by Stephen Arbogast
In early August students began returning to the University of North Carolina campus. Business school classes resume on September 8. The new first year MBA class will soon begin absorbing the financial theories honed and propagated at U.S. business school for decades. They will measure the cost of capital using a hypothetical risk-free rate of return and a stock market Beta supposedly reflective of the market’s volatility. They will then use these concepts to evaluate capital projects across a raft of different industries. Will their professors tell them that increasingly these concepts lack relevance?
On July 25th the Economist newspaper published an issue whose cover story was ‘Free Money – When Government Spending Knows No Limits.’ Inside was a briefing entitled “A New Era in Economics – Starting Over Again.’ This briefing chronicles a veritable revolution in economic thinking that is now running alongside the pandemic, the BLM social justice movement and the presidential election. The striking characteristic of this revolution is not that it has spawned different schools of thought – the economics profession continuously does that. Rather, it is that the reported new schools all endorse massive, open-ended government intervention in the economy via unlimited printing of fiat currency.
Some quotes are needed to capture the essence of this shared perspective:
“Take the first school. Its proponents say that so long as central banks are able to print money to buy assets they will be able to boost economic growth and inflation. Some economists argue that central banks must do this to the extent necessary to restore growth and hit their inflation targets. If they fail it is not because they are out of ammunition but because they are not trying hard enough.”
“….the second school of thought…relies on fiscal policy. Adherents doubt that central bank asset purchases can deliver unlimited stimulus…Better for the government to boost spending or cut taxes, with budget deficits soaking up the savings created by the private sector. It may mean running large deficits for a prolonged period, something that Larry Summers of Harvard University has suggested…Central Banks can continue to finance governments so long as inflation remains low”
“The third school of thought…focuses on negative interest rates…the likes of Kenneth Rogoff of Harvard University and Willem Buiter, the former chief economist of Citigroup, a bank, envision interest rates of -3% or lower…To stimulate spending and borrowing, these rates would have to spread throughout the economy: to financial markets, to the interest charges on bank loans, and also to deposits in banks, which would need to shrink over time.”
The emergence of these schools amounts to a potential overthrow of the financial paradigms on which traditional business school finance is based. Why is this of interest to industry in general and the energy industry in particular? Because, as a highly capital intensive industry, energy is strongly dependent on reliable evaluation techniques for allocating capital. If these are now distorted in ways that are little understood, the industry for some period will be flying blind.
In order to fly less blind, we need to understand this economic revolution, whether it will sweep all theory before it, be fully deployed in practice and only discover its unintended consequences/collateral damage over time. This begins with identifying the drivers behind this revolution.
The Economist article also provides some clues: ”The pandemic has…exposed and accentuated inequities in the economic system…Even before covid-19, policymakers were starting to focus once again on the greater effect of the bust and boom of the business cycle on the poor. But since the economy has been hit with a crisis that hurts the poorest hardest, a new sense of urgency has emerged. That is behind the shift in macroeconomics. Devising new ways of getting back to full employment is once again the top priority for economists.”
Said differently, a focus on combating economic inequality, compounded by the intensification believed fostered by the pandemic has called forth new economic schools; these are united in their desire to use the monetary and fiscal powers of the state in unprecedented ways to address inequality and social justice. Other concerns [addressed below] are treated as lower priorities or judged not a problem for the foreseeable future.
Why does this economic revolution hold the potential to upend traditional finance? To answer this question, we must revisit the foundations of finance as traditionally taught and observe what changes the new economic schools are bringing about. The foundation of what used to be called modern finance is the idea that free markets operate rationally to evaluate risk and reward and allocate capital accordingly. Asset prices and key economic indicators are thus valid signals. They express the collective wisdom of investors betting their convictions with their funds. As such, they can be ‘trusted’ by managers and policymakers as authentic expressions of fair value.
Theory in this space took the form of the ‘Efficient Market Hypothesis.’ In general terms this stated that public markets rapidly absorb all available public information and reflect it in asset prices. This hypothesis then laid the foundation for estimating the cost of capital for individual firms by the efficient market providing a risk free rate of return and Beta, the measure of the market’s overall price volatility. Firms or individuals seeking better than cost of capital returns must either possess information not publicly available or take on more risk without succumbing to the adverse consequences of doing so. A final point to mention is that free capital markets provide discipline in the form of punishing performance failures. Firms which take on more risk and don’t evade downside consequences see stock prices collapse; often they end up in bankruptcy.
From the 1970s through 2007, such creative destruction rippled through sectors of the U.S. economy. Real estate, energy, the savings and loan industry and tech startups all experienced market meltdowns and widespread bankruptcies. The U.S. government did not escape this discipline. The Federal Reserve was forced to boost bank prime rates above 20% to kill a stubborn inflation; this prompted James Carville to observe that if reincarnation exists, he’d like to come back as the bond market.
Fiscal and monetary practices since 2007 are killing this version of market efficiency. The new schools of economic thought are not theoretical exercises constructed in rarified university enclaves. They are the conceptual echoes of policymaker ‘successes’ since the great Financial Crisis. The economics profession, trailing behind policy actions, has now conceptualized into general theories what originated as emergency experiments. These in turn are being directed towards the new objectives of fighting economic inequality and promoting social justice.
