Blog 2 Columns

[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’.

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.

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 more 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”.

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.

[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.

Globalisation, a term that when used in economics refers to the integration of national economies into a global marketplace, is perceived to be part of the reason for economic weakness in some countries. This is a perception that the politically-astute feed upon, often by invoking the “we” fallacy.

According to the “we” fallacy, anyone who happens to be located inside an arbitrary border is one of “us” and deserves preferential treatment at the expense of anyone who happens to be located outside the border. The “we” fallacy underpins the concerns that are routinely expressed about trade deficits, the thinking being that “we” are being hurt because “they” sell more stuff to us than we sell to them*.

To expose the flawed logic that initially leads to teeth-gnashing over trade deficits and subsequently leads to protectionist trade policies, I’ll use a hypothetical example involving two pig farmers (Bill and Bob) and a butcher (Arthur). Bill, Bob and Arthur live and work in a small US town located 1 mile south of the US-Canada border. Bill is a more efficient pig farmer than Bob and is thus able to sell his pigs at a 10% lower price. Consequently, Arthur buys twenty pigs per year from Bill and none from Bob. This arrangement continues for several years, at which point Bill decides to move his farm 2 miles to the north (to the other side of the US-Canada border).

Business-wise, nothing changes and Arthur continues to buy 20 pigs per year from Bill. However, due to the minor change in the physical location of Bill’s farm the business that Bill and Arthur have been conducting for many years now adds to the US trade deficit. In other words, a business relationship that nobody was previously concerned about suddenly becomes a problem for the collective “we”, even though nothing has really changed. Bob, sensing an opportunity, complains to the US government that he will have to fire his farmhand unless something is done to prevent his business from being undercut by cheap imports. In response, the US government slaps a 15% tariff on Canadian pigs, prompting Arthur to start using Bob as his pig supplier.

In this hypothetical example Bob has clearly benefited from the government’s interference in the pig market, but only at Arthur’s expense. Arthur is now forced to pay 10% more for his pigs, which will either cut into his profits — and, perhaps, curtail his plans to invest in the growth of his business — or cause him to raise his prices. Whatever happens, Bob’s gain will be matched by the loss incurred by other people within the US. In other words, the US “we” will not actually benefit, even in the unlikely event that the Canadian government doesn’t take counter-measures in an effort to protect its own collective “we”.

In the same way that the overall US economy failed to benefit from the pig tariff in my hypothetical example, “we” can never benefit from policies that restrict international trade. This is because from an economics perspective there is no “we”, there are just individuals trading with each other for their mutual benefit. A consequence is that when measures are taken by the government to protect the collective “we”, what actually results is the artificial creation of both winners and losers. The benefits gained by some individuals within the economy will be offset by the losses of others within the same economy.

The upshot is that protectionist measures are, at best, a zero-sum game, although in most cases they will turn out to have a net-negative effect on the ‘protected’ economy because they will interfere with price signals, keep inefficient businesses alive, and generally make both the cost of doing business and the cost of living higher than would otherwise be the case.

Protectionist measures are often popular, though, especially during hard economic times. Here’s why:

First, you generally need only a superficial understanding of economics to see the immediate and direct effects of a policy, whereas a deeper understanding of economics is often required to see the long-term and indirect effects. Very few people have this deeper understanding, so all they see are the immediate and direct effects of protectionism, which could be positive.

Second, the immediate benefits of the protectionist policy are typically concentrated, whereas the costs are widely spread. As a result, a politician can adopt a protectionist stance to gain the support of the relatively small number of people who are advantaged without losing the support of the much larger number of people who are disadvantaged. It’s an example of robbing Peter to pay Paul, where Paul notices and Peter doesn’t.

Third, when things are obviously going wrong it’s convenient to point the finger of blame outward at “them”. It certainly beats trying to identify the real source of the problem when doing so would lead to the finger of blame being pointed inward.

I guess we should be thankful that the same flawed logic that is often applied to international trade is usually not applied to interstate trade and is never applied to trade between towns, neighbourhoods and individuals within the same state, because if it were then there would be a lot less trade and a lot less wealth. The only reason the flawed logic isn’t applied at a more micro level is that the collective “we” is arbitrarily defined as everyone on a particular side of a country border.

*Refer to my 13th February blog post for an explanation of why a trade deficit is never a problem.

The following monthly chart shows that the year-over-year (YOY) growth rate of US True Money Supply (TMS) made a multi-year peak in late-2016 and has since fallen sharply to an 8-year low. The downward trend in US monetary inflation since late last year has been driven by the commercial banks, meaning that the pace of commercial-bank credit creation has been declining. The Fed, on the other hand, hasn’t yet done anything to tighten US monetary conditions. All the Fed has done to date is edge its targeted interest rates upward in a belated reaction to rising market interest rates.

That the Fed has been tagging along behind the market is evidenced by the following chart comparison of the US 2-year T-Note yield (in blue) and the Effective Fed Funds Rate (in red). The chart shows that a) the 2-year T-Note yield bottomed and began trending upward in the second half of 2011, b) the Effective FFR bottomed and began trending upward in early-2014, and c) the Fed made its first rate hike in December-2015. The market has therefore been pushing the Fed to raise its targeted interest rates for several years.

Interestingly, the Fed has caught up with and is possibly now even a little ahead of the market. This suggests scepticism on the part of the market that economic and/or financial conditions will be conducive to additional Fed rate hikes over the coming few months.

Based on the prices of Fed Funds Futures contracts we know that the market does not expect the Fed to make another rate hike until December at the earliest. This expectation is probably correct. Rather than make an additional ‘baby step’ rate hike there’s a good chance that the Fed’s next move will be to start reducing the size of its balance sheet by not reinvesting all the proceeds from maturing debt securities. Unless the stock market tanks in the meantime, this balance-sheet reduction will probably be announced on 20th September (following the FOMC Meeting) and kick off in October.

When the aforementioned balance-sheet reduction does start happening it will constitute the Fed’s first genuine attempt to tighten monetary conditions, although, as mentioned above, US monetary conditions have been tightening since late last year thanks to the actions of the commercial banks.

The job of a judge or juror is to impartially weigh the evidence and arguments put forward by both sides in an effort to determine which side has the stronger case. The job of a lawyer is to argue for one side, regardless of whether that side happens to be right or wrong. As a speculator it is important to think like a judge or a juror, not a lawyer.

Unlike a lawyer, a speculator can change sides ‘mid-stream’ if necessary to keep himself on the side favoured by the current evidence. There is no need for him to stick to a position come what may. However, changing sides is easier said than done, which is why so many speculators and commentators aren’t able to do it. Rather than let the evidence determine their stance, they adopt a stance and then look for confirming evidence. If they come across conflicting evidence, they downplay it. They aren’t aware of it, but their goal is to prove a particular case rather than align themselves with the strongest case.

Sometimes the case that a speculator desperately wants to prove also happens to be the case supported by the strongest evidence, enabling him to make large gains. However, if he continues to think like a lawyer he will eventually run into the problem that the weight of evidence shifts. After the inevitable shift happens he will steadfastly maintain his earlier position and lose whatever advantage he previously gained from being on the right side of the market.

In my speculations and financial-market writings I’m sometimes guilty of thinking like a lawyer. That’s why I developed the gold model (the Gold True Fundamentals Model – GTFM) that was discussed in a blog post last month. This model prevents my own biases and opinions from getting in the way when assessing whether the fundamental backdrop is bullish or bearish for gold.

The bottom line is that there is never a requirement for a speculator to defend a position. Unlike a lawyer, he is free to change with the evidence.