Intro
These articles explore key economic ideas that all financial professionals know, but in my quest to "question everything," I hope to convey a pragmatic, divergent viewpoint that challenges your beliefs and illuminates potential ramifications of how various asset classes would be affected.
The Governing Dynamics
(5035 words)
The entire world is a giant free market with varying degrees of distortion, and the building block of a free market is business. Someone combines physical or digital raw materials into a product or service and charges more than it costs to produce, which is the profit margin that pays for everything in life from wages to taxes to expenses - for everyone. Creating a viable business from scratch is challenging, and rare, but once a business hits escape velocity by generating enough revenue to pay for its own expansion, it can choose to pursue its potential by attracting investment capital, or slowly expand on its own. A viable business model that generates a high return on capital invested over a long period of time is the holy grail of investing, and its potential cash flow is the basis for determining its value.
Ultimately, if the core product or service remains in demand and has a large enough market, competition emerges, which creates downward pressure on prices as profit margins get squeezed. Over time, successful businesses in free market capitalism tend to consolidate and form oligopolies of grand size and efficiency. With rules enforced by the government to ensure no collusion in price setting, the natural competition between large players with efficiencies of scale produces the lowest possible price for the consumer as the businesses integrate within our daily life, penetrating the borders of a purely domestic economy to improve the lives of the entire world.
The government does not exist as an independent entity. It's just a group of people we elect and grant the power to fund communal operations by extracting taxes from the profits of viable businesses (meaning, all personal taxes actually come from the profits of the business). No new economic rules emerge from this process; the economy remains nothing but a collection of viable businesses in different stages of maturation, and the resources they use. The government has expenses, income, and debt with interest just like a business that must be paid or rolled forward. Businesses, however, are embedded with an ownership stake that ensures efficiency and price discovery because the operators are incentivized to produce the most profit possible since the excess is retained by the owners and/or distributed to shareholders. The government lacks this accountability since its services don’t have ownership, so its spending is often indiscriminate and wasteful at best, or unnecessary and corrupt at worst, especially when there isn’t a hard restraint on its ability to issue debt and/or create money. When you compound the problem in a (indirect) democracy by requiring politicians to appease voters to get elected, and further compound the problem with a central bank able to (indirectly) fund the deficits, the misaligned incentives guarantee an ever increasing amount of government debt that continually debases the currency and inevitably leads to collapse. In order to change this output, you have to change the misaligned incentives of the inputs, or hope the productivity of technology outpaces the growth of the debt so the increased taxes can pay for it.
A healthy domestic economy has sound money, sound banking, and a natural balance of goods and services. The reason manufacturing is the engine of an economy is because it produces the base level physical goods of survival. The human body needs food, shelter, clothes, (and an iphone 🙂) to survive. The next add-on layer of goods consists of furniture, appliances, cars, TVs, etc.. Wherever a modern civilization exists, the physical goods of survival are created first. Services are the multiplier jobs that layer on top. A culture can certainly exist by satisfying only its survival needs, but it cannot exist by only having add-on services. The need for a car to get to a job creates the need for a mechanic etc., not the other way around. When you export the base layer of manufacturing it creates an imbalance in the economy that will show up in GDP and trade deficits as the economy slows and/or stops growing organically.
It makes no sense why government deficits count in GDP because it’s not a viable business model producing sustainable growth. Once you remove the distortion, we haven’t had much growth since the turn of the century, but it’s actually worse because government spending has a multiplier effect until it reaches the point of diminishing returns, which some people estimate around 90% debt/GDP. Until then, one dollar of deficit spending produces more than one dollar of growth, but after that point it takes ever higher amounts of spending to generate the same dollar of growth, which is a doom loop if the problem causing the deficits is structural like globalization because you’d have to keep shoveling more and more money into the furnace to get less and less heat. Therefore, in order to get a more accurate gauge of our true GDP, you’d have to subtract the deficits and the “pre-diminishing return” multiplier, which would reveal the developed world has been broken and flirting with depression for twenty plus years.
