Friday, 12 February 2016

Stocks and The Money Supply Bear Market

The great bull market is over. Following at least two years during which the stock market disconnected greatly from any sensible long term estimates of earnings and economic fundamentals, speculators are in the process of landing on earth once again. Greater fools are increasingly in short supply as around the world stock markets have plunged since peaking during spring and summer time last year. Many major stock markets have since “officially” entered a bear market. [1] The S&P 500 is down 14.2%, Nikkei is down 28.3%, Shanghai has plunged 46.5%, stocks in Europe are down 26.6% while the oil dependent major stock market index in Norway has shred 20.8%.

Even more noteworthy, the stocks of major banks have crashed. Since their (intermediary) peaks in Q2 last year, Goldman Sachs has dropped 35.6%, JP Morgan 24.3%, Bank of America 39.6% and last but not least, Deutsche Bank has plummeted a full 57.0%.

What to blame this time around? Well, China of course. And sharply lower oil prices which today are even lower than in the midst of the previous banking crisis (December 2008).

That oil prices consistently remained near $100 per barrel for almost four years (2011-2014) no doubt helped fuel booms across all sectors benefiting from high oil prices. These sectors faced great challenges during the whole of 2015 and do so even more today as oil prices have continued to drop and are now eating away at balance sheets and expected earnings. Investors are now on the hook for big losses. Of grave concern is the exposure banks have to the oil sector as default- and delinquency rates will increase as a result of lower oil prices. Furthermore, market values of collateral will also decline due to the lower cash flows these assets now generate (e.g. oil rigs). To protect their balance sheets, a natural response by the banking sector is not only to not extend further loans to the sector, but also to tighten lending to other parts of the economy. One therefore should not be surprised to see a sharp contraction in bank lending growth going forward. This could trigger an economic collapse in the U.S. and world-wide for one primary reason: ever since the Federal Reserve started tapering in 2014 and ending QE3 the same year, it has been the U.S. commercial banks that have supplied the economy with ever more money. When bank lending growth stops the money supply growth rate will stall as well, bringing with it a plethora of necessary economic adjustments. The truth is however that, though it has remained high, the lending growth rate in the U.S. has already stalled...

…resulting in a money supply growth rate that has remained flat for the better part of the last year, but which during the last week has collapsed to a level last seen toward the end of 2008. 

And do keep in mind: though the money supply growth rate has been uncommonly stable for quite some time, it is considerably lower today than at any time since the 2008 banking crisis. The money supply growth rate has in effect been in a bear market for some time.

Some of these economic adjustments caused by a slowing money supply growth rate are already well under way, the most apparent ones perhaps being the sharp fall in stock market prices and the dramatic increase in junk bond yields. [2]

A feed-back loop is now in progress: the significant growth in money supply following the 2008 banking crisis created an asset price boom that has now come to an end and is rapidly deflating. The financial turmoil this creates will further deter bank lending growth which will result in stock prices and other assets and commodity prices deflating further. Margin calls will surge while margin lending will contract pushing stocks down still further. The previously money supply-inflated company earnings decline rapidly and stock prices fall substantially quicker as expectations move quicker than earnings reports. Write-downs and big bath accounting soon follow suit adding to the woes. When such events unfold, stock prices easily shred 50% of their peak values and, if history is any guide, fall back to pre-boom levels. Interest rates will rise and the expectations of such an increase combined with a flight to safety will mirror a decline in P/E ratios. Employment previously benefiting from ever new injections of money will now to some extent be lost. Capital will also be partly lost. Consumption spending will decline and savings rates will increase. Investment spending will also drop and remain low until new savings have accumulated sufficiently and the economy has adjusted to the new economic reality. 

Way before the economy has fully adjusted, but after the stock market has lost much of its value, the Federal Reserve will intervene. QE4 is implemented and the whole merry-go-round starts once again. But central bank interventions will become less and less effective with every bust as savings and capital are becoming increasingly scarce. 

Such is the case not only in the U.S., but in most (developed) countries around the world as only too evident in surging debt levels. This is one reason “currency wars” might soon be replaced with “capital wars”, i.e. a state where countries once again compete to attract savings and investments from abroad. And such a war is not won by implementing negative interest rates and destroying the local currency. Quite the opposite. 

