Thinking Things Over: How Does an Economy Grow?

Thinking Things Over

Musings on the Markets from Inside the Beltway

By John L. Chapman, Ph.D.                                                                                           Vol. I, No.6  082811

In this note:

  • Bernanke’s speech on Friday at Jackson Hole, WY
  • Warren Buffett and investing in Bank of America
  • How an economy grows – and how investors secure a happier future

Next week:

  • What is “capital” – and why does it matter in terms of prosperity?

I.  Bernanke’s Speech at the Fed Meeting at Jackson Hole

Fed Chairman Ben Bernanke gave his keynote speech Friday at the Kansas City Fed’s annual meeting at Jackson Hole, Wyoming, exactly a year after announcing his second great foray into “quantitative easing” (or, “QE2”).  For the uninitiated, this is a fancy way of saying “printing money”, and there was great speculation, and near-certain prediction from insiders, that some form of “QE3” would be announced this week.  The stock market seemed to be demanding it over the last ten days, rising and falling on rumors as short term-dominated thinking on Wall Street loves easy money that flows into financial assets, thereby enriching those who work directly in the sector.

Happily, Mr. Bernanke surprised to the upside, deferring for now any further immediate moves toward more monetary easing, though leaving that option open. He further stated that economic growth was, after all, largely dependent on factors beyond the control of the central bank, and encouraged policy-makers to take various steps toward fiscal discipline and stable growth.  This was a welcome hint of humility for those of us who abhor the Fed’s “dual mandate” of price stability and increasing employment, and would prefer that Mr. Bernanke dust off his Hippocratic Oath in considering strategy for monetary policy.

Of further interest was the sharp rise in U.S. equity markets after the speech was fully absorbed, with the S&P 500 ending the day 1.5% higher, hardly the swoon anticipated at lack of QE3.  While not perhaps for the right reasons – it is possible institutional investors read into the speech that further easing is coming – we’d prefer to think that more sensible long-term thinking centered in on his admission that the Fed is very limited in what it can do to spur growth.  For it is and always has been true that the central bank, in the long run, cannot positively impact real growth and human progress, but it can cause catastrophic harm via money supply changes that lead to relative price distortions in the real economy, which in turn lead to capital being misallocated (sometimes massively so).

For all of us at Alhambra Partners, we continue to worship at the church of sound money, and hold that it alone is a near-sufficient, and certainly necessary, condition for long term economic growth that is sustainable.  Whenever we hear Mr. Bernanke even so much as genuflect in this direction, as in no news on QE3, we consider it to be good news.

II.  Warren Buffett’s Investment in Bank of America

We noted with some bemusement this week that the Oracle of Omaha, the world’s second richest man for much of the last fifteen years, invested $5 billion in cumulative preferred shares in Bank of America (BAC), just a week after lecturing his “mega-rich” friends on their duty to pay more in federal income taxes. Mr. Buffett receives a 6% priority return on his shares, callable at an attractive premium for him, and he also obtained the call option right to purchase 700 million shares of BAC common at a strike price of $7.14, for ten years. His option is already in the money as of the day of the announcement after BAC’s shares soared at the news, and the stock closed Friday at $7.76, after trading as low as $6.11 the day before the announcement.

People in our business worship Mr. Buffett, and we tip our hat to his long track record of investing success, spanning five decades, and over four with Berkshire Hathaway.  But this observer can only say to him, spare us, please, the lectures based on erroneous economics, and the platitudes about “investing in America” and a “great company” in Bank of America.  Mr. Buffett has a cachet about him now that he is clearly able to leverage: who among us could have negotiated such favorable terms for a special class of preferred shares and a ten year option for up to 7% of the company at a strike price he knew would be in the money the moment this went public?

And we look askance at the fact that this is now the third recipient company of federal  bail-out money for Mr. Buffett, after General Electric and Goldman Sachs, both of whom offered him ten percent preferred shares, and calls at guaranteed attractive returns.  The cynic in us says that Mr. Buffett has correctly adduced that too-big-to-fail is still alive and well under President Obama, with whom Mr. Buffett not so coincidentally spoke right before the deal’s announcement this week.  We’re not in any way suggesting any even implicit guarantees were made to Mr. Buffett, but only the naïve think that BAC would not be bailed out if it came to that, and preferred shareholders of course are prior to common.

