monetary system in which the Fed acted as a lender of last resort – that is, it would create credit in pinch, backed by bank loans made to customers – but it sought to maintain the external value of the dollar relative to gold by varying the rate at which it would lend.  If the value of the dollar was dropping versus gold, then it would increase the rate – the cost of money – and in so doing eliminate any economic incentive to create credit.  If the value was increasing, they would drop the rate accruing on loans.  Since in the wake of World War I, in which the US dollar was suddenly the only major currency able to maintain the gold standard, the pressure was consistently towards increased dollar valuations, and the Fed thus pumped credit – via interest rate signaling – into the market.

Industry expanded.  Prices for primary goods tradeable on world markets dropped as innovation and efficiency expanded.  Money eventually ran out of good investments and started chasing itself – indeed today’s SPAC phenomenon is a direct parallel of similar “shell” IPOs that helped accelerate the asset price inflation in the 1920s – closed end funds, which were able to leverage themselves up to 10 times and, in the days before securities regulation of any significance, no reporting requirements, no prospectus, no information.  Asset values chased asset values until a series of minor shocks earlier in the year triggered the earthquake of late 1929.

The trouble was, the overall microeconomic landscape back then was much more basic – you’d almost say immature – than it is today.  Functionally it resembled the simplistic Marxist landscape of capitalists (owning the means of production and having sole access to the money economy), industrial workers (who were primarily consumers of goods with wages largely delinked from productivity gains), and primary goods workers (basically farmers, in what was still a smallholder agricultural economy which mixed subsistence with sale of agricultural surplus in highly competitive, if mostly still localized, markets).  Goods could move between markets with trains and the emerging automobile making transport easier; services largely could not, and the tertiary economy was highly atomized and localized, and relatively unimportant in terms of having a marginal impact on the economy as a whole.

Today that isn’t the case.  Capitalists as a class – or a better term would be “the wealthy” – no longer have any particular monopoly on the means of production, particularly in a world of broadly diversified ownership.  Much has been made of the private equity revolution of the past twenty years but most corporate equity is still owned broadly by the public in the US, and even private equity vehicles largely acquire their investment capital from pension funds, insurance companies, and other investment vehicles which pool ownership across dozens, hundreds, or even millions of common indirect owners.  Industrial workers form a decreasing proportion of the workplace – not just because many manufacturing jobs have moved offshore, but also because innovation has allowed far more automation, and far less need for human capital, than ever before, a trend that continues to accelerate.

The tertiary economy, however, now dominates, and it’s no longer localised.  In an information and increasingly virtual world it increasingly dominates the global economy: the entire Internet is tertiary.  Entertainment and media, travel and tourism, logistics – but more than that, there the R&D machines which feed pharmaceuticals and the broader industrial economy, marketing and advertising, management consulting – all of these are components of the tertiary, even when occasionally embedded with.  Most of the turnover in our economy today is interlinked, and more of it than many realize is relatively high wage.  Not high enough to allow direct participation in the capitalist world of financial markets, but more than enough to be far more resilient than the simplified economies of the 1920s.  

And importantly, the tertiary economy is much less directly linked to marginal activity.  Think of a programmer at an online retailer: once they build the site, there’s essentially infinite leverage on the finished product.  But the “hourly wage” of such a programmer is also somewhat irrelevant.  What is the “hourly wage productivity” of a management consultant, or a medical researcher, or for that matter, that of a masseusse?  The intangible products they produce have values which are essentially arbitrary and not strictly linked to input pricing and per-unit leverage against a fixed capital spend – the basis of how classical macroeconomic models of pricing, inflation, capital accumulation all work.

What this means – I think – is that a collapse in financial asset values would not have the knock-on impact that the 1929 and 1931 market crashes had on at least the US economy, and possibly more broadly across the post-industrial economies of the West (I’ll set the quasi-commodity economies of Canada and Australia to the side for the moment; that’s worthy of another essay).  The link between asset values – and the credit creation they enabled – and microeconomic activity in the tertiary economy has largely decoupled, so long as the level of credit creation within the tertiary economy is not overheated.