[1] A drop of 20% or more from the peak say some financial pundits.
[2] Do keep in mind that the damage was actually done during the period the money supply was inflating.

Disclaimer: I am short U.S. mid-caps and the Norwegian Benchmark Index. Read the full disclaimer here.


Stock Market Correction Over? This Chart Says No, Far From It

Thursday, 4 February 2016

Friday, 29 January 2016

Charts: A Longer Term View of U.S. GDP Growth (as of Q4-2015)

Is The U.S. Stock Market Living in Denial? These Charts Suggest Yes!

Updated as of 28 January 2016

Also see:

Stock Market Correction Over? This Chart Says No, Far From It

Charts of The Day: The Manic Depressive ECB Monetary Policies

I'll leave you with this question: how can anyone sensibly plan is such a manic depressive monetary environment? 

Monday, 25 January 2016

Central Planning Dictates, Social Democratic Folly and the End of Economic Growth

"Encounter of the carousing bubble lords and menacing poverty". Source: The Mirror of Folly, BibliOdyssey

Central planning committees around the world, made up of elected politicians, bureaucrats (i.e. an official in a government department, in particular one perceived as being concerned with procedural correctness at the expense of people’s needs) and central bankers, are today facing perhaps the biggest ever threat to their very existence: the end of economic growth. 

For decades, central planners have experimented with faulty economic policies, many of which were based, in the best of cases, on little more than good intentions based on unsound economic doctrines. In the worst of cases, these so-called policies were nothing short of governments enriching themselves at the expense of the people they claim to represent. In both cases, the “spending oneself to riches” philosophy, built on inflationary policies and steered by legislation, has now however arrived at the final chapters as unmanageable debt levels have long gone consumed away any reasonable prospects for future economic growth in developed nations all across the globe, including Japan, the U.S., the U.K. and many countries in mainland Europe. What do all these countries have in common which their politicians brag about constantly? Democracy - the holy grail for freedom, peace and prosperity. At least, so we’re taught from an age too young to remember. A fait accompli highly desired compared to its alleged only adversary; the evil dictator. Democracy, or the rule of the majority, in its current form has however greatly failed the people for a few main reasons in my opinion. Firstly, government powers have now come to interfere with a vast and ever growing range of choices which only individuals should be able to make in a free society. Secondly, these ever growing self-imposed “responsibilities” of governments have made it exceedingly difficult for the electorate to monitor government. A direct result of the increased complexity is that it facilitates the government legislating away not only ever more individual freedom, but also ever more resources. Thirdly, as governments are now able to interfere in most aspects of everyday life for the people they are meant to serve, elections are frequently (always?) won by the parties promising the most in economic terms (by robbing Paul and giving it to Pete and through issuing debt). The net result is an ever growing mountain of government debt, both in total and relative to economic indicators such as industrial production and GDP. National central banks have helped make it possible for governments to amass these unmanageable levels of debt, not to mention the banks which are forced to own the government bonds through balance sheet rules and regulations. In return, these banks have been granted monopoly powers to create money. Those working hard to satisfy the needs, wants and demands of others, i.e. the private sector which economic growth hinges on, are now on the hook to repay these debts. In a fiat money world, purchasing power granted through bank loans is acquired through money created out of thin air. The problem is the money to repay the debt needs to be acquired through the creation of real goods and services (consumer and producer goods) produced at a profit. As scarce resources are gradually being depleted through the misallocations and overconsumption the economic policies facilitate, people will increasingly find it difficult to not only service those debts, but worse, will find it near impossible to maintain capital and add to it (see The Economic Meaning and Consequences of Debt, The Crank Report, Issue #5). Economic growth suffers as a result. Many, if not most, developed nations are at such a stage as we speak and have been for years. Absent a rude awakening or some form of a revolution of some sort, nations around the world will not grow in economic terms, at best. A further decline in living standards is sadly the most likely outcome. This outcome will only further be cemented by the natural policy response – intervention begets yet more intervention.

