The Centre Cannot Hold
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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.
Turning and turning in the widening gyre
The falcon cannot hear the falconer;
Things fall apart; the centre cannot hold;
Mere anarchy is loosed upon the world;
The blood-dimmed tide is loosed, and everywhere
The ceremony of innocence is drowned;
The best lack all conviction, while the worst
Are full of passionate intensity.
William Butler Yeats (1919)
Years of misguided fiscal and monetary policies led to the 2008 financial crisis. Now a refusal to shed these discredited policies and embrace creative and politically bold solutions is keeping our economy mired in high levels of structural unemployment and below-trend growth. In addition to the bugaboos of efficient markets and investor rationality that have led policymakers and investors astray for so many years, we can add a misguided faith in Keynesian solutions to debt crises, a near-religious belief that mild deflation must be avoided at all costs,1 and uninformed media hype about the alleged benefits of mergers and acquisitions to the list of bad ideas that continue to lead economic policy and markets astray. As David Rosenberg, who has been far more prescient than most about the direction of the economy in recent years, has written, those who missed the current economic relapse “live in the ‘old paradigm’ world of recoveries occurring in the context of a secular credit expansion and they have not updated their models to the realities of a secular credit contraction.”2
The evidence is clear that normal monetary and fiscal transmission mechanisms have broken down. And it is not simply a matter of poor execution, although the stimulus bills and mortgage remediation plans promulgated by the government were hardly paragons of efficiency or efficacy. It appears that the U.S. and global economies have reached the tipping point beyond which the majority of money creation takes place outside the control of governments and central banks. This condition should not apply in a true crisis situation in which non-governmental actors pull in their horns and government agents are empowered by panicked politicians to pull out all of the stops and literally flood the financial system with funds. In non-crisis times, however, the market should be willing and able to fund itself.
Unfortunately, due to the failure of policymakers to adopt the proper policies to stimulate growth (as well as the noxious anti-growth rhetoric and legislation promoted by the Obama administration), non-governmental economic actors (i.e. corporations and consumers) are again refusing to spend. As a result, the system has been seized by a massive paradox of thrift that is more akin to what one would expect in a crisis or near-crisis scenario. Policymakers learned the wrong lesson from Keynes. Rather than continued debt-financed government spending, they should have focused on this paradox of thrift that arises when corporations and businesses lose faith in leadership. Trying to cure a debt crisis with mountains of debt that will ultimately have to monetized is enough to make anybody stuff their cash in the mattress and start building bunkers in their back yards.
Comparisons with the Great Depression are useful as far as they go, but they may not go as far as necessary to get us out of our current morass. The 21st century world and its economies are profoundly different from the early 20th century one that suffered a calamitous economic collapse. For one thing, there were leaders that people believed in; perhaps new ones will emerge now to replace the imposters who are currently in office. But the key to studying history’s lessons is not simply looking for similarities between the past and present, but drawing the proper distinctions that can lead mankind to improve his current course of action. The current approach to solving our economic ills has been driven by a near religious fear of even mild deflation, and has taken the form of a purely Keynesian brew of government spending and artificially low interest rates that penalize savers. While Keynesian stimulus was needed at the height of the crisis, maintaining this approach once markets and the economy have stabilized is a recipe for years of below trend growth and extension of the boom and bust cycle that has characterized the last three decades of the U.S. economy. The Obama administration’s economic team learned the wrong lessons from Keynes and from history.
At the household, corporate and state government levels3, economic agents are shifting from spending to saving as they absorb the lessons of 2008 and pay the piper for previous profligacy. Only the federal government keeps spending like a drunken sailor, with federal spending having increased from $2.7 trillion to $4.4 trillion since the Democrats assumed control of Congress in 2007. (The Presidential veto pen has been put on ice, particularly when it comes to preventing unnecessary spending. Presidential leadership means saying no to the strong, not to the weak. It means standing up to Wall Street in action, not just in empty rhetoric.) The individual savings rate has increased from 1 percent to 6 percent and is likely to rise further without an improvement in consumer confidence. This savings phenomenon is evident in the drop in credit card balances, which hit an 8-year low in July. Corporations are bolstering their balance sheets with cash and engaging in a massive paradox of thrift by conducting business in a manner that benefits them individually but harms the economy collectively because it limits hiring and spending. The primary reason corporate profits are rising is that companies are limiting their hiring and cutting back on discretionary spending. To the extent they are increasing capital expenditures for expansion, they are doing so in a manner that is inimical to job growth. Revenues are beginning to increase, but corporate managements are not running out to hire new workers in a world where employing someone is taxing and aggravating.A word also needs to be said about the false hopes being placed on the nascent boom in M&A deals. The only ostensibly positive thing these deals do is boost short term stock market prices of the companies being purchased. The thought that M&A activity is a signal that corporate managements are gaining confidence in the future is completely misplaced. In fact, quite the opposite is the case. Corporations seek out acquisitions when their existing markets run out of growth prospects. Having lost confidence in their ability to grow organically, managements look for new markets to conquer in order to maintain or stimulate growth. Two more points should also be made about mergers. First, many studies have shown that the majority of mergers do not produce the results that are intended. The challenges involved in combining different companies and cultures are significant, and more often than not enormous resources are wasted in the process. One need go no further than to study the enormous write-offs that have followed so many mergers to see this point. Second, the mergers being contemplated are the last thing needed by an economy with a structural unemployment problem. Virtually all mergers result in so-called “redundancies,” which is a polite word for layoffs. If there is a merger wave right now, it will only make the unemployment situation worse.
1 Even James Bullard, President and CEO of the Federal Reserve Bank of St. Louis, notes in his now famous paper entitled “Seven Faces of ‘The Peril’” that “the relationship between deflation and longer-run growth is not as obvious as some make it seem.” (p. 17, fn. 17) Mr. Bullard notes that the United States grew rapidly in the late 19th century despite ongoing deflation. HCM is suggesting that this assumption, like many others that govern current economic thought, should be questioned. After all, despite the deflation that has plagued Japan for many years, that country has hardly fallen off of the map or descended into anarchy, and some would argue that it is far more civilized in many respects than many other countries around the world (including many Western countries). That said, the United States is a far more fractured society than Japan, and steps should be taken to prevent the types of societal instability that a prolonged period of deflation would bring.
2 David Rosenberg, Gluskiin Sheff, “Breakfast with Dave,” August 25, 2010, p. 4.
3 State governments are required by law to balance their budgets.