We long for an end to an economy so steeped in moral hazard and cronyism, and pray, indeed, that this becomes an election year issue, as we need to have a national conversation about this in the United States. Meanwhile, we would politely suggest to Mr. Buffett that if he wants to show unambiguous faith in the American economy or in any individual company, that he buy common shares with the rest of us – and he can feel free as well to unilaterally remit a much higher share of his income or capital gains from said purchases to the U.S. government at any time.   

III.  How Does an Economy Grow?  Thoughts on Strategy to End Our Current Economic Torpor

The U.S. economy is plainly in trouble, and has been throughout this two-year old “recovery”.  2nd quarter growth was revised downward to 1.0%, after 0.4% in the first quarter.  The University of Michigan’s monthly Consumer Sentiment Survey came out Friday and is now at its lowest level since November 2008 – not a good month, as readers here recall. Nina Easton writes in the latest Fortune that over 6.2 million Americans have now been unemployed for a year or more (we haven’t dug through the primary source data for this but trust her due diligence, so cite her here), which is both emotionally demoralizing and terribly detrimental to skills.

Perhaps the most disturbing data point of all however is the second quarter earnings report from Wal-Mart (WMT). While profits were up 5.7% year-over-year and the firm raised near-term guidance on earnings, same store sales have declined now for nine consecutive quarters in the United States. In an internal company survey of customers, Wal-Mart found that 40% of its customers were holding off or had already eliminated the intent to buy things they want or need, such as consumer durables. And 15% of Wal-Mart customers were from households that had “recently” experienced an involuntary job layoff.

That this iconic consumer goods giant, which now captures 10% of all non-automotive retail dollars in the U.S., has evinced such disquieting customer data for this extended a period is disheartening, but indicative of the times. And it is not unrelated to corporate America’s sitting on the sidelines with over $2 trillion in liquid assets, or the Fed’s holding of $1.6 trillion in excess reserves from the commercial banking system in the U.S, or the moment to moment volatility on a confused and very uncertain Wall Street – all of which more than explains the inability of 20 million Americans who want to work to remain sidelined, with several million more in part time underemployment.

And all of this, too, leads to non-stop chatter in American households, on golf courses, in board rooms, and even high school class rooms: how can we, quoting our favorite Democrat President of the 20th century, John F. Kennedy, get this country moving again? And indeed, the world economy?

Various Alhambra Partners publications will be addressing this question at length in the months ahead, as we assure our clients and readers we spend a lot of time thinking about this from every angle: we have long maintained that there is nothing fundamentally wrong with the US economy that better policy will not quickly cure.

But the short answer to this question was summarized neatly in Friday’s Wall Street Journal, where Steve Moore has written a useful comparison of Reaganomics and Obamanomics after 30 months of activated policy for each.  For in describing the very different approach Mr. Reagan took from that of his current counterpart, we find the crux of our answer.

President Reagan understood that the U.S. economy is composed of literally hundreds of millions of individual and corporate agents making literally trillions of decisions every day.  All of these agents have one thing in common: they seek to acquire or accomplish their ends facing pervasive scarcity of the means to acquire and accomplish, and a correlative scarcity in desired end goods (or states) themselves.  Further, the knowledge of how best to make use of these scarce societal resources is embedded in the trillions of decisions made every day, based on unique skills, reasoning, wisdom, obtainable relevant information, and “know-how’ possessed by these hundreds of millions of agents, all of whom also were uniquely endowed with knowledge and insights about local market conditions and consumer demand.

Mr. Reagan reasoned, conversely, that no central planning bureaucracy in Washington, D.C. or anywhere else could ever hope to substitute for this matrix array of knowledge and skills, dispersed across the country and indeed, the globe.   So as a general matter, he rejected any primary role for government other than that of limited “umpire” in the production of the goods and services that bring us life, and wished to empower and incite these hundreds of millions of people to pursue their designs unfettered by the government.

Mr. Reagan had one other core belief where the policy options to induce economic growth are concerned: he rejected the proposition so often made by elected officials that they can “grow the economy”.  Rather, the economy grows.  And it grows – that is to say, prosperity is brought about – by increasing the supply of goods and services available to us all.  This is a critical point to understand: by contrast, Mr. Obama asserts that he can “grow the economy” by inciting demand via increasing spending – by the government where needed.  President Reagan rejected this: he understood that production is the source of demand, and that we produce in order to consume.  Mr. Reagan recognized, and would tell President Obama today, were he alive, that the Obama policy mix is a giant error of confusing cause with effect. Spending can only result from prior production that has generated income.  To allow the government to borrow (or debase the currency via inflation) in order to spend merely commandeers resources from the private sector and redirects them: no new wealth, the “stuff” which confers both progress and enjoyment of life for people, is created via government spending.  At best therefore government stimulus is neutral in its effects, and likely wasteful and thus harmful, for reasons of mal-directed resources, unfounded and unsound investment, and the moral hazard associated with the rent-seeking – that is to say, “cronyist” and self-aggrandizing – behaviors induced by government dispensing spending power or resources to favored recipients.