Now, it’s not the role of economics to interpret or conclude about the desirability of economic growth. It is however the role of economics to explain not only how growth might be attained, but also how it might be attained most efficiently. Below we’ll explore briefly economic growth in its sustainable form: Natural Economic Growth before moving on to another form of economic “growth”: Artificial growth. 

This is Natural Economic Growth…

Natural economic growth, or a rise in living standards, which we might also refer to as sustainable economic growth, comes about as a result of production, saving and investment. Savings can only accumulate if less is consumed (spent) than is produced (earned). Real saving therefore cannot be generated through inflating the money supply as both assets and liabilities increase simultaneously when it does. Taking up a loan and depositing it in a savings account therefore does not qualify as real saving. The higher saving is in relation to consumption, which we may refer to as the consumption/saving ratio (C/S), the more resources become available for investments. As saving and investment are both necessary for real economic growth to take place and as there can be no investment without saving, the lower the C/S ratio, the higher the potential economic growth. Conversely, the higher the C/S ratio, the lower potential growth becomes. Less consumption and more saving hence bring about more output in the future. Conversely, more consumption now means less saving today and lower future growth. Increased saving available for investments also brings with it the added benefit of naturally pushing the interest rate on loanable funds lower than would otherwise be the case. This reduction in interest payments will by itself make more investments profitable than otherwise as the break-even point decreases. As producer goods accumulate and become more advanced, businesses and labour become more productive. The supply of consumer goods increases while their prices decline. As a result, real wages increase, raising overall living standards with it. This process allows future consumption to increase. The process of real, or natural, economic growth is therefore as follows, broken down into the two main sectors of an economy, namely consumer goods and capital goods:

          Consumer goods sector: Demand for consumer goods decline, prices decline, profits decline, wages 
                                          decline, labour force declines and the supply of consumer goods also

As time preference decrease (i.e. people can wait a little longer before a given end is achieved – consume later as opposed to sooner), the C/S ratio falls, savings increase, interest rates fall and investments increase. As this happens, a portion of the labour that previously worked in the consumer goods industry now start working in the capital goods industry instead. This will bring about the following changes in the capital good industry:

          Capital goods sector: Demand for capital increases, prices increase, profits increase, wages   
                                       increase, labour force increases and the supply of capital goods also increases.

The process of real economic growth is therefore as follows:
Supply of savings increases, capital goods increases leading to an decrease in the consumption to saving ratio, the marginal productivity of labour increases which brings about an increase in the supply of consumer goods, prices for consumer goods decline and real wages increase. Standard of living increases accordingly.

In summary, natural economic growth starts with production, followed by increased savings driven by reduced consumption leading to increased investments which then lead to higher production and productivity and more output at lower prices which ultimately results in an increase in real wages and living standards. This kind of growth is sustainable and the process can be repeated over and over again creating ever higher living standards. Mises called a progressing economy “…an economy in which the per capita quota of capital invested is increasing” (Mises, Human Action, A Treatise on Economics, 2008, p. 292). He further stated that “The vehicle of economic progress is the accumulation of additional capital goods by means of saving and improvement in technological methods of production the execution of which is almost always conditioned by the availability of such new capital” (Mises, 2008, p. 295).

Many economists and financial commentators believe that a drop in consumption will lead to an economic slowdown. They however likely err in forgetting or completely ignoring the capital goods sector, a sector which is also a part of the economy and which benefits from a decrease in consumption and an increase in saving. This brings us to another kind of economic growth which has been much more prevalent in developed economies for many decades and perhaps especially since the end of the 1990s: artificial growth.

…and this is Artificial Economic Growth

Ever wondered why the economy moves in cycles? Ever wondered how the stock market can deliver tremendous returns for years for then lose these gains over a relatively short period of time? The boom and bust cycle is not an inherent feature of capitalism as Karl Marx, many modern day social democrats, socialist “economists” and even some free-market economists seem to believe. These cycles are instead an inherent feature of central- and fractional reserve banking where additional purchasing power can actually be created absent prior saving. Furthermore, the current banking regime is not endogenous to the market economy as it exists only due to government decree. It is this system, in tandem with banks and insurance companies having to own government debt that create business cycles of the violent sort. In this sense, the cycles are created centrally and not by the market itself. As government has the ultimate responsibility for the existence of the current banking system, it is the government that should solely be blamed for the business cycle. As politicians haven’t bothered to learn about monetary economics, they are in fact committing a grave error which can only be described as gross negligence or utter incompetence.  In the private sector, people can go to jail for the former and are usually fired for the latter.