Ideally, when someone makes an assertion like that you’d want to see evidence in other data, so if what I’m describing is true you would expect to see a decrease in the labor participation rate since around the turn of the century when the WTO policies put globalization into high gear. You would also expect to see a long era of decreasing interest rates that ultimately end up pushing the zero bound because the free market is a self-correcting mechanism, so when economic growth slows, interest rates fall to stimulate demand for the borrowing to restart it. But if the problem causing the slowdown is the manufacturing base of the developed world domestic economies relocating to the developing world to capitalize on cheap labor, inexpensive land, lack of regulations, etc, then the self-correcting mechanism of the free market won’t be able to restart the engine to regain the previous trend line of growth even at zero rates, so it forces the government to keep pouring gas into the car with deficit spending but the engine is missing to restart it. I have no idea why people say “raising the debt ceiling is paying for bills we already incurred” when bills are paid with income, not debt, so raising the debt ceiling is the definition of NOT paying the bills.
Advocates of globalization (who tend to be heavily invested in its beneficiary businesses and therefore have a conflict of interest preventing them from seeing the truth because they’re being paid to not see it) (if this is you I don't mean this personally) argue that digital services have replaced our manufacturing base, but this is demonstrably untrue. All you have to do is look at the trade deficit, which is the middle class standard of living being exported overseas. If digital services were an equivalent replacement there wouldn’t be such a drop in the trend of GDP, or the labor participation rate, or interest rates, and there wouldn’t be such a wealth imbalance, or populism, or the pervasive feeling that Main Street is being left behind, which are symptoms of a systemic problem. Even digital services that can be exported and improve the trade deficit are not equivalent because they tend to be higher skilled jobs with a much smaller employee-to-executive ratio per revenue produced; whereas, manufacturing creates more secure jobs for a greater number of workers that requires less formal education and naturally has a more balanced distribution of the wealth produced, particularly because private sector unions help balance the power (and unintentionally caused their own demise). If anything, based on the percentages of the population’s formal education, it could be argued there should be more manufacturing jobs than services.
The free market response to the competition of cheap overseas labor would have been a dramatic drop in our wages to compete with them, but the problem is twofold: no one would work for that rate; and it would be devastatingly deflationary because no one would earn enough to pay their developed world expenses. If our domestic companies all bandied together and agreed to stay onshore for the sake of our country, the strength of our currency would have made their exports too expensive for developing countries to afford, so it was inevitable that they would expand overseas to increase their markets, but an interesting alternate history to consider is what would have happened if a law was created stating any final goods sold to a retail customer must be (predominantly) manufactured within the same country (yes, it’s complicated). Our companies could have added facilities in Mexico and China to expand their markets, but if their final products had to be sold within the same country, their profits would be dramatically less because the prices they could charge would be proportional to the low wages the local foreign workers could afford. A policy like that would have put Main Street equal to Wall Street and resulted in much smaller market caps for our global companies, and a reduced imbalance of wealth. But a policy of global cooperation in an era of competition was not meant to be, particularly when the lobbyists of our global companies had so much influence over policy and so much incentive to sell out our middle class for their own benefit.
If I argue in favor of globalization, the international penetration of US companies and their products and services increases the exposure, and potential adoption, of our culture and values (even if only internally) like a philosophical Trojan Horse, which, in theory, could improve our security as a nation in the long-term if more of the world adopted the broad ideas and policies of a free market democracy (the faults of which we will explore in future articles). However, our overseas military bases that come along with the deal certainly cause a perceived threat to the cultures who don’t follow our lead, which creates disdain and blowback, so influencing the creation of Bollywood in the wake of Hollywood doesn’t come without the price of critics and haters protecting their own culture and values. The Trojan Horse of our exported culture certainly amplified the spread of our life improving, efficiency enhancing technologies throughout the developing world, and it happened much faster without any restrictions or laws protecting our middle class, so if you look at it from the perspective of humanity as a whole, it’s a sacrifice the developed world middle class is making to lead the competition for who owns the technology taking over the world. Is that a trade-off worth making? Will global markets inevitably self-correct, or is there a higher design unfolding through the global penetration of technology and its interconnected network?