With that in mind, actually, the broad economy can thank the Global Financial Crisis for its relative resiliency today.  The crisis of 2008-2009 was sparked by excessive credit creation in the tertiary economy – primarily mortgage lending in the US and Europe – which then destroyed household wealth and the incentive to borrow and spend among individuals.  It also led to the destruction of capital, but that only really mattered for structural reasons: too many of the providers of financial infrastructure, the boring bits like moving money between banks and making sure there’s really collateral behind loans, were also among the capital markets participants who had seen wealth destroyed.  The “financial crisis” was one of market infrastructure and its linkage to market valuations (there was also a liquidity crisis, which is a bit more complex); this was painful but essentially an organizational issue, and was dealt with in the short run by the government providing short term credit (which was repaid), and in the long term by legal reforms.  The “mortgage crisis”, on the other hand, while being the valuation issue that sparked the financial crisis, was the real macroeconomic event.  The credit destruction at the household level that took place led to the difficulties seen in all Western economies to respark consumer spending, renew forward expectations of money’s ability to value use and consumption (as opposed to capital) goods, and the like, for nearly a decade – indeed, it was still not fully remedied when the pandemic hit.

And hit it did: accelerating over the course of roughly eight weeks, the lockdowns started rolling across the globe, the market value of capital dropped by 30% in a matter of weeks, and economic activity ground to a halt.  I think that subsequent events have demonstrated that these two distinct events – the market drop and the economic seize up – while roughly simultaneous, actually had very little to do with one another.  Markets were waiting to see if central bankers would restore the money stock with aggressive activity; when it happened, stock markets returned to pre-pandemic valuations and in many cases actually exceeded them. Economic activity dropped due to lockdowns and a massive change in household risk tolerance – and the money pumped into the system has largely gone to reducing the risk profile of individual households.  People have not bought more aggregate use goods; they are buying less.  They are reducing their outstanding debt – again, mortgage balances are falling along with credit card and auto loan balances – but unit sales of cars remain largely depressed.

I’ve become convinced that because of that disconnect, we’re no longer in a position to apply prior rules about the linkages between money creation and credit and business expansion.  Business expansion is largely driven by demand, which in turn is driven by credit availability, risk appetite, and personal spending preferences.  With the severing of the ties between the money market for capital assets and the money market for use assets, the traditional and non-traditional central bank tools for expanding aggregate credit need to be re-examined.  And with credit creation in the capital markets largely having no impact on business activity in the tertiary economy – which basically requires no capital goods purchases to operate other than knowledge, as intangible an asset as fiat money is intangible an item of exchange – the notion that creating cheap money to drive business sector expansion to drive jobs is now largely discredited.

This, I think, hasn’t been recognized in my reading to date in the financial and economic press.  The Fed’s macroeconomic models still assume a relatively simplistic division of the economy into consumers, producers, and investors; they ignore the fact that most consumers are now themselves quite specialized types of producers operating in a segregated part of the economy which occupied a vastly smaller segment than it did in prior recessions (although the 2007-2009 crisis, arguably, was a dress rehearsal).  I think the Fed policy makers at the highest level sense this disconnect – hence their desire for fiscal policies which would directly cut checks to households and municipalities, to hopefully inspire direct increases in use activities (either purchases of stuff or hiring one another for services) – but it’s not explicit enough and definitely doesn’t come across in their econometric models.

Central banks, then, really are in a bind, because they’ve gone all-in on the opening pot with quantitative easing into this crisis.  I understand why they did it; the economy, threatened with a similar drop in activity in 2009, reacted pretty well to $1.5 trillion in quantitative expansion, so why not print $3.0 trillion for a potentially larger drop in activity?  They are learning in that regard; but they’re missing the lesson offered up over the past ten years of asset price increases which bore no resemblance to the muted real growth levels seen in the broader economy.  That lesson – that there is now a disconnect in valuation between the two “economies” – has been lost.