Fractional reserve banking supported by central banks is what allows the business cycle to form. In short, the current system makes artificial growth possible. Artificial growth, which we may also refer to as inflationary growth, is a kind of growth that is not sustainable and which ultimately leads to a decrease in living standards (or lower living standards than otherwise would have been the case). The distinguishing feature of this kind of growth is that it is driven by an increase in the money supply instead of savings. This explains why it can be referred to as inflationary growth. The appearance of a boom is jump-started with an injection of money usually from banks (instead of directly from the central bank) into the business sector pushing interest rates on loans artificially low (i.e. lower than the current supply of saving would indicate). This has the following effect on the capital goods sector:
Demand for capital goods increases, prices and profits increases, wages increase, labour force increase and the supply of capital goods increases.
The monetary injection has exactly the same effect on the capital goods sector as savings have: the sector becomes more buoyant and a portion of the labour force moves from the consumer goods sector to capital goods. But that is where all similarities end. The shift in resources from the consumer goods sector to the capital goods sector is not due to the free will of the market: time preferences have not changed (there has been no decrease in the Consumption/Saving ratio) and resources have not been allocated to the capital goods sector due to excess resources in the consumer goods sector. The increased activity in the capital goods sector is in effect paid for through a reduction in activity in the consumer goods sector even though this is not what consumers wanted (as reflected in the lack of savings to support the expansion). This unwanted shift in resources from the consumer goods sector to the capital goods sector is what makes this kind of growth unsustainable – there simply is not enough saving to support it. Newly created money is not savings, nor is it capital. All the new money issued through granting loans to businesses do is to provide these businesses with purchasing power to extract resources from other areas of the economy (similar to what government deficit spending financed with government debt does) against the actual free will of consumers (which cannot easily observe nor comprehend what is actually taking place). This process can go on for some time as labour and resources are bid away from the consumer goods sector with the help of an ever expanding credit granted to the capital goods sector. But as long as this expansion is financed by new money instead of savings it must eventually come to an end. Sooner or later the consumer goods sector and consumers suffer as resources are continually drained from them through a general loss in purchasing power and access to fewer resources in general. Fewer consumer goods produced than would otherwise be the case combined with an inflating money supply causes the prices of consumer goods to increase and consumption to be restricted (Salerno, 2012). [1] This inflationary boom, which is not actually a “boom” or economic growth at all, comes to an end when credit expansion for whatever reason is ended or the economy has been sufficiently drained of resources (savings). At this stage, the full force of the market shows itself and consumers’ real time preferences, i.e. more consumer goods and less producer goods, are once again established. Much of the artificial growth now reveals itself as investments that cannot be completed, maintained nor continued and a very real bust become apparent for all to see and feel in one way or another. The boom turns out to have been an unsustainable spending spree and the increased economic activity this brings about was erroneously viewed as economic growth. Resources were squandered making society worse off in economic terms as a result leading the economy into an inevitable recession or even depression.

As artificial growth is what created the economic issues in the first place more of the same will only make matters worse. This is why “quantitative easing” or increased lending by banks (of credit unbacked by prior saving) cannot do anything else but damage the economy still further. What is needed instead is to allow the economy to adjust without intervention and make it easier for people and businesses to accumulate saving (through decreased taxes, lower government spending, less regulation, sound monetary policies etc.) which can be channelled into rebuilding and expanding the capital base once again. Accumulating saving is a long and slow process, too long for politicians focused on the next election and too long for special interest groups to wait for their share and too unprofitable for the banking sector thriving under the current banking system. Alas, what has happened since the 2008 bust is simply more of the same, albeit through a slightly different route (e.g. here). As money supply growth continues to outpace saving growth (e.g. here) and as government debt has surged since 2008, the next inevitable bust in all likelihood will be much worse than last time around for the U.S. economy and many other regressing economies.

