Monday, October 06, 2014

A Rare Guest Post

Today, I am breaking convention by posting a piece as a favor to a reader who is restricted from publishing by his employer, but wished for comments from a thoughtful audience. On his behalf, I gratefully ask interested readers for their constructive comments.
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Some Consequences of Government Regulatory and Monetary Policy on the Private Sector and Capitalist Systems

There has been much speculation about the end game to the US Government Debt "build out" that found it's start in the Reagan era and continues unabated today. Doomists say it's the end of Capitalism, while Socialists claim it's the natural result of the central government's responsibility to it's people. I should start by acknowledging that this paper lacks in the exactness and completeness that would qualify it as academic. I would not qualify as an academic or an expert. As someone working my entire career in various segments of the capital markets, I've had the good fortune to observe the evolution of the system and the broad reaching impact that technology has had upon it. This missive is my attempt at tying together and unifying a number of seemingly disparate observations. My hope is that, in producing it, I inspire further thought and data gathering that might support (or for that matter refute) the system, as I describe it. My wish is that in doing so, we might find a way to adjust the system or better prepare for the outcomes. 
Money is a strange beast. It is everything and nothing at the same time. It is a placeholder for usefulness and a measuring stick of scarcity. It's creation is as mysterious to most as its destruction and it is the measure and means by which most everything is exchanged. In response to the outcome and effects of the 2008 financial crisis the US Federal Reserve embarked upon a policy course aimed at injecting the financial system with a massive dose of liquidity, with a goal to resuscitate a global system undergoing the equivalent of a massive heart attack. This policy was selected as the best choice to accomplish the following:` 
  1. The Government's creation of Money for the assumption of private sector at risk assets to revive the banking system through the public assumption of impaired collateral in exchange for the "good" collateral comprised of US Government obligations.
  2. The Government's creation of Money for the manipulation of rates to spur private sector investment and generate economic growth. Spur Lending by ensuring that the means to finance debt could be obtained cheaply and simultaneously encourage saved capital to take the risk needed to revive capital formation, and encourage employment.
  3. The Government's creation of Money to support its own public sector investment and enterprise and in this manner, directly spur employment through government funded projects.
Concurrent with the swift and decisive application of Monetary response, the public, though its elected officials, demanded that the Government implement a new set of more stringent banking regulations, in the hopes of ensuring that Banks would maintain the discipline and capital required to avoid future financial calamities. So under a changed regulatory regime, where does this liquidity go, what happens to it, and what are the side effects of its application? 
The Banking system effectively squirrels money away to support regulatory mandated de-leveraging of the Financial system. Changes in Banking regulations, accounting standards and Insurance Asset risk ratings, have increased the statutory pool of money needed to support a dollar of liabilities. As a result, the cost of debt-based risk capital increased to reach the equivalent hurdle rate per unit of capital supporting it, as lower leverage requires higher returns to equilibrate statutory capital returns. 
The unintended consequence of increased regulatory risk controls is the creation of the less regulated shadow banking system. Non-bank lending requires less statutory capital to support a unit of risk. While the intent of reducing systemic risk is noble on the Government's part, it is a blunt instrument approach and only results in the formation of alternative systems to which the risk now resides. In effect, many of the risks previously borne on depositors has shifted to the hands of shareholders. Unfortunately, lower rates of deposit return have also encouraged depositors, seeking higher yield, to become the unsecured shareholders to the very risks which regulators sought to have them avoid. 
The post 2008 world of lower economic growth (lower interest rates require higher levels of savings to produce the equivalent unit of purchasing power and unemployment reduces end demand) creates a conundrum for Corporate America. Corporations must satisfy shareholder's preference for growth in earnings. The means to do this can crudely be divided into three means: financial engineering (M&A, Stock Buybacks), the zero sum game for the consumption dollar (assuming no population growth), or the reduction in the unit cost of goods sold. The later has been the unprecedented beneficiary of technology based productivity gains. If returns generated by these gains are greater than the gains made per additional unit of employment or bricks and mortar enterprise expansion, then it logically follows that capital will flow into this segment of a corporation's enterprise. It is my contention that the availability of cheap capital as mandated by government monetary policy, intended to spur employment thru private sector economic expansion, has resulted in the systematic downsizing of the very labor force that capital was created to support. Simply put, investing in productivity has a higher return than investing in labor, the consequence of which is systemic under- and unemployment. 
Clearly, the investment in productivity, and the readily available capital to do so, favors the largest private sector players, with the lowers percentage of inelastic fixed overhead (inelastic meaning impervious to productivity gains). These companies not only have scale to maximize productivity at the expense of labor, but also have the capacity to create accretive value for equity holders in the acquisition market by transforming smaller, less productive companies. This transformative value proposition is supported by the our Government's current Monetary and Regulatory policies. The bifurcation of the corporate have's and have-not's is the logical outcome and, unsurprisingly, repeats itself in the distribution and movement of individual wealth. So the transfer of Money from the Public sector to the Private sector in the system described logically ends in the hands of the equity holders. These unsecured risk takers reap the biggest reward per unit of private sector profit. (debt holders returns are capped in exchange for seniority and thus security, in the capital structure). This has certainly been the case since the Shift in Monetary policy which began with the Reagan era. This private sector wealth increase has disproportionately fallen in the hands equity holders who had the economic means to own disproportionate equity, or the entrepreneurs who retained it. 
It's no surprise where the money flows next, once Government Liquidity has created disproportionate wealth. Asset inflation is, at the top end of Art, Wine, Real estate, Antiquities, Gems, Precious Minerals and other scarce goods, both unprecedented and perfectly logical. These items represent real insurance against the perceived risk of the current Monetary system to the beneficiaries of that system. The misperception that these assets are "uncorrelated" adds to their cache. The cruel irony here is that correlation may not be as risky as causality. 
This all brings us around to the "1%", the "extinction of the middle class", and the way I believe we need to think about inflation. Asset inflation and wealth created by lower cost of goods sold will perpetuate the concentration of wealth gains to those that can afford investment over savings ( as a means of income replacement for those who's purchasing power is eroded by lower wages). As systematic un- and under-employment proliferate, purchasing power will be eroded for those who are victims of productivity gains. As they become less useful, their only defense is to deflate their economic value in an attempt to compete. This creates what I call "relative inflation", defined as the shortfall in purchasing power that occurs when the aggregate unit cost of labor decreases at a faster rate than the cost of finished goods. By example if todays milkshake costs $1 and I earn $1 after tax, I can buy a milkshake. If tomorrow's milkshake costs $1 and I earn $0.95, I have 3 choices if I want a milkshake; I can borrow $0.05, erode my savings by $0.05, or misappropriate the $0.05 or the milkshake its self. The poverty effect created by relative inflation will no doubt erode savings and increase crime. As regulations prevent increased borrowing by those who's wealth is eroded, few if any choices remain. 
In summary, current Government policies (both Monetary and regulatory) combined with advances in technology, have had the perverse effect of increasing the systematic unemployment and wealth gap they were put in place to address. Rather than creating a level corporate playing field, they have actually increased the too big to fail risk while shifting economic credit risk from the regulated to the unregulated. These policies force risk aversion thru the erosion of purchasing power resulting in an ever-increasing wealth bifurcation in our population.
By investing in higher education the Government can perhaps slow down the effects of productivity on systematic unemployment, but I do not believe it would be sufficient to end the cycle. Labor shortages would only be maintained at the bleeding edge of technology, where supply requires levels of understanding that may not easily be translated to mass education. 
A tighter monetary policy resulting in higher interest rates rates would negatively effect asset inflation but would benefit savers. This would be a logical way to fight relative inflation, but the economic thought consensus needed to prosecute such a policy would require a shift in economic thinking. It is my personal belief that only by understanding the interconnection of public debt, regulation and their collective effect on wealth creation and destruction, can our policy makers begin to make effective choices with intended outcomes.