The policymakers’ ‘successes’ need to be both recognized and understood. Foremost among the successes was staving off a global depression of 1930s proportions. This required not only liberal use of the Keynesian fiscal and monetary tools, but audacious venturing into the new territory of Quantitative Easing (QE). In both Europe and the U.S., monetary authorities purchased mountains of government securities. This monetization of government fiscal deficits had not been practiced outside of wartime for fear of stoking inflationary fires. This time the monetary authorities were able to buy the debts not only of the U.S. Treasury but also the obligations of technically bankrupt governments like Spain and Italy. The ‘success’ that followed was palpable – markets stabilized, interest rates came down and stayed down, and economic growth resumed. In the U.S. this growth reached a record level of longevity. Perhaps most surprising, inflation did not get out of hand. In fact, inflation barely reached Central Bank target levels in some countries and never got there in others. As fiscal/monetary outcomes go, this seemed like the economic equivalent of a grand slam.
There were of course those who warned of distortions and unintended consequences. These warnings took the form not only of an eventual return of inflation but also that asset prices were being distorted by evidence of a Central Bank ‘put,’ i.e. those investing in risky assets would eventually be bailed out if their bet went south. Another name for this phenomena is ‘moral hazard,’ i.e. the idea that bailing out investors only encourages riskier investing. These warnings did not get much traction. The apparent success in arresting first the Financial Crisis and then its step-child, the Euro crisis silenced much criticism. The long recovery that followed further burnished Central Bank tactical reputations. And, there was an all-important embedded assumption – that the use of these tactics was exceptional, and that with recovery there would be reversion to ‘normal’ market conditions. Some years ago the U.S. Federal Reserve embodied this assumption with its stated policy of selling off government securities each month to reduce its bloated balance sheet.
The pandemic has now reduced this embedded assumption to rubble. The necessity of stabilizing markets in the wake of global economic lockdowns has required government deficits, monetary interventions and QE on a scale which makes 2008-13 look small by comparison. More important, it comes on top of the debt piles left over from the last crises. The elephant in the room is thus an unspoken sense that there is no way, or at least no crisis-free way, back to monetary normalcy. The imperative of fighting the pandemic in the short run comes at the cost an implied future austerity road to normalcy that few are prepared to contemplate.
Faced with this dilemma and unable to provide a road back to normalcy, the new school economists are offering a ‘double down’ pathway instead. Deficits are treated as no threat because inflation is no longer a threat. Hence the pathway is open to use cost-free capital to address longstanding social ills. QE is also not a problem because the Central Bank can hold these securities indefinitely and the monetary reserves created by its purchases are also largely sitting at the Central Bank. It might get expensive for the Central Bank to pay out interest on such enormous reserve deposits but with short term rates at or near zero, such costs are almost negligible. So far, so good. But will this structure hold as the economy evolves? Examining the firmness of this framework’s assumptions will give us clues.
Fundamental to this whole framework is quiescent inflation. Here it is worth examining how the monetary authorities got away with their tactics deployed against the Financial Crisis. Deep recessions are deeply deflationary. Expansionist monetary policies always enjoy the insulation that comes from battling a raging recession – but why did not inflation spike once recovery was well underway? The answers here are deeply structural, and many economists have been slow to appreciate them in total. The globalization of supply chains over the last several decades unleashed two huge deflationary effects. First, it directly introduced much cheaper labor into the manufacture of goods. Everything from sneakers to clothing to furniture now came with a label announcing that it had been made by workers paid a fraction of the U.S. minimum wage with few if any benefits. Second, it undermined the bargaining power of U.S. and European private sector labor unions. Firms’ ability to move factories and production to China or Mexico didn’t just mean U.S. workers couldn’t demand perpetual increases in wages and benefits – it meant their jobs were at risk if they walked out on contract negotiations. These effects were compounded by a third – the increasing incursion of robotics, tech and AI into manufacturing and inventory management. Whereas previously consumer prices carried the cost of high inventory stocks, just-in-time supply chains tied to big box, price discounting retailers made ‘low, low’ prices an every-day feature of the shoppers’ landscape. The U.S. Dollar also rallied versus most foreign currencies, including the Chinese RMB. This further cheapened imports and intensified competitive pressures on domestically made goods. Finally, U.S. oil & gas fracking made supplies plentiful, injecting a depressing effect across all energy intensive activities.
Monetary authorities primarily target inflation indexes composed of goods and services. These enormous deflationary effects bore directly on the goods captured by the indexes. In sum, deep secular trends in the global economy gave Central Banks unprecedented ‘running room’ on the type of inflation which these Banks target when setting policy.
Does this mean there was no inflation? Not really. There was inflation of a different kind – asset inflation. One could see this in housing prices across major cities in Europe and America. One could also see it in stock prices. The Dow Jones Industrial Average, which plummeted into the 6000s in 2008, recovered to 18,000 in 2016. It then exploded over three years-time, approaching 30,000 on the eve of the pandemic. Putting this in perspective, there is a huge gap between U.S. GDP growth and an almost 500% rise in stock prices. That gap consists of the distorting effects of QE and the moral hazard associated with the Fed ‘Put.’ Put another way, the Efficient Market Hypothesis has given way to TINA – There is No Alternative [to buying stocks].
