Capital Markets Advisors

Turning Change Into Opportunity


Wednesday, October 7th, 2015

The industrial world has entered a new economic era, and the transition has rendered much of monetary policy largely irrelevant. The Fed has pumped out multiple trillions of dollars since 2008, with no verifiable evidence that the flow had any commensurate impact on economic growth. And now that it is considering tightening monetary policy, we should expect significantly more unrest.

While the current world-wide fixation on when the Fed will finally tighten keeps the blogosphere occupied, it probably misses several important economic points. One is that what we used to call the industrial world (now often devoid of industry, which has moved to what used to be called the third world) has gradually entered a new economic era – not actually post-industrial, but perhaps post-rational. That transition has rendered much of monetary policy at least suspect, if not downright irrelevant.

Another economic point is the electronification of a whole host of functions, with the accompanying instantaneous international impact of decisions (or, more important, the lack of decisions) in the remotest corners of the globe. To top off this phenomenon, there is the silence of international capital movements, with trillions of dollars, or other currencies, flitting from owner to owner, venue to venue, and currency to currency, with only the aftereffects to show that it happened.

A final economic point is the appearance on the global power scene of what used to be called the emerging markets, which have indeed emerged from the shadows in an economic sense, but often not in a political sense. These economies, which have grown explosively, turning out huge new upper-middle and upper classes (which we used to call the nouveau riche) still feature political systems that are largely totalitarian, or have immature structures for handling rapid social change. Any trained sociologist will tell you that such a combination is a recipe for unrest.


A Little History

Given that as background, it is worthwhile to look at some recent economic history, primarily in the US. The first historic event is really several events – the Bush tax cuts of the 2000s. While tax cuts are always popular, at least superficially, these had the effect of creating a substantial federal deficit during a period of relatively high employment. Why is that important? Well, despite Dick Cheney’s famous statement that, “Deficits don’t matter; Reagan proved that,” they actually matter a lot. This one had two effects: 1) It convinced people that it was acceptable for the federal government to run perpetual deficits, and 2) it took away a powerful fiscal tool in case the economy cratered.

The second major event was the Fed’s decade-long policy of monetary ease during a period of strong economic growth. But to understand this event, we must understand a few things about monetary economics, or the role of money in the modern economy.

While most people think of money as something physical, more than 99.999% of it is electronic, in the form of someone’s promise to pay. We get paid, and pay for things, and every entity of every size does as well, by exchanging someone’s promise to pay. Thus, promises to pay are the new equivalent of gold bars, or the Federal Reserve notes in your wallet. As we go forward, it is crucial to remember that all money, for practical purposes, is someone’s promise to pay. In other words, the terms “money” and “credit” become synonymous.


The Bursting of the Bubble

The Fed’s 10-year experiment with easy money created a credit bubble, largely in the US. We didn’t see price inflation as a result, but we certainly saw credit inflation. If you have a free hour or two, we could discuss in detail the phenomenon of an unfolding credit bubble, but right now we need to understand the mechanics of that bubble’s bursting. Some aspects are obvious, such as the debt write-downs and the economic contraction; but many people are not aware of the long-term deleterious effects of a large economic bubble.

One effect is to push the level of economic activity well above the equilibrium level for an extended period. This unsustainable level convinces most observers that it is actually equilibrium, so that the contraction due to the bursting appears to be much further below equilibrium (i.e., disastrous) than it actually is. At the same time, the bubble creates enormous excess capacity in every area where credit has an impact; capacity that has to be absorbed before true economic growth can return. So when we look at the fiscal and monetary response to the recent burst bubble, we see two misconceptions.

The first is that the pre-bursting level was equilibrium, and should be attained as soon as possible, when, in reality, it normally takes about 10 years for the equilibrium level to reach the bubble peak. The second is the belief that some combination of economic policies can make the excess capacity disappear immediately. Neither of these is true, of course, but the general public and their political representatives tend not to understand. Of much more concern is that, in this case, the Fed appeared not to understand either.


Applying the Fix

Whether you consider yourself a Keynesian or not, it is clear that one economic engine that can be turned on at the appropriate time is fiscal policy. Whatever your ideological stance, history is full of examples of substantial incremental government spending, often called deficit spending, enhancing an economic recovery. In this case, however, the deficit engine was already running at full speed, so it had very little power left to give. Thus, all of the remediation was left to monetary policy.

Now we need to understand that monetary policy is, by its very nature, a blunt instrument, like a hammer. To the extent that a drop in economic activity is, in any way, a result of relative borrowing costs, a drop in market rates of interest will act as a stimulus. However, if the demand for credit is low for some other reason, like the bursting of a credit bubble, then we should expect a precipitous drop in rates to have very little effect on economic activity, which is what happened.

At that point the Fed made its second mistake in a 10-year period – it entered into a very large quantitative easing. Why it expected this to push up economic activity will remain one of the great mysteries of this decade. Suffice it to say that the Fed has pumped out multiple trillions of dollars since 2008, with no verifiable evidence that the flow had any commensurate impact on economic growth, beyond what the normal absorption of excess capacity and the normal growth of the equilibrium level of activity would account for.


Tracking the Money

Which leaves us with an obvious, if strangely unasked, question: Where did all the QE go? Of course, some of it stayed in the US, but much of it did not. If the mechanism of QE was the Fed buying debt instruments in the markets, then a more precise version of our question is: What did the holders of those bonds do with the proceeds of their sales to the Fed? The answer is, they went looking for some sources of yield to replace what they were no longer earning. Some of that yield came from equities, helping to explain the almost decade-long bull market in stocks, which appears to be ending. But there was another place to obtain yield under what looked like acceptable risk, and that was the high-yield sector, both domestically and overseas. And that leads to the moral of our story.

As long as the QEs were ongoing, we saw a counterintuitive growth in the high-yield sectors, such as energy in the US and the BRICs overseas. As soon as QE stopped, we saw an almost immediate slowdown in these sectors, particularly overseas. Countries such as China, Brazil and India felt a sudden deceleration, like when an airliner begins its descent. Whether they understood what was happening at the time, we will only know later. But the timing of the simultaneous slowdowns leaves no room for debate as to the causes.


Stepping on the Brakes

So now the Fed is wondering whether to start a gradual tightening, and the question appears to be all about the impact it will have on the domestic economy. This is a classic example of looking at second base when the ball is going to first. Worrying about domestic thunderclouds at this juncture will only lead to shock and awe when the real rumbling and lightning flashes start appearing overseas. The countries most affected have already shown an inability to deal with what would be an externally imposed economic downturn, so we should expect significantly more unrest over the first year of Fed tightening.

And it isn’t like there won’t be any domestic impact. It’s just that it won’t initially be in the arena of GDP or non-farm payrolls. It will be in the credit losses of the holders of that high-yield paper we spoke about earlier. Some of those losses will be very substantial, and the liquidity in that market is already low. If those losses are concentrated enough, in both time and holders, they could spark a secondary panic, perhaps prompting the Fed to step in as lender of last resort. Thus, we have the possibility of the central bank dealing with an international crisis resulting from its own monetary policy. All of which amply demonstrates that the idea of domestic monetary policy in the 21st century is nothing but a myth.

  • Connect With Us

    Visit Us On FacebookVisit Us On TwitterVisit Us On Linkedin