“With all the mess going on at the moment, I thought it was worth while stepping back a little and trying to look at the bigger picture.” So begins Andy Lees’ latest must read letter to clients whch explains succinctly virtually the entire story of where we were, how we got to where are now, how the current trajectory is unsustainable, why due to decades of capital misallocation anything that the Fed does now is essentially irrelevant, why our untenable debt pile does nothing but perpetuate an unsustainable ponzi scheme which will result in an unseen explosion in the true cost of capital: gold, and why the bond market will eventually, and inevitably, force an epic repricing in the cost of non-gold capital absent the arrival of the deux ex machina of real, actionable innovation that the Fed, and all global central planners, keep hoping for. Because the longer we keep plugging away with that worthless substitute, financial innovation, which is anything but, the greater the final collapse. Andy’s conclusion: “Until the debt is cleared and capital starts to be properly allocated, economic growth per unit of additional debt will continue to sour. Until we get some real breakthrough technology, requiring large amounts of capital to both innovate and then roll out, we have no chance of supporting the economy.” Too bad than that this absolutely spot on observation reflect precisely the opposite of what the Fed is pursuing.
Why are we here: simple – years of central planning resulting in the greatest experiment in capital misallocation in history.
We are in this mess because of excessive leverage and excessive consumption, financed by excessively cheap real capital – (not just Bernanke & Greenspan but further back to the end of the gold standard, and in fact even before that as it was this misallocation of capital that forced us off the gold standard in the first place). If capital had been allocated productively, then by definition debt would fall as a percentage of GDP. Total debt may rise, but efficient allocation of capital would always mean the economy would grow faster than the debt as it means you are making a positive rather than negative real return on that capital.
Whichever way you look at it, capital has been massively misallocated for years.
Corporate profits… or massive debt-funded ponzi scheme?
How can that be when corporates report massive profits? The profits are based on paying their workers a salary that meant they could only buy the goods they made by borrowing; in other words, a massive unsustainable ponzi scheme that could only ever end up with default. Without the household debt accumulation, there would be no market to sell their products to, and without paying the workers sufficient, the debt would always have to default.
This required a massive increase in financial innovation to keep the illusion of corporate profitability alive – (household debt was a way of delaying putting the true costs through the corporate P&L account and recognising the costs). Financial sector innovation is itself another form of capital misallocation, taxing people away from real innovation – (to keep the illusion alive, an ever greater percentage of economic output had to be allocated to this illusion machine) – helping add to the resource constraint we are in today.
If financial innovation, which we have so much of is not needed, what is the right kind? And why is it so sorely missing.
A lot of what are described as efficiency gains have been just the removal of levels of safety and the removal of innovation in the system. Innovation and ongoing operations are always and inevitably in conflict, with the most readily apparent conflict between short and long term priorities. A second handicap to innovation is the way efficiency is achieved by breaking down things into small repeatable tasks. This specialisation and repeatability is a company’s greatest strength, but it is also its greatest weakness. Innovation is neither repeatable nor predictable. It is non-routine and uncertain. (Book: The Other Side of Innovation).
The culprit: none other than the great moderation, and, now, ZIRP4EVA:
Low real interest rates support excessive consumption, taking money away from innovation and balance sheets. When the US started suffering from its peak oil in 1970, rather than innovation it turned to globalisation to tax the broader global resource balance sheet, just as Britain and Europe had done 100 years earlier through colonialism, and recently accelerated that with the WTO. Globalisation has always been about accessing resources.
Which bring us to topic #1 here, and everywhere else where economics is involved: cash flows.
This has been a factor mobilisation story on unprecedented proportions, but appears to have reached its conclusion as resource constraint has meant the “cash flow” to grease the wheels has started to become more expensive and constrained. Profit without productivity can only carry on for a finite period; we are now clearly consuming down our balance sheet or putting it through the P&L account.
So we are left with a massive amount of debt, a massive amount of capital and labour that is unprofitable in the world we face, and a balance sheet of insufficient resources to keep the illusion alive. The only thing that will get us out of this in the long run is innovation which will expand the balance sheet, expand the pie and create the jobs that people want.