Coleman said...

"It is my personal belief that only by understanding the interconnection of public debt, regulation and their collective effect on wealth creation and destruction, can our policy makers begin to make effective choices with intended outcomes."

Surely that means an examination of international balance of payments problems?

I think the bottom line moving forward is that America has to save more.

On productivity, I'm not sure we'll ever be able to nail that one down in advance.


RichL said...

A few random thoughts:
- If the 1% are investing in illiquid rare assets, but which lack cash flow, the prospects for a random markdown for no particular reason, other than the herd getting spooked, is a near certainty.
- Business processes are so much more efficient now that employment must decline. The offset is the demography of the world, where workers will get scarce as they age out of the work force. The transition will be bumpy, but folks over 55 don’t harness their anger in the way that 15 to 30 year-old males do, so political change will be slow in coming.
- When a newspaper classified ad is replaced by a Craigslist ad, the measured economic effect is a large decline in dollar transactions which can be measured in GDP, but the replacement is more efficient and not captured in the national incomes data. This is going on everywhere, and the belief in measured economic statistics is painting a false picture of what is happening in the economy.
- The same process makes industries prone to near-random obsolescence, transforming large wealth into small, yet creating large wealth in the hands of the challenger. When everyone can listen to the same music CD, rather than listen to live music- the only alternative 125 years ago- the presence of winner-take-all economics is not going to go away.

Anonymous said...