If you follow the money of our trade deficit, it isn’t quite as bad as it seems because only a portion of it goes to the local foreign workers for their labor and/or the parts they manufacture to assemble into final products like an iphone. Much of our trade deficit ends up in the coffers of US companies overseas, which boosts their revenues and their stock prices for shareholders. This network of technology expanded their total addressable markets to the entire world and created eggerious wealth for founders, early investors, boards of directors, higher paid employees, and shareholders, all at the cost of our lower skilled, less educated, domestic middle class, especially the people who don’t own assets and can’t keep up with the debasement of the currency this arrangement forces to mask the economic hole it creates. People like to blame the Fed for our wealth imbalance when it’s actually the fault of globalization. The policies of the Fed and Treasury are an effect of globalization, not a cause of the problems it creates. Many people get this backwards. The world has divided, and will continue to divide, between those who do, or don’t, share in the ownership of global companies.
The Federal Reserve does not control interest rates; the economy controls interest rates. Does the Fed control innovation and technology? Do they control demographics? Do they control China? Do they control pandemics? Does the Fed control globalization? Do they control geopolitical tensions, or OPEC, or the invention of shale oil technologies? Do they control the creditworthiness and optimism of consumers and businesses that borrow? These are the forces that control interest rates; the Fed and Treasury react to them.
To think the Fed controls interest rates is to focus only on the supply side of the equation, but in a fractional reserve system the banks have a near infinite supply of money because in practice their ability to create money never gets exhausted. Has there ever been breaking news about JP Morgan unable to make a loan because they ran out of balance sheet capacity? The Fed can create whatever level of reserves that are needed to support whatever level of viable borrowing is demanded.
If you ask most people who are not financial professionals to describe how fractional reserve banking works, they’d say something like: “the bank keeps a fraction of a customer’s deposit and loans out the rest,” but if that were true the money supply wouldn't expand. What actually happens is banks treat their deposit base as the reserve requirement and lever it up by creating money out of thin air just like the Fed. Since this easily gets lost in abstraction, the best way to express it is to imagine if the homebuilders were allowed to act like a bank. A family comes in and wants to build a home, so D.R. Horton runs a credit and income check, displays their options, and the family chooses a $500k house, so the sales guy goes into the back room, clicks a couple buttons, and literally prints $500k in hundred dollar bills (we’ll use cash for clarity when really it's credit), which he uses to pay all the contractors to build the house. This is where the majority of our money supply comes from. This is why the dollar has lost 99% of its purchasing power over the last century. This is economic activity that wouldn’t exist in a hard money system (which I’m not advocating) due to the limited supply of gold available to lend, making it difficult to get credit, so only the best business ideas, and the people with the highest creditworthiness would qualify. As the price of money goes up it incentivizes more production and mining, utilizing the self-correcting mechanism of the free market, which tends to naturally keep the money supply in proportion to the number of people and efficiency of the technology to produce it.
Interest rates are determined by the borrower. Mortgage rates are influenced by the 10-year risk free rate, but that responds to inflation, growth, term premia, and supply with a touch of rate differentials, currency strength, sentiment, and carry costs thrown in. In fact, the ten-year yield is so independent from the Fed that it disagrees vehemently with their outlook during inversions. The Fed is reactionary, not causative, which is why there’s decades of quotes from Fed governors who are surprised, even confused, by the reaction of the economy to their policies. People act like the Fed is a grand conductor of the ebbs and flows of the ocean when really they’re on a tiny raft getting tossed around like a ragdoll as they react to the chaotic, uncontrollable ebbs and flows of economic forces beyond their control. This is what happens: banks create margin and cause a stock bubble that bursts and the deflationary effects force the Fed to react; World War happens and the Fed reacts; a Baby Boom, geopolitical tensions, shale oil, globalization, a pandemic, technology etc etc... happens, and the Fed reacts. Their policies are an effect of economic events, not a cause of them.
The reason so many people find this heretical is because the prices of financial assets are extremely sensitive to overnight borrowing rates, so it’s easy to conflate the wild fluctuations of Wall Street with a illusion of control on Main Street, but it’s the forces of demographics, technology, globalization, the cost of energy, and the creditworthiness (balance sheet) of the borrower that sets long term interest rates for Main Street.
