In 1989, the second installment of the Back to the Future trilogy came out. I still remember dreaming of owning Marty McFly’s hoverboard. Biff Tannen’s hoverboard was unsafe, obviously. And then, there was the garbage-powered DeLorean:

Savings Equals Investment

In my last post, we discussed the importance of saving in determining where we are in an economic cycle. Typically, high savings rates precede economic expansion, and low savings rates precede economic contraction. However, it isn’t quite that simple. It should be, but it isn’t.

The reason savings rates are important is because savings become investment. Savings are the source of real wealth accumulation in an economy. The more people save, the more real wealth is available for investment in new companies and innovative projects that improve productivity. When less savings is available, it leads to a lack of available credit, less entrepreneurial innovation, and slower growth. This also typically leads to poorly run companies failing when their profits decline and they can’t survive without additional credit (i.e. debt), which is no longer available. This what drives the business cycle, and it is how a healthy market-driven economy should work.

Remember, I said should.

But “should” and “is” are two different things. DeLorean’s are still not cool and they don’t run on garbage. But, to complete the analogy, that won’t stop some people from throwing banana peels in the gas tank anyway.

Garbage in Garbage Out

Modern America is not a purely capitalist economy. It has capitalistic undertones, and certainly veins of capitalism run throughout. However, our system as a whole suffers from capitalism’s similarly-looking but evil kid brother: crony capitalism. Cronyism is the practice of big corporations using government power to manipulate markets to their benefit (and the benefit of the politicians they support). This is done through tariffs, licensing requirements, subsidies, increased regulations, and many other even more creative ways.

Enter the Federal Reserve System. Readers of this blog know full-well the Federal Reserve is not only itself a crony, but it’s actions provide the ammunition by which cronies from other industries can do their cronying. The Federal Reserve, of course, controls our nation’s money supply. Money is a kind of proxy for wealth, or at least it is perceived as such. When the federal reserve decides to increase the supply of money in the economy, it has the mimicking effect of a rise in savings. The only difference is that it isn’t real savings.

The federal reserve just prints money out of thin air. But although it’s fake wealth, it’s real money. The real money printed out of thin air is given to banks who lower interest rates because they are flush with cash. This sends signals to entrepreneurs and business owners that the economy is doing well (because an increase in credit is supposed to be from real savings). Businesses then assume there is, therefore, a likely increased demand for whatever services they wish to provide. It’s sort of like having your gas tank full of Doc’s “fuel”. It says it’s full, but…

Ka-boom

So what do business owners do? They take out additional credit to expand. Only, they are expanding their business because fake wealth is masquerading in real money’s clothes. Sure, Doc’s fuel filled up your gas tank. Sure, you may have pulled out of the driveway and driven down the street. This can go on for a while, but sooner rather than later the tin can blows up your engine.

When we take into account the low savings rate, along with the Federal Reserve’s recent move to raise the interest rate on excess reserves, we have both the real and fake wealth diminishing. To make matters worse, the FED is now preparing to punch the DeLorean’s gas pedal. They are now selling their holdings of treasury debt in order to reduce their balance sheet and plan to increase the pace throughout this year. This has the effect of rapidly taking away the real money (i.e. fake wealth) that has goosed the economy to its present levels. This like taking a needle to the proverbial bubble. Pretty soon, investors will realize what is happening. When they do, they’ll be like Biff Tannen, exclaiming “Why don’t we make like a tree…and get outta’ here!”

Why does this matter?

Like we learned through the tech bubble in 2000 and the credit crisis of 2008, a healthy economy needs good fuel to run. What we have today is not only a uncool DeLorean, but one which our ‘wise’ leaders have decided to pump full of garbage. We may be humming along just fine right now. We may even get another mile or two down the road. But one thing is certain: at least for the U.S. economy, we are going to need some engine work before too long. It’s important that your current investment portfolio reflect this reality.

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