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Interest Rates and Gremlins

August 29, 2017

Everyone is familiar with the term “interest rate”, but most people don’t understand what the term means. Unless you understand what the term means, you won’t fully understand why the central bank’s ‘management’ of interest rates damages the economy.

To understand what the interest rate is, it helps to understand what it isn’t. It isn’t the price of money. The price of money is what money buys, which can be different in every transaction. For example, if an apple is priced at $1, a new car is priced at $30,000 and a dental checkup is priced at $100, then the price of a dollar can be said to be 1 apple or 1/30000th of a car or 1/100th of a dental checkup.

The interest rate is the price paid by a borrower for a temporary increase in his purchasing power, or, looking at it from a different angle, the price received by a lender in consideration for temporarily giving up some of his purchasing power. This price will naturally take into account the risk that the borrower will be unable to make full repayment (credit risk) and the risk that money will be worth less in the future than it is at the time the loan is made (inflation risk). However, even if there were no credit or inflation risk to consider the interest rate would still be positive. The reason is that a unit of money in the hand today will always be worth more than a promise to pay a unit of the same money in the future.

This means that as well as being determined by the risk of default and the risk of inflation, the interest rate in any transaction will be determined by the time preferences of the borrower and lender. Someone with a strong desire to consume in the present has a high time preference. It’s likely that if this person has insufficient money to satisfy his immediate desire to consume then he will be willing to pay a high rate of interest to temporarily increase his purchasing power. Alternatively, it’s likely that someone whose desire to consume in the present is low relative to the amount of cash he has on hand will be willing to lend money to the right borrower at a relatively low rate of interest.

In any given transaction the credit risk component of the overall interest rate will end up being part of the lender’s real return if the borrower doesn’t default, but if credit risk is priced correctly then over a large number of transactions the amount received to compensate for this risk will be offset by actual borrower default. For example, if the risk of borrower default is correctly priced at 5%/year, then over a large number of transactions enough borrowers will default to impose a cost on the lender of 5%/year. Therefore, the time component of the interest rate is the same as the expected real return to the lender.

The implication is that on an economy-wide basis the real interest rate should be determined by the average of people’s time preferences.

To further explain, when the quantity of real savings is high relative to the general desire to consume in the present, the average time preference is low and the real interest rate SHOULD be low. Entrepreneurs and other businessmen will respond to this interest-rate signal by embarking on long-term projects that assume a future increase in consumer spending (high savings in the present implies higher consumer spending in the future). Capital equipment will be purchased, office buildings and shopping malls will be built, etc. When the quantity of real savings is low and people throughout the economy are consuming with abandon, the average time preference is high and the real interest rate SHOULD be high. Entrepreneurs and other businessmen will respond to this interest-rate signal by holding-off on new long-term projects. Although they won’t look at it in these terms, in effect they are being told, by the way the market is pricing time, that the future level of consumer spending will be insufficient to support certain investments.

The word “should” is capitalised in the previous paragraph because in the real world there exists a gremlin with the power to distort the interest rate. The gremlin is constantly tinkering with the interest rate, the result being that this vital price signal is always misleading to some degree. In fact, thanks to the mischievous acts of this gremlin the interest-rate signal is occasionally the opposite of what it should be.

Of particular relevance, due to the gremlin’s preference for distorting the interest rate in a downward direction the real interest rate is sometimes low during periods when the quantity of savings is low and the majority of people are spending like crazy, that is, when the average time preference is high. The result is that entrepreneurs and other businessmen throughout the economy embark on long-term projects that have no hope of being profitable. Individuals will naturally make mistakes, but for a large proportion of the population to make the same investing error the interest-rate signal must be wrong.

No prize for guessing the identity of the gremlin.

