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.