Floating rate debt like credit cards based on a spread over SOFR or the prime rate are certainly influenced directly by the Fed, but the Fed isn’t in control of their own policy; the economy is. People who overweight the effect of the Fed are conflating overnight rates with interest rates of all durations. Truthfully, the Fed doesn’t even control overnight rates. They do what the market tells them to do. When there’s disagreement between the market’s projections and the Fed’s, and the market is wrong, commentators like to say: “the market is coming around to the Fed,” but what’s really happening is both are acquiescing to the data from the economy, which is often volatile, highly unpredictable, and prone to long delays from policy initiations.
The only power the Fed has is in the direction of tightening because they have the power to end inflation at will by inverting the curve and creating a floor for maturing debt to be rolled over at higher rates, which squeezes margins and disposable income and induces a recession, but the illusion of their control gets exposed in the other direction when they can’t stimulate growth or CPI no matter how low overnight rates go, or how much money they print because there’s no widespread transmission mechanism into consumer pockets on Main Street except a weak psychological wealth effect from creating asset bubbles that stimulate some additional spending, and the even weaker effect of putting minor downward pressure on long-term rates through quantitative easing. If no one has the balance sheet capacity, the optimistic willingness to borrow or creditworthiness, then nothing the Fed does will move the needle. Eventually, balance sheets get repaired through deleveraging over time, which is the essence of the business cycle as the Fed gets pulled along in the caboose.
The other power the Fed has is lifting toxic assets off the balance sheets of the private sector. This is the real purpose of QE. It’s like an immune system detoxifying the body to prevent systemic collapse. The flaw is that the natural process of getting sick from consuming toxic substances is how we learn what to avoid to be healthy.
In terms of globalization, if the government wasn’t allowed to run deficits, and the Fed didn’t exist, once our global companies moved offshore, our financial system would have collapsed, which is how market forces would have behaved to retain balance as the drop in our prices and wages made them competitive with overseas labor. Obviously, that couldn’t happen, so the Fed and Treasury have been forced to continually debase the currency through ultra easy policies that stimulate asset prices. This is the crux of the problem. While our global companies with ever increasing markets as their technology penetrates the world can justify expensive valuations, if you gut the stable, secure manufacturing jobs from the lower half of the income spectrum and force them to either drop out of the labor force or accept a lower paying, less secure alternative, eventually the wealth imbalance this creates will break the system either through populism arising to impose policies like unilateral tariffs or through the ever expanding government debt required to prevent collapse reaching the point of no return when the interest expense consumes all the tax revenues collected, which then forces the Fed to directly fund the deficits and ultimately lead to currency collapse (again, unless AI saves us - we’ll return to this in later articles). In other words, globalization, fueled organically by the innate incentives of Capitalism via businesses seeking the lowest expenses creates a built-in mechanism that results in a race between the forces of technology restoring balance through a productivity miracle and the destruction of the currency.
The other reason people overweight the effect of the Fed is because they want someone to blame, so if you put them at the center of the financial universe like the Wizard of Oz, they’re an easy scapegoat to criticize when things go wrong, even though all they do is react to economic data, usually with a giant lag, which is why they’re always late.
The Fed did not repress interest rates for a decade; globalization did. As evidence, I’d like to direct your attention to the 2-year yield, which is enough duration to be independent, but not too long that other forces affect it as well, therefore ,I agree with Jeff Gundlach's view that the Fed ultimately just follows the 2-year. When actual inflationary pricing pressures began in earnest from the one-off Covid fiscal stimulus hitting a constrained supply chain during a geopolitical oil shock as an unleashed consumer was released from lock down, the completely independent 2-year yield skyrocketed higher months before the Fed even thought about thinking about raising rates. Yields did not rise in anticipation of Fed policy; they rose in reaction to incoming and projected economic data, which is always the case, even though it often appears like the reaction is to the Fed.