[1] A Reformulation of Austrian Business Cycle Theory in Light of the Financial Crisis, The Quarterly Journal of Austrian Economics. According to Salerno, «This phenomenon is known as «forced saving», because the redirection of resources from consumer goods’ production to capital goods’ production caused by bank credit expansion does not comport with the voluntary saving preferences of households (p. 9). 

Saturday, 23 January 2016

Monday, 18 January 2016

Myopic Monetary Policies

“But the problem [with monetary policy] is not so much what we can do, but what we ought to do in the short run, and on this point a most harmful doctrine has gained ground in the last few years which can only be explained by a complete neglect – or complete lack of understanding - of the real forces at work. A policy has been advocated which at any moment aims at the maximum short-run effect of monetary policy, completely disregarding the fact that what is best in the short run may be extremely detrimental in the long run, because the indirect and slower effects of the short-run policy of the present shape the conditions, and limit the freedom, of the short-run policy of tomorrow and the day after. I cannot help regarding the increasing concentration on short-run effects - which in this context amounts to the same thing as a concentration on purely monetary factors - not only as a serious and dangerous intellectual error, but as a betrayal of the main duty of the economist and a grave menace to our civilisation”. - F.A. Hayek

The above quote from Hayek might sound like something a clear thinker wrote recently. It wasn’t – it was first written 71 years ago back in 1941. Ever since (and many years prior, e.g. the “roaring 1920s”) the focus on “short-run effects” have come to dominate monetary policy in the U.S. (and most other economies), perhaps most clearly during the last 20 years and most notoriously since 2008. 

Today, some of the by-products of these myopic monetary and economic “policies” are blatantly obvious:

  • Interest rates at historical lows fuelling regular and spectacular asset bubbles (e.g. 2000, 2008 and currently).
  • A bloated money supply that today is more than thirteen times greater than in 1980 leading to a sharp fall in the purchasing power of money and a general rise in price- and asset price inflation. For example, since 1968 the US dollar has lost more than 96% of its purchasing power compared to gold.
  •  Record levels of government debt and debt to GDP ratios which will hinder future economic growth.
  • A significant depletion of the rate of savings as evidenced by a record low net saving to GDP ratio during the last ten years.
  • A sharp fall in private investments with investments in percent of GDP having fallen to a 50 year low over the past ten years.

As saving is required for investment and as the maintenance and accumulation of capital is a prerequisite for economic growth, the U.S. economy is currently positioned for further economic decline rather than the growth monetary cranks and demagogues, including but not limited to central bankers (central planning econometricians) and politicians (most of whom are social democrats whether they admit it or not) allegedly crave. I say “allegedly” as both the monetary and economic policies that have been in place for decades and again especially since 2008 can only serve to strangle market forces naturally and relentlessly pushing in the direction of increased economic prosperity.

For short-term thinkers, a favourite culprit for lacklustre economic growth is a “lack of lending” (78.5m hits on Google). If only banks (or governments or central banks) would lend out more money all our economic woes could be solved quickly and harmlessly is perhaps a reasonable exemplification of this line of thinking. The answer to this (lack of) reasoning needs to be broken down in two parts: 1) the lending of money previously saved and 2) lending new money into existence. Firstly, the act of saving frees up resources in an economy. The actual money saved during the process is simply a ticket or a claim for purchasing power earned during the act of consuming less than was produced. Whether the saver choses to exercise this claim or not is largely irrelevant as the excess of production over consumption has already benefited society in economic terms. As long as the savings have been stored in the form of money and not in the form of actual physical goods locked away, the saver has no control of how the surplus is utilised in the economy. For example, assume you live and work in an economy producing potatoes, the only food item and good produced in the economy. During the course of a year, you produce one ton of potatoes while only consuming 365 kilos. Your excess production over consumption hence amounts to 635 kilos which you sold on the market for one potato dollar (PD) each. Your monetary savings therefore amounts to PD635 for which you can claim 635 potatoes at a later stage. What happened with the 635 kilos of potatoes you sold on the market? We don’t know, but what we do know is that someone else benefited from them through consuming them, re-selling them or perhaps storing them for later consumption. The fact that you saved the PD635 is totally unrelated to what happened to the physical surplus generated and does not lead to a reduction in potatoes available. In general, as long as the saver doesn’t utilise the claim to purchasing power gained through the act of saving (producing more than is consumed), the purchasing power of others increase as a result of fewer money chasing the goods and services available in the economy (remember the purchasing power of money increases when the demand for money to hold increases, i.e. prices fall). 