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The weakest boom ever

August 21, 2017

[This post is a slightly-modified excerpt from a recent TSI commentary]

The US economic boom that followed the bust of 2007-2009 is still in progress. It has been longer than average, but at the same time it has been unusually weak. The weakness is even obvious in the government’s own heavily-manipulated and positively-skewed data. For example, the following chart shows that during the current boom* the year-over-year growth rate of real GDP peaked at only 3.3% and has averaged only about 2.0%. Why has the latest boom been so weak and what does this say about the severity of the coming bust?

Before attempting to answer the above question it’s important to explain what is meant by the terms “boom” and “bust”.

An economy doesn’t naturally oscillate between boom and bust. The oscillations are related to fractional reserve banking and these days are driven primarily by central banks. When I use the term “boom” in relation to an economy I am therefore not referring to a period of strong and sustainable economic progress, I am referring to a period during which monetary inflation and interest-rate suppression bring about an unsustainable surge in economic activity.

Booms are always followed by and effectively give birth to busts, with each bust wiping out a good portion (sometimes 100%) of the gain achieved during the preceding boom. Putting it another way, once a boom has been set in motion by the central bank a bust becomes an inevitable consequence. The only unknowns are the timing of the bust and how much of the boom-time gain will be erased.

Returning to the question asked in the opening paragraph, the main reason for the unusual weakness of the latest boom is the unprecedented aggressiveness of the central bank’s response to the 2007-2009 bust. In broad terms, this response came in two parts. First, there was the initial knee-jerk reaction during 2008-2009 that involved massive bailouts for banks and bondholders. In particular, by various means the Fed channeled many hundreds of billions of dollars into financial institutions to keep these institutions in business and ensure that their largest creditors remained whole. Because the Fed cannot create new wealth, this effectively involved a huge transfer of wealth from the rest of the economy to financial institutions and the associated bondholders. Second, the Fed continued to ramp up the money supply and keep its targeted interest rates near zero for several years after a recovery had begun, that is, the Fed’s ‘crisis-fighting’ persisted for many years after the crisis was over. Ironically, this got in the way of the recovery.

A related point is that from a monetary perspective the biggest difference between the current boom and earlier booms is that a lot of the monetary fuel for the current boom was directly provided by the Fed, whereas almost all of the monetary fuel for earlier booms was loaned into existence by the commercial banks. When commercial banks lend money into existence the first receivers of the new money are individual and corporate customers of the banks, but when the Fed creates money via its QE programs the first receivers of the new money are Primary Dealers (PDs). The PDs invest the money in bonds, which means that the second receivers of the new money will be bond investors. These investors then use the money to buy other securities (bonds or stocks). The upshot is that when the Fed creates money the money gets shuffled around between the accounts of financial-market operators for an extended period, only leaking slowly into the real economy.

This explains why the economy has fared unusually poorly during the current boom while the stock and bond markets have fared unusually well. In effect, due to the way the new money was injected it had a much greater impact on financial asset prices than the real economy.

This could actually be a blessing in disguise. If the boom were to end within the coming 12 months, which it will if monetary conditions continue to tighten, then the ensuing recession may be far more severe in the financial markets (where the monetary inflation had its greatest impact) than in the real economy. In other words, the bust may look more like 2000-2002, when a short and mild economic recession was accompanied by a 50% decline in the stock market, than 2007-2009, when a devastating economic recession was accompanied by a similar decline in the stock market.

*The booms in the GDP growth chart included herewith are roughly equal the periods between the shaded areas, except that the official recessions (the shaded areas on the chart) typically didn’t begin until 6-12 months after the preceding boom ended. For example, whereas the most recent official recession began in December-2007, the bust probably began in late-2006 — when (mal) investments in sub-prime lending started ‘blowing up’.

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Can a government surplus cause the economy to tank?

August 15, 2017

According to the article linked HERE, if the US or the Australian or the UK government repaid all of its debt, the economy would tank. The article contains such a large number of factual errors and such a copious amount of nonsense that completely debunking it would take far more time than I’m prepared to spend, so in this post I’ll only deal with a few of the flaws.