Higher education is not an asset if there are no jobs that require those skills and pay enough return on the investment. We don't lack workers with a BA in this economy, we lack positions that genuinely require those skills. In contrast, the workplace is rife with jobs that demand that credential but would never in a million years actually benefit from a worker with that level of education.

This is a deeper problem in the economy. In short, all gains to productivity have been captured by capital and none have flowed to the worker. Interest rates HAVE to rise to reflect the real risk to money invested in different ways. Asset appreciation in weird places is nothing more than distortions caused by cash chasing return. Asset appreciation in things the wealthy buy is merely evidence that there is no disposable income any more below the top quartile, at best.

I'm trained the neoclassical structure, but these are my observations from actually living this crap. My policy prescription would be to quit propping up the banks and provide liquidity directly to the people - who would USE it. Some inflation might result, but I would expect it to be minimal based on general disinflation in most parts of the economy at present.

Anonymous said...

Coleman - When I wrote this, I did leave out the role and interactions of the "global" system, and perhaps as a subconscious nod to the complexity of tying multiple interdependent policies together. Your point is well taken.

RichL - Great thoughts. I think we may be seeing some spooking at the moment. I agree with all your points, of course. I would postulate all of these, though I was careful not to speculate the future but rather form a framework to explain the present.

Jobs is a tough thing to look at because of the distortions in the specification of credentials, as Anonymous pointed out. Maybe a different way to think about productivity and "labor" is to think of each employee as self employed and the actual utility of having that person fulfill an economic role. If Trucks are automated and self drive, then the economic role of a long haul trucker is diminished (perhaps to zero) depending on his ability to compete on an economic basis using old technology + labor against new technology + labor(or lack thereof). I respectfully disagree with the assertion that Asset Depreciation is nothing more than distortions by cash chasing returns.
I see it as a complex form of insurance. Weird places become not so Weird if you buy my reasoning.

I've tried to look at behavior around me from the perspective of a rational economist ( I am not one, by profession or formal training ). I'm attracted to this way of thinking as someone who is a student of games. I believe current policy lacks sufficient respect for the gamification of capitalism.

Perhaps more thought should be focussed on reverse engineering the policies that would give us the outcomes that we want. The pharmaceutical industry has undergone as radical shift from hypothesizing the mechanism to cataloguing the interactions. I believe this method of discovery can and should be applied to economic and social policy.

Mercury said...

What I find most significant here is not the originality or validity of what your reader describes but the fact that these same assessments/complaints are coming with increasing frequency from more diverse perspectives. Welcome to life on the Red Pill.

And I know Zero Hedge gets a lot of grief in these pages but they’ve been pounding the table on these suddenly more mainstream issues for years: the nature of sound money, ineffective post-crisis banking reforms, the underappreciated risks of the massive shadow banking system, the forces of wealth concentration inherent Fed’s ZIRP and QE programs, public companies’ new preference for buybacks (etc) over cap-ex, the increased correlation of different financial assets, the death of the middle class and the failure of official stats to accurately measure the true state of inflation and employment. Who’s the Cassandra now?

The most plausible explanations/blame for these phenomena seem to fall into two categories: 1) inevitable and systemic 2) bad and/or to much central planning. The Zero Hedge school is big on #2 but there’s a lot of interesting stuff at places like FTalphaville regarding #1: the new economics of abundance, hyper-efficiency and ubiquitous technology which will soon include more AI and robotics.

Personally I’m pretty evenly divided between #1 & #2 but I’m more pessimistic about #1; that toothpaste isn’t going back in the tube and it’s likely to result in more social strife than freedom from want.

coleman said...

Anon - No offense intended with my point. Not sure if it came off that way, but rereading my comment it seems a little terse.

Where I live, the progessive policy wonks in politics publish manifestos - its supremely interesting to know the thinking of people that form governments. One (perhaps asia centric?) point that was made (by an econ phd) was that with ageing, there will be a global skills shortage that will force countries to bid for high skill labour more aggressively.

I have a theory about attachment and developmental psychology, roping in emerging neuroscience on the basis of trauma being the missing key in progressive policy. Where I am they say conservatives talk character, progressives talk opportunity. I think opportunity + unwinding the deleterious underpinnings of suboptimal personal trajectories is the future vis a vis productivity and education. Its hard to write briefly about, but I really think a future where 'low skill' is vanquished is possible.


Jay said...

Each percentage point in increased interest rates would add $177 billion to the annual federal deficit. Raising taxes or cutting spending in any meaningful way seem to be politically impossible, so we seem to be trapped in our current policy.

My guess: we muddle through until China decides they don't need US demand any more. What happens then? Don't know, but I doubt it'll be pretty.