How do we get rid of the debt? Are we in a debt trap whereby any interest rate hike will kill the recovery? Clearly it is going to be incredibly difficult, but low real rates are the cause of the problem, not the solution. I don’t personally see a zero rate trap, but we need to allocate capital far more productively than we are doing.
The cost of money itself is hugely important. How negative were real rates? When people talk of borrowing from the future, surely the same logic applies to the cost of capital. If we have had low or negative rates that supported excessive consumption, we now need to have high real rates to direct capital back to innovation and gradually repair the balance sheet. The real cost of capital has to go up. No matter how much fighting the Fed and Treasury do, the real cost of capital will rise. The bond markets have to be allowed to clear some of the debt and thereby remove some of this misallocation of capital.
It’s not “debt trap”, it is “Fed trap”
Does that mean we are trapped in a position whereby the Fed cannot raise rates? Quite frankly it doesn’t really matter what the Fed does; real rates have to go up, are going up and will go up. The more the Fed and the government misallocate capital, the more the real cost of capital will have to rise higher to compensate. The only thing that will get real rates down is either a massive new discovery of incredibly cheap fossil fuels or the innovation that delivers cheap fusion. Otherwise it is a case of the cost of capital rising and causing demand destruction.
Getting the central banks monetary policy inline with the real cost of capital in the market must be the first step to rectifying the misallocation of capital. One obvious thing would be for economists to stop ignoring CPI of food and energy as irrelevant as it is the fastest growing part of the economy. By ignoring it, they are turning what should be a smooth and relatively painless transfer of capital into an occasional out-of control collapse and transfer. Getting both a proper monetary and fiscal policy framework in place, based off genuine data rather than smoke and mirrors and fiddles must be the first priority.
Which brings us to where we are now: a massive, unsustainable ponzi scheme:
Whilst politicians and investors acknowledge that excessive leverage created the asset and debt bubble, they do everything they can to prevent a rational deleveraging or efficient allocation of capital. For the moment the best measure of the cost of capital is gold. For years gold fell as fiat money was printed and this unsustainable ponzi scheme established, however as that ponzi scheme now unravels, gold must go up. The scale of both the ponzi scheme collapse and gold appreciation will be huge.
The problem is total credit market debt is still increasing.
As Fitch recently highlighted, Chinese on & off balance sheet debt has expanded by nearly 40% GDP in each of the last 3 years. In other words, the misallocation of capital is continuing making the ultimate problem that much worse. China is now getting almost no growth per unit of additional debt.
With each additional unit of debt, we are digging ourselves a deeper hole to get ourselves out of. Surely it is better to at least slow the digging? If we can allocate capital productively at the margin – (we know where we need to start making real returns) – then once we can start making a positive return on that marginal debt, then it becomes easier to support the residual debt we have.
If Andy is right, the framework of the next great class class conflict is set: it will be between the productive private economy and the “unproductive economy.” Yes: Marxist tensions are about to make a repeat appearance:
Private sector annuity rates will be tumbling and yet the unproductive public sector are still being given great pensions. We are taxing the productive private economy to give to the unproductive economy. This has to end. The idea of a European fiscal union fills me with dread as that would be locking this unproductive transfer into stone. Rather than keep kicking the can down the road, lets own up to our excesses and start putting the economy back on track. Don’t reward the rioters in London with yet another handout; force them to pay for the damage they have caused and the police time they have consumed.
Is Greenspan to blame for this dead end? Yes… but only so far. One can just as readily blame the traditional duel between short and long-termism, or what is known better as “it will be the other administration’s/generation’s issue.” In other words, Washington is just as guilty as Wall Street, and that infamous private bank.
Why have we misallocated capital for so long? We can blame it on democracy, but bigger than democracy is the culture that forces politicians to favour the immediate status quo over the longer term good of the country. That culture then presumably comes down to poor understanding which comes back to low levels of education. We need to address these route courses.
The real cost of capital has to rise. That will happen through default in one way or another. Debt has to be cleared. Multiple contraction is inevitable.
Financial sector innovation has to be squeezed by engineering and scientific innovation. Until the debt is cleared and capital starts to be properly allocated, economic growth per unit of additional debt will continue to sour.
Energy is the cash flow in this story. Until we get some real breakthrough technology, requiring large amounts of capital to both innovate and then roll out, we have no chance of supporting the economy.
Nothing can be added to this.