To begin, the article points out that US government surpluses have, in the past, often been followed by depressions or recessions, the implication being that the government surplus caused the subsequent economic downturn. The two specific examples that are mentioned are the Great Depression of the 1930s, which apparently followed surpluses during the 1920s, and the recession of 2001, which followed the so-called Clinton surplus of 1999.

This is nothing more than confusing correlation with causation. The same logical fallacy could be used to show that a rising stock market causes a depression or recession, given that the stock market almost always rises during the years prior to the start of an economic contraction.

In an effort to show that there is, indeed, a causal relationship between a government surplus and a severe economic downturn, the article includes the following quote from an ‘economist’:

…reducing or retiring the debt isn’t what caused the economic downturns. It was the surpluses that caused it. Simply put, you cannot operate an economy with no money in it.

This brings me to the concept that runs through the article and is the logical basis for the assertion that government surpluses are very bad. It is that the running of a government surplus removes money from the economy and, therefore, that paying off most of the government’s debt would eliminate most of the economy’s money. That the author of the article found economists who genuinely believe this to be the case is extraordinary. It is akin to finding a physicist who genuinely believes that the Earth is flat.

The fact is that neither a government surplus nor a government deficit alters the economy-wide supply of money; all it does is change the distribution of the existing money supply. Here’s why.

First, when the government runs a deficit it is a net taker (borrower) of money from bond investors. It then spends the money. Money is therefore cycled from bond investors through the government to the individual or corporate recipients of government payments (including government employees). If this money had not been ‘invested’ in government bonds then it would have been invested elsewhere and subsequently spent in a different way.

Second, when the government runs a surplus it is a net provider of money to bond investors, with money being cycled from taxpayers through the government to the accounts of these investors. Collectively, the bond investors who receive these payments immediately turn around and reinvest them in corporate bonds or equity. Private corporations then spend the money on employee wages, employee healthcare, supplies, maintenance, plant, training, dividends, etc.

Either way, there is no change to the economy-wide money supply.

To further explain, in general terms there are only two ways that money can be added to the economy. The first involves deposit creation by commercial banks. For example, when Fred borrows $1M from his bank to buy a house, the bank adds 1M newly-created dollars to Fred’s demand account. That is, the money supply is boosted by $1M. The second involves asset monetisation by the central bank. In the US case, prior to 2008 almost all money was created by commercial banks, but from September-2008 through to the end of “QE” in October-2014 the Fed was the dominant creator of new money. Since November of 2014 the commercial-banking system has been the sole net-creator of new money.

In general terms there are also only two ways that money can be removed from the economy. The first involves the elimination of a deposit at a commercial bank when a loan is repaid (note that a loan default does not reduce the money supply). For example, if Fred were to pay-off his $1M home mortgage in one fell swoop then $1M would immediately be removed from the money supply. The second involves the sale of assets by the central bank — the opposite of the asset monetisation process.

Notice that the government was not mentioned in the above two paragraphs. Regardless of whether the government is running a budget deficit or a budget surplus, the banking system determines whether the supply of money rises or falls. I’m not saying that’s the way it should be, but that’s the way it is.

The next part of the article is a tribute to the old canard that the government’s debt doesn’t matter “because we owe it to ourselves”. In reality, there is no “we” and “ourselves”. The government’s debt comprises bonds that are owned by a few specific entities. It is to those entities, that in the US case includes foreign governments, to whom the debt is owed, with taxpayers technically being ‘on the hook’ for the future repayment. I say “technically” because what happens in practice is that the debt is never repaid; it just grows and grows until eventually the entire system collapses.

Related to the “government debt doesn’t matter because we owe it to ourselves” nonsense is the notion that the government’s debt is the private sector’s asset and, therefore, that more government deficit-spending leads to greater private-sector wealth. Ah, if only wealth creation were that easy! In the real world, government debt is not an additional asset for the private sector, it is a replacement asset. This is because when the government issues new debt it necessarily draws money away from other investments. Putting it another way, investing money in government bonds involves foregoing other investment opportunities. To argue that this would be a plus for the economy is to argue that the government usually allocates savings more productively than the private sector.