My modest proposal right now, oddly, is that the Fed should start signaling that it will wind down its non-government asset purchase programs, and should tighten capital rules for banks to lend into the financial system.  It’s fairly clear at this point that the financial asset system is both self-referential, and irrelevant to household activity.  But the excess valuations, brought on by ten years of excess financial market credit creation for institutional assets, will ultimately have distortive effects downstream.  

This, by the way, is the contrapositive of the proposals of people who advocate Modern Monetary Theory, which we’ve talked about on the site before.  That theory advocates for governments to grant direct payments to households, financed by central bank money creation, as a means of increasing household economic activity.  I don’t necessarily disagree with that, but that requires a coordination of political will with central bank policy, and I worry about the implications of mixing the more or less successful model of the independent central bank with highly charged redistributionist debates.  What I would propose is do instead deflate the market for financial assets to reduce the distortions caused by the disconnect in the value of a dollar in financial markets (worth less and dropping) and the value of a dollar in the tertiary economy (holding rather stable, with some evidence it is increasing).  

This is one area where central bankers are in heated agreement: it’s far simpler, from a central banking toolkit perspective, to combat inflation (which is where the value of a dollar drops over time), than it is to combat deflation.  And by the slow but sure evolution of both the broader economy – more complex, less strict divisions between participants, more self-circulation within sectors and weaker linkages across sectors – and of the financial markets, we’ve engineered rapid inflation in the latter market and deflation in the former.  Take the more direct path, therefore, and attack financial asset inflation, and have some confidence that the linkages to and therefore impacts on the broader economy – even weakened by the pandemic – are demonstrably muted versus past crises.

The dollars chasing themselves in the capital markets are essentially dead money; they’re not being used for marginal capital investment at all; the money simply circulates faster, reducing the meaning of the system much as hyperinflation does anywhere.  I think, though, that the emergence of the tertiary economy in the presence of future alternatives for value exchange – not Bitcoin! – things like direct barter markets (some of which have emerged anecdotally during the crisis, for example) and the vast expansion of peer-to-peer payment exchange which over time can obviate the need for banks as monetary intermediaries (we’d still need them for credit creation and exchange) is likely a dimly emerging view of what the exchange economy will look like in the future.

I mentioned before the idea that household demand, which ultimately drives business activity, is dependent on credit creation, risk tolerance, and consumer preferences.  A missing aspect of this crisis, and one of the critical reasons I think we’re facing deflationary pressures in the household and tertiary economy, is that even prior to the pandemic, I’m pretty sure we were seeing signs of the end of peak consumption demand, both because of reduced household growth in the developed world, but also because I think we’ve reached peak satiation, at least in terms of consumer goods spending.  The marginal satisfaction obtained from goods and services consumption is definitely declining in the developed economies, in particular for goods.  That’s not a bad thing, at least not in my book – there is a moral stance inherent in that statement which I’m aware of, involving moderation in all things and an ethic of personal simplicity which, while beyond the scope of this essay, is a constant theme on The Essence of Water.  But purely economically, we should expect consumer goods and services price deflation if marginal consumption demand is dropping.  The success story of the pandemic is the fact that consumer debt is dropping in the US; households, by that measure, are being rational about the forward outlook for pricing, because deflation means it becomes more expensive to pay existing debt than it was expected to be in the past when the debt was incurred, so you should move to shore up your balance sheet.

The existence of economic rationality by households, even in the midst of a public health crisis which has led many to at least seem panicky and irrational, is another reason to attack the inflationary spiral in the capital asset market first.  There, rationality does seem to be leaving the building, as valuations – which should in some world be based on the expectation of future cash flows – start to become fully disconnected from revenue, either top line or bottom line and definitely after tax.  Central bankers have the tools to impact the markets which are in the throes of that spiral; by comparison they can’t directly impact household market price deflation, particularly when that deflation is a result at least in part in shifting consumer preferences for less aggregate consumption in the first place.

In other words, time for the Fed to start burying some dead presidents.  We’ll be fine.

Or to put a more 2020 spin on it… the reasons we’ll wake up in a cold sweat at 3am in the near future won’t be the result of a decline in asset prices.  I have no doubt, however, that we’ll have a host of other reasons.  Sleep well.