For Mr. Reagan, what this reduced to was a policy mix designed to induce maximum production – that is, supply of goods and services:

  •  Tax cuts as incentives to increase work and output, raise incomes, and induce hiring.
  •  Government spending cuts to ensure that the maximum leeway for deployment of society’s scarce resources was left to the millions of economic agents who best knew where the unmet needs were, and how best to use these scarce resources
  • Sound money, to encourage saving, capital accumulation, and long-term investment, by reducing
    uncertainty about  currency value in the future as well as ensuring an ability to accurately price goods and account for profit and loss (which in turn allows for judicious use of society’s scarce resources – sound money, in short, ensures that optimizing decisions are being made with scarce factors, and that waste is avoided).
  • Unrestricted trade with nations anywhere and everywhere, to foster lower consumer prices, wider array of goods, and specialty in production globally, which encourages a better division of labor as well as higher productivity
  • Reduced regulatory burdens, to cut through “red tape” and allow entrepreneurs to focus on business
    creation and expansion

This is the formula for strong and sustainable growth which the world needs to rediscover, to end the current torpor.

Unfortunately, in all five areas current policy points the other way: taxes are set to increase, which will discourage production, work, and investment. Government spending has of course exploded, and with it has come all the usual waste and distortions, not to mention criminality. The Federal Reserve has made an explicit effort to debase the dollar for years now, with disastrous consequences for investment in the U.S.  Trade agreements have stalled, and regulation of the private sector has increased dramatically in recent years, to the point of stifling companies like Boeing, which seeks to start a nearly-built new factory in South Carolina (after sinking a billion dollars into this new facility there and already hiring over 1000 workers) but cannot due to a fight with Mr. Obama’s National Labor Relations Board, which is bothered by Boeing’s lack of unionization – never mind that the workers there do not care about this, and want to begin working!

In the coming months we will have much more to say about this. But the uncomfortable truth is that for now, policy seems little likely to change, bringing no relief to millions who live in fear of a tougher future now that is infected with policies that are wholly antithetical to jobs and wealth creation.  And the further uncomfortable reality is that there can be no real boom in U.S. equities until this policy mix changes.

Mr. Chapman is chief economist at Alhambra Investment Partners, and director of research at Hill & Cutler Company in Washington, D.C.  He and Alhambra founder Joe Calhoun are writing a book on investing and capital preservation in the current turbulent era.   

4 Responses to Thinking Things Over: How Does an Economy Grow?
  1. I can agree with some of the conclusions you have reached in this article but I think you are making some important misstakes as well.
    First you cannot compare the type of recession that we had during the Regan years, one caused mainly by the FED to bring down inflation to the type we have now which to a large degree is caused by debt overhang. This also means that policy should be very different.
    Secondly the type of problems we have in the american economy now were built up during years of bad policy as well as bad decisions by orivate companies and that this situation could be solved quickly by simply instituting some classic supply side economic measures I find rather simplistic.

    I should after this add that I do like your writing even though we approach the field from different sides.


    • John L. Chapman
      August 30, 2011 at 1:36 am

      Eric I very much appreciate your comments and your interest in Alhambra Investment Partners. You and I definitely agree that the problems we are facing now are of long origin, due to errors causes by people in both major political parties, and will be solved only with better policies that will take time.

      And I certainly do agree with you that there were some different aspects to the Reagan era recession (1981-82) versus today’s challenges. You are quite correct that the debt overhang today is more severe than it was then. Your thesis is indeed becoming a favorite in the mainstream of the economics profession, and in the corridors of elected officialdom in Washington DC. I would commend to you the name of Richard Koo if you have not heard of him: he has been the biggest advocate of this idea of a recession due to deficient aggregate demand, and the one we are suffering from now, due to balance sheet leverage.

      I have studied Koo closely and certainly it is hard to argue with his description of the distinctions per the above two ‘recession types’.