There are a lot more logical fallacies and factual errors in the article than I’ve dealt with above, but I’m going to leave it there. I just wanted to point out that much of what is observed about the relationship between government indebtedness and private-sector indebtedness can be explained by central bank manipulation of money and interest rates. When the central bank fosters an artificial boom via monetary inflation and the suppression of interest rates it prompts the private sector to go further into debt, which, by the way, is not an unintended effect.* At the same time, the rising asset prices and the temporary increase in economic activity that stem from the same monetary policy cause more money to flow into the government’s coffers, which could temporarily enable the government to report a surplus and should at least result in a slower pace of government debt accumulation. That is, it isn’t the reduced pace of government debt accumulation that causes the pace of private sector debt accumulation to accelerate; the driving force is the central bank’s misguided attempt to stimulate the economy.

I’ll end by stating that a government surplus is not inherently better or worse than a government deficit. What really matters is the total amount of government spending as a percentage of the overall economy. The higher this percentage, the worse it will be for the economy.

*Ben Bernanke made it very clear during 2009-2014 that the Fed’s actions were designed to boost the private sector’s borrowing and general risk-taking.

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The stock market’s mythical ability to discount the future

August 8, 2017

Some analysts state that the US stock market is over-valued and also that the stock market is good at discounting the future. Well, it can’t be both! If the stock market is good at discounting the future then current valuations are reasonable based on the profits that will be earned by companies over the next few years. On the other hand, if the stock market is over-valued then it is, by definition, doing a poor job of discounting the future.

Perhaps the stock market was once good at discounting the future, but a knowledgeable observer couldn’t claim with a straight face that the US stock market has been a good discounting mechanism over the past 20 years. Over this period we’ve seen valuations reach stratospheric levels in response to delusions about tech and internet company earnings, and then a collapse to bring prices into line with reality, followed by another rise to stratospheric valuations based on delusions that global growth knew no bounds and low-quality loans could be bundled together to create investment-grade securities, and then another collapse to bring prices into line with reality, followed by yet another upward ramp to stratospheric valuations.

The most recent multi-year ramp-up in stock prices was supposedly due to the discounting of an imminent ramp-up in corporate earnings, but S&P500 earnings during the second quarter of this year were no higher than they were three years earlier.

It is not difficult to come up with a superficial explanation for the US stock market’s abysmal 20-year record as a discounting mechanism. The explanation begins with the observation that from 1996 through to 2007 the market was dominated by the public, and, as the saying goes, the public will believe the most preposterous of bullish stories as long as the price is rising. As a result of the 2008 collapse, the public left the market and has not returned. At an earlier period in history this might have resulted in longer-term value-oriented investors taking control, but this time around it resulted in the market becoming dominated by computerised trading systems designed to scalp profits from extremely short-term fluctuations. That is, the market is now dominated by traders that make no attempt to discount the future beyond the next few hours or minutes.

The above explanation contains some truth, but for two main reasons it is far from complete. First, the general public hasn’t changed — it always has been and always will be the dumb money. Second, computerised trading systems are equally ‘happy’ to scalp profits by going short during declines or going long during advances. They are directionally neutral.

A better explanation begins with the realisation that the stock market as a whole has NEVER been a discounting mechanism. It has, instead, always reacted with a lag to changes in the monetary backdrop. The big difference over the most recent two decades is that for the most part the monetary backdrop has been far┬ámore supportive of asset prices than in the past. One consequence has been the stock market’s ability to spend a lot more time than usual in a condition called “extreme over-valuation”.

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Trump will not really cut taxes, revisited

August 2, 2017

When I posted the “Trump will not really cut taxes” article in February there was a realistic chance that some form of tax-slashing proposal would be implemented before year-end. That’s no longer the case, but as far as the US economy’s health is concerned it makes less difference than most people think. What really matters is the total amount of government spending; not how the spending is financed.