With that as background, it is time to contemplate whether the new economic paradigms will hold in the years ahead. There are some noteworthy reasons to doubt this and fearful risks if these paradigms collapse. The principal reason for doubt concerns whether inflation will remain quiescent. Several of the deflationary underpinnings are eroding. Trade tensions, especially among the U.S. and China, are reversing global supply chains. The political impetus to bring jobs back to U.S. workers is intensifying. The Democratic platform calls for strong measures to strengthen labor unions. These trends promise higher production costs and eventually higher product prices. Displacing workers with AI technologies will probably continue, but in the teeth of increasingly fierce political and labor opposition. Energy is also going to get a lot more expensive. This will happen in several ways. First, oil and gas prices need to recover more to enable new drilling in most producing regions. Knowing the cyclical nature of that industry, the recent bust probably is sowing seeds for a future pricing peak driven by supply constraints. Second, the energy transition underway is intrinsically inflationary. It amounts to substituting less efficient and costlier forms of energy for currently installed capacity on the grounds of lowering carbon emissions. This may be in the planet’s long term interests but nobody should assume it will either be cheap or cost neutral for consumers. In point of fact, it probably is going to require carbon taxes to make it happen, which will directly raise energy costs.
Two other factors bear on the outlook for inflation. The first is the likelihood of further massive government spending financed by deficits and funded by QE. This amounts to the ‘independent’ Central Bank now operating as the execution arm of the Treasury. This spending will look to stimulate demand, boost employment and fund transformational projects in infrastructure and energy. It will occur without traditional budgetary disciplines; these for governments have never really been that robust. Now however, spending will take place untethered to much sense that capital has a cost or that budgets really matter. This leads to the second factor – the embedding of a new set of investor expectations. In the 1970s inflation was propelled by embedded expectations that prices would only go up. This time the embedded expectation will be that government’s likely response to any crisis, indeed its only possible answer, will be to print more fiat money.
The growing evidence for this expectation is clearly visible for those who want to look. Gold prices, which hovered in the $1100-1200/oz. range as recently as 2019, now clock in at $1900-2000/oz. This has occurred in the face of depressed demand for gold jewelry; financial investors, speculators and selected Central Banks are now driving the gold price. This magnitude run-up requires more explanation than just low interest rates. Rather, it reflects a growing awareness of the ‘no way back’ to monetary normalcy and its corollary, an open-ended commitment to repeated, massive money printing. Bitcoin prices tell a similar story. Despite being almost discredited as a viable store of value. Bitcoin’s price has risen from 6600 in December 2019 to almost 12,000. Finally, there is the stock performance. Despite the worst economic decline since the Great Depression and structural damage to a host of industries that will take years to repair, the stock market has returned to pre-crisis levels. With a 10-year Treasury around ½ % and junk bonds trading around 3%, we have TINA on steroids. Behind this lies growing belief that the Central Bank will print any amount of money needed and buy almost any quality security to forestall a major market decline.
How long this modern day paradigm can hold is guess-work. However, it is not hard to spy the fearsome trap awaiting should it give way. A rekindled inflation would confront Central Banks with a decision on whether to allow short term interest rates to rise. Doing so will further ‘blow out’ already enormous government deficits. Financing these deficits will then require more debt monetization. This in turn will only feed the monetary aggregates. Labor market expectations may again start anticipating rising inflation. Investor expectations will increasingly turn to a daunting set of alternatives: either inflation will be allowed to run well beyond Central Bank targets, or government debts will be ‘restructured,’ or there will be an attempt at draconian austerity. Hints of what is coming may be found in recent Federal Reserve comments that it may ‘allow’ inflation to run above target as compensation for having run below target during the pandemic.
None of this will be good for the real economy. But then, the weakness of Keynesian economics and its extensions has always been its focus on deploying policy tools to manipulate economic behavior as opposed to creating stable conditions conducive to rational investing and innovative risk taking.
This lesson was painfully learned in the 1970s. What followed the corrective policies of that time was 40 years of largely uninterrupted growth with low inflation. It is especially striking that today’s economists seem so convinced that radical policies are needed to address a situation which before the pandemic was characterized by growth, very low inflation and rising living standards at the bottom of the income distribution. Would it not be better to again see the present moment as a gigantic emergency, calling for a dedicated pathway back to normal markets when it passes?
Identifying this pathway will be harder than before. The magnitude of the monetary aggregates and associated distortions are so much greater. It will take the dedicated efforts of many finance academics and professionals to tease out the best alternatives for a road back. Failing to recognize that financial conditions today bear scant resemblance to what we are teaching and that a financial storm of historic proportions may be building will leave us however facing a growing trap – endless money printing, an increasing flight from fiat currencies and the possible collapse of government credit.
The next Director’s Blog will thus take up possible measures for constructing a ‘road back.’