It is therefore the surplus generated through the act of producing more than is consumed that creates wealth in the first instance, independent on whether the monetary savings are added to cash balances or invested. The crucial point is that the surplus created does not diminish or change or remain “unutilised” if the money received for creating this surplus is added to cash balances. Of course, if the entire monetary saving at a later stage is used for consumption, the surplus previously created will be brought back to zero. If the savings are lent out, the borrower now is in possession of the purchasing power, or the claim on savings, which can be spent either on consumption or investment. If it’s spent on consumption, the former surplus is reduced. If spent on production activities, the surplus will gradually, depending on the nature of the investment, be consumed and transformed into new capital goods. If the investment is successful, the “old” savings would have resulted in productivity gains and increased production which may again lead to yet larger savings and so forth. If unsuccessful, the savings have been squandered and will need to be replaced to bring the economy back to its previous level of economic wealth.

We therefore see that whether monetary savings are lent out or not is secondary in economic terms to the act of producing more than is consumed. A “lack of lending” is therefore not the main culprit of slow economic growth, but a lack of production and savings are. The economy can however grow faster than otherwise if these savings are lent out to entrepreneurs that utilise this purchasing power better than the saver. Conversely, the economy will grow slower or even contract if the savings lent out are squandered. Lending money previously saved is therefore a two-edged sword as the economy can grow both quicker and slower as a result. Economic policy should therefore focus on how an increase in production over consumption can be attained and how the corresponding savings can be invested efficiently rather than focusing on how savings can drive consumption as is standard economic policies today. Economists solved the answers to these questions centuries ago – let markets, and not politicians, bureaucrats and central bankers, rule. Secondly, can lending money into existence help economic growth? This question has in many ways already been answered. The best that can ever be hoped for when money is lent into existence is that the recipients of the new purchasing power are shrewder and put the money to more productive use than those already benefiting from the savings an economy generates and the lending based on it. Exactly why this should be so however is not readily apparent as we can only assume that savings in general are channelled into the most productive uses first - the free market knows better than any other system where an investment is likely to attract the highest return compared to the assessed risks involved. Unfortunately, loans based on creating ever more fiat money tend to be channelled into areas of the economy politicians deem important, such as mortgages and wealth distribution programs. Such lending practices more often than not result in pushing house prices and building costs up at the expense of other sectors of an economy and leading to unsustainable and wealth destroying misallocations of economic resources.

In conclusion, as more money in an economy does not make it wealthier (if it did, we could stop working and print money instead), lending new money into existence can only lead to increased risk of economic failure through increased financial leverage, depletion of savings, less efficient allocation of scarce resources and the sapping of purchasing power from the productive parts of the economy. In short, the upside of lending money into existence is either strictly limited or non-existent at best while the downside risk is tremendous and ever-present. The same answer applies to the faulty doctrine of “kick-starting” the economy by way of some large government programme to increase employment, blessing part of the population with subsidies or showering a particular sector of the economy with easy and cheap credit at the expense of others, especially savers and those on fixed incomes.

It’s always some other reason than money per se fruitful ventures are not undertaken in general, and that reason is a lack of scarce resources or some other fundamental reason holding back (the opportunity for) investments such as a lack of savings, lack of profitable projects or economic uncertainty making planning difficult to mention a few. Underpinning them all is a lack of purchasing power. The by now regular and pending “debt-ceiling debate” will rather quickly be resolved by choosing the path of least resistance: raising the debt ceiling. And with it making the purchasing power of money weaker still. 

This article was originally published in The Crank Report, Issue #10, 21 October 2015.