If the Fed was repressing interest rates for a decade, where was the commensurate move higher in the independent 2-year yield during that time? Where were the higher consumer prices such a regime of repression would cause? Don't say it was a decade of lag effects when there’s a reasonable explanation like globalization (and shale oil) to explain the downward pressure on interest rates during that time. When the Fed represses interest rates they will be pinning the curve on purpose as a policy like the BOJ, which is exactly what they will do to prevent bonds from collapsing when interest rates consume the budget yet they still have to print money to avoid a deflationary collapse. If they pin the long end at 2%, the short end at 0%, and the Treasury sends out smaller, consistent checks to everyone in the lower half, they can hope to cause a more manageable widespread rise in general prices to inflate the debt back to a manageable size through an increase in nominal tax revenues from broad consumer prices and wages going up as they buy time for the productivity miracle from technology to catch up and then outgrow the pace of government spending, which would literally be a miracle because our projected entitlement obligations goes straight up. Or the Treasury can devalue the currency by remonetizing and revaluing gold 5-10x higher. The most interesting potential game changer is the revolution in energy being incentivized by Big Tech’s need to power data centers leading to disinflation in energy costs for both the consumer and businesses. Like any great movie, the story is rife with potential to go horribly wrong, but a happy Hollywood ending is still possible.
In lieu of writing about the mechanics of QE and why it doesn’t cause broad consumer prices to rise, here’s a ten page article about it from Harvard: Banks Can't Lend Out Reserves. However, it’s inaccurate to take the accounting identity too far and say none of the QE money makes its way into the economy or affects asset prices. If the Fed buys from the public or a non bank like a pension or insurance fund, or the primary dealers do, it’s transforming their duration into an investable deposit. The Fed prints money. People who think all of it sits as reserves at the Fed are assuming the dealers are only buying from the Treasury. The reason it doesn’t cause broad consumer prices to rise is because almost none of that money reaches broad consumers to spend, which requires the Treasury to distribute it according to an Act passed by Congress in enough size to create an imbalance of demand over available supply for general goods and services. Without a distribution into consumer pockets, the effect of QE is limited to asset price inflation from both the added liquidity and the duration transformation of balance sheets.
Here’s how ChatGPT puts it:
The Federal Reserve typically conducts its open market operations, including the purchase of Treasuries, through primary dealers. Here’s how the process works:
1. The Fed buys and sells Treasuries primarily through primary dealers. These are large financial institutions that participate in the open market operations (OMOs) and serve as the main intermediaries between the Fed and the broader market.
2. When the Fed decides to purchase Treasuries, it announces the operations, and primary dealers submit offers to sell Treasuries to the Fed. The Fed selects offers based on price and other criteria, effectively buying from the primary dealers.
3. While the Fed does not typically buy directly from pension funds, the pension funds can sell their Treasuries to primary dealers, who in turn can sell them to the Fed. Thus, pension funds and other investors can still indirectly participate in the Fed's Treasury purchase programs through their transactions with primary dealers.
4. The Fed controls the volume and timing of its Treasury purchases based on its monetary policy objectives. It determines the amount of Treasuries to buy and when to buy them to influence interest rates, manage liquidity, and achieve its macroeconomic goals.
Hey ChatGPT, when the Federal Reserve buys Treasuries from a pension fund, does the money it creates in this transaction end up as a bank deposit?
Yes, here’s how the process works:
1. The Federal Reserve decides to buy Treasuries from a pension fund to increase the money supply and stimulate the economy.
2. The Fed credits the account of the bank where the pension fund holds its deposit with the purchase amount. This credit increases the reserves of that bank held at the Federal Reserve.
3. The bank, in turn, credits the deposit account of the pension fund with the amount received from the Federal Reserve. This increases the deposit liabilities of the bank (i.e., the bank deposit of the pension fund).
4. The reserves of the bank at the Federal Reserve increase because of the Fed’s payment. The deposit balance of the pension fund at the bank increases, as the pension fund now has more money in its bank account. In essence, the money created by the Fed in this operation becomes a bank deposit held by the pension fund. Simultaneously, the reserves of the pension fund’s bank at the Federal Reserve increase, reflecting the bank's receipt of funds from the Fed.
Hey ChatGPT, can pension funds use the money they receive from selling Treasuries to buy stocks or other financial assets.
Yes.
