This is No Way to Run a Railroad
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This essay is excerpted from the most recent version of the HCM Market Letter. To subscribe directly to this publication, please go here.
“[C]rises are, in effect, not only inevitable but also necessary, since this is the only way in which balance can be restored and the internal contradictions of capital accumulation be at least temporarily resolved. Crises are, as it were, the irrational rationalizers of an always unstable capitalism. During a crisis, such as the one we are now in, it is always important to keep this fact in mind. We have always to ask: what is it that is being rationalized here and what directions are the rationalizations taking, since these are what will define not only our manner of exit from the crisis but the future character of capitalism? At times of crisis there are always options. Which one is chosen depends critically on the balance of class forces and the mental conceptions as to what might be possible. There was nothing inevitable about Roosevelt’s New Deal any more than the Reagan Thatcher counter-revolution of the early 1980s was inevitable. But the possibilities are not infinite either. It is the task of analysis to uncover what might now be possible and to place it firmly in relation to what is likely given the current state of class relations throughout the world.”
The misallocation of capital to speculative rather than productive uses is a great American tragedy. As described in detail in The Death of Capital, the manifestations of this misallocation include most private equity transactions and the lion’s share of the derivatives and computer-driven trades of stocks and other financial instruments on the world’s securities markets.
The markets are dominated by investment strategies that have as their common denominator a reliance on momentum. There are many flaws in these strategies, beginning with the fact that they typify the “Greater Fool” theory. Adding insult to injury, the economy currently underlying the market is evidencing little momentum one way or the other. As a result, most investors have spent 2010 chasing their tails. Unfortunately, one of the most plausible arguments for believing that financial markets will rally is to endorse the view that investors will be as cynical and short-sighted in their thinking as their political and business leaders. That’s a hell of way to run a railroad.
The railroad known as the United States economy is also chasing its own tail these days. Driven by misbegotten fiscal and monetary policies that ignore the lessons of history in favor of discredited financial and economic theories, the economy is trapped in a cycle of boom and bust. Every time the economy falters, our political leaders run to bail it out with politically-mandated Keynesian prescriptions that only exacerbate the underlying excesses and imbalances. Little or nothing is done to direct capital to productive uses and speculation is allowed to reign. As John Hussman recently wrote: “If our only response to excess consumption is to pull out all the stops trying to ‘stimulate’ consumption every time it falters; if our only response to reckless lending is to defend the bondholders every time their poor allocation of capital threatens to produce a loss for them, then quite simply, we will destroy our economy, our future, and our standard of living….[I]t’s difficult to envision a return to long-term saving, productive investment, and thoughtful allocation of capital until – as happens every two or three decades – the speculative elements of Wall Street are crushed to powder.”2
We have self-appointed diminutive macho-men like Rahm Emanuel barking about how crises are terrible things to waste while proceeding to do precisely that – squandering the opportunity that crises offer to effect meaningful reform by surrendering to special interests and lacking the courage to engage in genuine systemic change. The result – an expensive and profoundly flawed healthcare bill, an absurdly complex and at its core neutered financial reform bill – is not that the status quo is left in place but that it is made even worse. For this reason, the debates about whether the U.S. economy is enjoying a self-sustaining economy (HCM believes the recovery has been primarily government funded and is already fading as stimulus recedes) is primarily of short-term interest. In the long term, absent dramatic entitlement and other reforms, the economic outlook is bleak. There is genuine doubt concerning the ability of the U.S. government, as currently operative under the Constitution and other laws of the land, to deal with the mess in which we find ourselves.
One of the reasons that financial markets struggled in the second quarter was that money growth stopped on the part of the government and the private sector did not pick up the slack. The result was an effective tightening in monetary policy that exacerbated debt-deflationary forces already at work in the economy. Indicia of this include the 10-year Treasury yield, which remains stuck around 3 percent (and is likely heading lower), and declining inflation.
Inflation is Dormant
US headline CPI dropped by 0.1 percent month-over-month in June and has now declined by an annualized 1.5 percent over the past three months. While this is hardly catastrophic, it is likely to trigger another bout of non-traditional Fed easing if it persists. This would be a policy error; the central bank should tolerate mild deflation to allow the system to purge at least some of the excesses of the debt bubble. The recent statement from the Federal Reserve Open Market Committee that “economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period” is clear evidence that the central bank is watching these inflation numbers closely and is unlikely to be satisfied with what it is seeing. Many highly respected observers expect the Bernanke-led Fed to engage in further unorthodox monetary easing if such trends persist. HCM would view such policy as an extension of the unwise pro-cyclical policies that have contributed to the boom-and-bust cycle in which we are stuck. If zero percent interest rates are insufficient to stimulate economic growth, then the answer is unlikely to lie in the realm of monetary policy. The answer is not, as John Hussman stated earlier, to engage in further easing machinations. The answer is to address other policy shortcomings in the fiscal arena, including tax and budget policies that reward speculation and punishes production.
The equity market
July was a strong month for equities, moving the S&P 500 closer to the upper end of HCM’s range of 975-1150 for the year. The market appears to have dismissed fears of a double dip recession, although the fourth quarter GDP report released last week suggests that the economy is slowing down. HCM is not expecting a double dip, but thinks the economy will struggle to grow beyond the 2.4 percent rate it preliminarily showed in the second quarter. Accordingly, our best judgment is that the projected upper end of our trading range (1150) will not be breached, but like many investors we feel like we are chasing our tails in making such a prediction since in today’s computer-driven markets this level could be pierced in one over-heated computer-driven trading session. HCM does not think the stock market is particularly cheap in view of the economy’s prospects despite relatively low valuations. We would also not dismiss the possibility of an extraneous event involving Iran or domestic U.S. politics from upsetting markets before the end of the year.
1 David Harvey, The Enigma of Capital and the Crisis of Capitalism (London: Profile Books Ltd., 2010), p. 71.
2 John Hussman, “Misallocating Resources” July 12, 2010, Hussman’s Weekly Market Comment.