To understand what I mean, it helps to think of the government as a giant parasite that feeds on the economy. The parasite uses part of what it eats to foster its own growth, while the remainder passes through and is excreted back into the economy. The parasite’s food is a mixture of taxation and borrowing, and provided that it is growing or maintaining its current size then a reduction in one food source MUST be offset by an equivalent increase in the other food source. For example, if the parasite doesn’t shrink then a reduction in taxation must be made up by an increase in borrowing.

The above is an over-simplification because the method by which the parasite gets its sustenance will have some influence on the economic outcome, but it hopefully explains why the Trump tax cuts are not a ‘make or break’ issue as far as the US economy’s health is concerned. The crux of the matter is that as long as the amount of government spending doesn’t shrink, less wealth being sucked out by direct taxation will result in more wealth being sucked out by another method.

That’s why the only genuine tax cut is the one that’s funded by reduced government spending.

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The “commodity supercycle” myth dies hard

August 1, 2017

[The following is an excerpt from a TSI commentary published about one month ago, but with updated charts.]

Some commentators on the financial markets still refer to something called the “commodity supercycle”. This is remarkable considering that the inflation-adjusted (IA) GSCI Commodity Index (GNX) made a new all-time low early last year and that relative to the Dow Industrials Index the GNX is not far from the all-time low reached in 1999. The relevant charts are displayed below. Just how badly would commodities have to perform to completely bust the supercycle myth?



We’ve been debunking the “commodity supercycle” in TSI commentaries for at least 10 years. The following lengthy excerpt from an August-2007 commentary is an example:

…when it comes to the “commodity supercycle” we are definitely sceptics. We concur with the view that commodity prices in general and metal prices in particular are in long-term upward trends, but we do not think these trends are being driven by the strong growth of “Chindia” or the global spread of capitalism or the industrialisation of Asia or the movement of billions of people to the ranks of the “middle class” or any of the other catchphrases routinely used to neatly explain the price action. In our opinion, these explanations rank alongside slogans such as “new economy” and “technology-driven productivity miracle” that were used to legitimise the price action of tech stocks during the boom of the late-1990s.

As we see it, inflation (money supply growth) is causing a rolling boom/bust cycle whereby the combination of relative valuation and scarcity determines which sectors will be the major beneficiaries of inflation during the current cycle and which sectors will be relegated to the investment ‘scrap heap’.

The analysts who concoct simple explanations based on real (non-monetary) changes in the world and repeat these explanations in mantra-like fashion will look incredibly prescient for a long time, even though they largely ignore the monetary factors that are actually at the root of the price changes. Some of these analysts will even take-on the status of prophets due to their apparent abilities to see the future. But the inflation-fueled boom will eventually turn into a bust, even if the touted fundamental bases for the boom persist. For example, the growth of the internet and technological progress in general did not ‘miss a beat’ when the NASDAQ crashed. All that happened was that the primary focus of inflation shifted, causing the “new economy” prophets to fade away and bringing to the fore a new bunch of prophets who chant “commodity supercycle”.

The above three paragraphs can be summarised as: There never has been and there is never likely to be a “commodity supercycle”. Instead, during some periods financial assets are the main beneficiaries of monetary inflation and during other periods commodities are among the main beneficiaries of monetary inflation.

It’s as simple as that.

The periods when financial assets are the main beneficiaries of monetary inflation are, on average, much longer than the periods when commodities are among the main beneficiaries of monetary inflation. This is because central bankers generally view large multi-year rises in commodity prices as evidence of an inflation problem and large multi-year rises in financial-asset prices as evidence that everything is fine. Consequently, steps are taken to curtail the monetary inflation more quickly when commodity prices are leading the charge.

The situation today presents an asset-allocation challenge because it’s far too soon for a new long-term commodity boom to get underway, but the major financial assets (stocks and bonds) are near their highest valuations ever. We are dealing with this situation by becoming more short-term-oriented in our thinking, which for us means not looking beyond the next 6-12 months when deciding what to own.

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