End ChatGPT
Certainly, there are degrees of easiness, and tightness, of credit based on whether banks perceive the overall economic risk of lending as higher or lower, but that is determined by borrower side influences (the economy). The only power the Fed has is one of distortion. Markets are in control, the economy is in control. The Fed can only ignore them for so long before they end up breaking the economy unnecessarily, so they speak a lot of words and inevitably follow the market. Since they can only do harm, there’s really no need for the Fed to exist. Markets don’t have egos, or memories, or worries about repeating past mistakes; they don’t need to get reappointed before turning hawkish; they don’t indirectly collude with the Treasury or other central banks; and they’re driven by the collective intelligence of the crowd with skin in the game, so when they’re wrong, they adapt fast, in real-time. With that said, I do wonder if the birth of the coming revolution of technology would have been possible without the long period of liquidity added by central banks to avoid the deflationary pressure of globalization, mask the depression, and repress the political backlash from an angry public that would have stopped or reversed it.
I do think there’s a case to be made for a lender of last resort in a fractional reserve banking system, but that should require hard rules about repayment and personal consequences tied to receiving a bailout, so there’s no rolling accumulation of debts or moral hazard. In other words, the damage caused by letting the market purge itself would be arguably worse than providing necessary liquidity to prevent it, but if a bank got itself into such a situation, what should be wiped out is the equity of the CEO and board of directors (or another law with personal consequences). Watch how carefully they manage their balance sheets if the consequences affect them personally. In other words, it’s possible to be both a critic of the central bank, Treasury, and banking system, understand the solutions to those flaws, and still see the entire mess as prerequisite conditions for the emergence of a future that will transcend it.
(I won’t even wade into reasons of how the influences of the global Eurodollar system can supersede Fed policies, which is Jeff Snider’s domain.)
Here’s a few quotes from recent articles to illustrate the difference between people operating on a level of concepts vs the pragmatic point of view grounded in physical limitations and the incentives of economic participants I am trying to express (my comments in parentheses):
“By suppressing the cost of debt, Quantitative Easing (no, globalization) encouraged the federal government to take on a much greater amount than would have been possible otherwise.”
“This fiscal profligacy enabled by monetary accommodation (no, globalization) is now one of the forces behind persistent (no, cyclical) inflation pressures in the economy (a deflationary collapse is coming, which will cause the next reflationary impulse).
“But massive asset purchases by the Fed (as a reaction to structural stagnation caused by globalization) have also exacerbated inequality, with the wealthy actually benefiting from the current economic environment…while the rest struggle with a slowing labor market amid persistent cost pressures (which is caused by Treasury and Fed reaction to the economic hole of globalization).”
“This bifurcation only exacerbates the trend toward growing social unrest (which is the self-correcting mechanism of the market that the Fed and Treasury are interrupting, necessarily).”
“The pressure on unions to force wages up only exacerbates a wage/price spiral of inflation (no, it doesn’t - wages are just another price going up with the rest of them; it’s not self-fueling, and it’s the desirable outcome that’s been happening for 100 years).”
“We’ve entered a new era of higher interest rates and higher R star (no, we haven’t, it’s trillions of stimulus creating transitory economic activity still working through the economy; it’s not a sustainable new source of growth or inflation (unless UBI and YCC happens)).”
SUMMARY
I grew up in Rochester, NY, where Kodak employed most of my mom’s side of the family. Kodak was not a victim of globalization because it fell on its own sword, but the result was the same: they all lost their jobs - along with many people in other manufacturing facilities in the area that moved overseas. A successful global manufacturing plant is an engine of money production that offers lower skilled, less educated people more job security, more money, and more benefits, which changes the psychology of their spending and creates discretionary income to invest and grow wealth in a way that is not available with other jobs. The wealth imbalance that has occurred in the wake of globalization is not sustainable. One of the governing dynamics of life is how living organizations move from balance to imbalance back to balance in perpetual adaptation to change. I believe technology will be the catalyzing force that restores balance as the entire world is transformed into a new way of co-existing with each other, and with technology, as a unified global system emerges, which we will explore in The Spirituality of Technology in a few weeks.
Next week we'll explore inflation in The Nominal Game We Play and The Fallacy of Real Yields & Universal Inflation.