      But at the end of the day, I just do not think it is anything other than a distinction without much of a difference. The challenge Reagan faced WAS severe: 20% interest rates, rising inflation to low double digits, capital flight, mal-investments that had to be liquidated due to the inflation, and importantly, unemployment that peaked at 10.8% and declining real wealth of most Americans. It was a fairly *miserable* time.

      Further, for me, the *origin* of trouble for both WAS the same: monetary mismanagement, via credit inflation, that had distorted the real price structure of the economy and thus led to many erroneous investment decisions that later had to be liquidated. There was also an undercapitalized and over-levered banking system then as well — who can forget Penn Square, Continental Illinois, et al.?

      I would close by saying to you, what is “truth” in economics is universal, and time- or circumstance-independent. So a policy of sound money to promote savings, capital accumulation, and long horizon investment, along with clarity in asset pricing, is *universally* and *eternally* the correct policy. (This is not to say the Fed would never conduct easing in my preferred world, as shifting money demand may necessitate that; but as long as we have a Fed, we can address this via rules that are known and not altered). Similarly, a policy of low marginal tax rates on after tax income and capital wll induce the work and saving and investing we need to rejuvenate this economy and get trillions in cash off the sidelines and into production. That is always and everywhere true. A policy of less intrusive and more business-friendly regulation, one that prohibits fraud or theft but other than this leaves contractual bargaining between buyers and sellers, is *always* optimal. Unrestricted trade between nations is always preferred. And so on.

      So, yes, I do assert that the Reagan formula was, and would be again, the correct one, given our current challenges, but I’d love to hear your thoughts — I live in Washington DC and all I do is hash all these issues out, and try to understand what it all means for investing, all day long! Meanwhile, I hope you will keep reading our output, and commenting as able. Thanks again for your interest in Alhambra Partners, and if we may ever help you with anything, please let us know!

  2. I’m not an economist; I’m an average American worker and taxpayer. Actually – wait a minute – I think that makes me an economist at the micro-economic level Dr. Chapman refers to. And so this very average American would like to say that one thing should be evident in any study of economic theory or results – that while we may individually make decisions that are at any given moment wrong, or wrongly-motivated, in aggregate and over time the collective weight of all such decisions by all American taxpayers is correct. Vox populi, vox Dei. I have more confidence in the aggregate decisions by my fellow American taxpayers than I have in all the members of this – or any – administration taken together. In fact, my trust in this administration is ridiculously low, because very few of them have ever been in a position to have to make a decision that would determine if a company succeeded or failed, or if even a small investment was wisely managed.

    Somehow we have an uncanny instinct for that which is right, and that which is wrong. It would be better for this country if our leaders would show more confidence in US and less confidence in their own arrogance. Sadly, that isn’t going to change. So we simply have to exercise the one right they can’t influence – the right to remove them for the prospect of finding someone else who will adopt that attitude. We may not find a Ronald Reagan, but perhaps we can find enough of an anti-Obama to avert disaster. My sense, shared by many with whom I speak, is that we haven’t much time left.

    Thank you for a cogent and thoughtful article. I look forward to reading more.

    • John L. Chapman
      August 30, 2011 at 3:23 am

      Rick thanks very much for your thoughts, and thanks as well for your interest in Alhambra Partners. We hope you will become a “regular” here as we are ramping up research output, and that for commentary as well.

      As to the substance of your comment, I cannot but agree with you. As you can appreciate, in our business, we tend to steer clear of politics; our job is to read the trends and forces shaping the macro-economic landscape and deploy our clients’ funds where we see the best chance of capital preservation and upside gain…..regardless of what elected officials are in place in governments around the world. Nonetheless, while we take the political actors as a “given”, your observation is correct. Our firm is headquarterd in Miami, and we have staff in Denver CO as well, but I myself live in Washington DC, so I have had the chance to meet a great many people who work in the present Administration. I’m afraid the dearth of business experience, and especially with P&L responsibility, is staggering in its effect. Because so many of these policymakers have no prior business experience, and the President himself spent less than one year with a for-profit consulting firm — the only time he has ever worked in the for-profit sector, I am afraid you are correct that they cannot be expected to do the right things regarding growth.

      I’m afraid we will muddle along, into next year, and we will hope for a good national discussion and referendum on these current policies, versus those of Mr. Reagan, next November. Meanwhile, thanks for reading and please come back!
      Washington, D.C..

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