and the Keynesians
June 4, 2013
A polarizing choice confronts policymakers. Either they side with Paul Krugman and the Keynesians, and advocate for aggressive fiscal measures to stimulate America’s economic growth rate, or they align themselves with the so-called austerians, who argue that budget cutbacks are necessary to eliminate deficits. A third option is rarely discussed. Its most outspoken proponent, Horace “Woody” Brock, says that America should continue to borrow, but spend wisely – and develop new policy instruments that would eliminate asset bubbles and stimulate economic activity.
Brock may be the most astute economist among the discordant voices telling us what's going on and what we can do about it, with a more sophisticated and nuanced explanation of our investment and economic times than Ferguson, Nassim Taleb, Nouriel Roubini, Paul Krugman, Larry Kudlow, Larry Summers, Mohamed El Erian or the other voices of the hour. In an interview on May 20, he managed to weave a coherent picture that encompasses everything from the optimal fiscal/monetary/government policies to raise economic growth rates in the U.S. and Europe, to whether Japan is truly on track for an economic resurgence, to a surprisingly workable way to prevent future global economic crashes, to different ways the Fed can disengage from its QE program without causing a catastrophic rise interest rates. Along the way, he made a convincing argument that we are not experiencing what everybody thinks we are in the investment world: a near-bursting bubble environment in bonds.
Monetary policy: Flexible leverage control
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Since all of Brock's ideas and recommendations fit together and have to be considered holistically, there is no obvious place to start describing them. But perhaps the least controversial, most accessible part of his proposals addresses a crucial question for Federal Reserve and government policymakers: How do we prevent future global economic crises?
The interviewer mentions the historic Dodd-Frank legislation, but Brock impatiently waved it aside. Instead, he thinks we could write a far, far simpler law – which would go a long way toward averting the next 2008-like collapse.
The first thing to understand, Brock said, is something you don't ever hear economists talking about: financial bubbles and overshoots have replaced inventory bubbles and overshoots as the cause of economic recessions. This bears repeating: Brock says that when you look at economic cycles – as many Advisor Perspectives readers do when they make tactical investment decisions – the cycle is no longer driven by Ford Motors laying off workers because it unwisely built a glut of automobiles during the booming top of the economic cycle, joining manufacturers who were coming to the same realization at about the same time. Instead, the cycle is now driven by rising asset prices (housing, stocks, securitized mortgages) fueled by crazy leverage. Think: zero-down mortgages and 50-1 leverage on Wall Street.
"In recent years, we've experienced the Russian crisis, the Meriwether [LTCM] crisis, the tech bubble crisis of 2000, the Asian Flu crisis, the peso crisis, the housing crisis in 2008 – and what do the all have in common?" Brock demanded. "In every case, it has been about leverage and speculation in asset markets."
Alas, monetary policy is not an ideal instrument to control asset bubbles the way it once regulated booms and busts in the manufacturing sector. To see why, imagine that back in 2005, the Fed had decided that it wanted to discourage thousands of Americans from flipping homes or buying them on spec with zero money down. So it dramatically raised interest rates throughout the economy. "That certainly would have killed the housing bubble," Brock said. "But it would also have kicked 15 million people out of jobs on Main Street at a time when inflation was low." Using monetary policy to address asset bubbles, Brock said, would trigger recessions in the corporate/manufacturing sector – a less-than-optimal outcome.
So are we helpless? Only if we limit ourselves to the blunt monetary policy instrument. As Brock put it, paraphrasing a body of work by Nobel-winning economist Jan Tinbergen, policymakers need another knob on their dashboard – one that specifically controls excess leverage without bludgeoning the corporate/manufacturing sector.
His proposal is so simple you could write it on the back of a napkin: raise margin requirements on any financial asset – stocks, real estate or whatever – as its price goes up beyond its mean-reverting (average historical) valuation. Reduce the amount of permissible leverage in proportion to the degree of deviation from the mean. "If housing prices go up, then you would have to keep putting more and more money down, which would kill the psychology of the bubble," Brock said.
The same requirement would, of course, prevent Wall Street from leveraging its collective balance sheets by a 50-1 margin leading into the next financial crisis. "On Wall Street, the objection you hear is: oh, we can't tell when we're in a bubble," Brock argued. "I say, who cares? What you do know is that theoretically and in the data, the average PE is 15 for the stock markets of the 10 largest countries for the past century. So if a PE of 15 is the norm," Brock continued, "and the market goes to 20, then you have to put more down if you want to buy stocks. When the PE goes up to 34, as it did in 2000, you bloody well better be putting 95% down, and in doing that, you deflate the tech bubble."
You might be surprised to learn that this proposal has historical precedent. A review of margin requirements shows that investors who could put virtually nothing down to buy shares of stocks before the 1929 crash were later required to limit their margin accounts as low as 0% and as high as 55%, with the figures moving around as the markets did. Brock pointed out that in January, 1958, when the Dow was at 440, a person could buy stock with 50% down. By August, when the Dow had breached 510, the investor had to put down 70%, and by December, when the Dow was trading around 580, the requirement had grown to 90%. "When everybody has to put 90% down," said Brock, "You no longer have a bubble."
Somewhere on the back of that napkin, the leverage rule would mandate that any Wall Street deal could be audited after the fact to look for a criminal breach of these clear leverage guidelines. "The big banks would have to prove that they met the leverage requirement," Brock said. "It bypasses all the tricky ways of getting money outside the banking system, and there are tricky ways, and you and I are not going to stop them," he continued. "I don't care where you get the money; show me that your own skin in the game was within the allowed leverage ratio, or you go to jail."
Notice what Brock has accomplished here. The Fed can now stimulate the economy during recessionary periods without fearing the usual consequences of an asset bubble. By adding a very simple extra knob on the dashboard, monetary policy becomes much more valuable as a damping mechanism for America's economic ups and downs.
Some readers are going to object that what we just wrote on the back of this napkin is interfering in the normal processes of capitalism. "Excess leverage is an externality," Brock answered. "That means that doing it hurts a lot of other people who weren't involved. When there is an externality, government policy should say ‘no, you aren't going to do that.’ You are not going to be allowed to make money by pouring lead into a river and poisoning the children downstream, and you aren't going to keep all the gains on the way up and avoid the losses on the way down and cause 55 million people to lose their jobs. That," Brock insisted, "is not capitalism."
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