“Now look at them yo-yo’s that’s the way you do it
You play the guitar on the MTV
That ain’t workin’ that’s the way you do it
Money for nothin’ and your chicks for free”
Dire Straits, Money for Nothing, 1985
In the real world, there are no free lunches. There is only your lunch, or someone else’s. And contrary to popular perception, this includes the Federal Reserve’s all-you-can-eat buffet, where you get your money for nothin’ and your checks for free.
Dire Straits
In response to the appearance of COVID-19, governments around the world have intentionally shut down much of the economy. In the past few weeks, we have begun to see the impact of the government shutdowns. 30 million Americans have filed for unemployment, pushing the rate of unemployed to levels last seen during the Great Depression. Initial estimates have GDP contracting nearly 5% in the first quarter. Projections for the 2nd quarter are in the range of 20-30%. The financial markets have been volatile, rebounding from their lows in recent weeks but remaining 10-15% below the highs in February.
As a result of deteriorating economic conditions, the Federal Reserve promised to spend $4 trillion to provide “liquidity”. That is, the Federal Reserve is buying all kinds of securities with newly created digital money. At the same time, Congress approved the ironically named “CARES Act” in which it courageously spent $2.3 trillion of money that its citizens will have to pay back. The experts clearly think spending money will solve our severe economic problems. Sadly, it will only make things worse.
Look at them yo-yo’s
The biggest economic problem we are facing right now is a lack of production, both in terms of goods and services. Since the west essentially shut down in mid-March, global composite indexes (a measure of economic production) have plummeted.
Without production, consumption cannot take place. Impoverished areas of the world don’t need to spend more on Amazon.com to become wealthy. They need to sell things on Amazon. They need to produce things that other people want to buy. Wealth is a consequence of production, not consumption.
Significantly, the government’s reaction to the viral outbreak has been to shrink production everywhere. At the same time, the Federal Reserve declared it has an “infinite” amount of currency to support the economy. As one fed governor put it, “we create it electronically.” And to prove their point, the US government created $6 trillion of programs in just the past several weeks.
To summarize, the government is simultaneously shrinking production and increasing the amount of money in the global financial system. This extra currency does not create extra wealth, because currency isn’t wealth. Rather, it does one of two things, both of which are bad. If the currency sits in the federal banking system (and much of it will), it becomes nothing more than unproductive government debt. Government debt becomes a drag on economic growth and a weakening private economy. In our current environment, this leads to lower rates, lower growth, and lower productivity. If the extra currency gets into circulation (as some no doubt will) it will lead to a rise in prices of assets and other consumer goods. All this means is that the government ‘stimulus’ leads to lower growth and a devaluing of the US dollar. The checks may be free, but the price is steep.
Theft by any other name
“Your silver has become dross, your choice wine is diluted with water. Your rulers are rebels, partners with thieves; they all love bribes and chase after gifts.”
-Isaiah 1:22-23a
I admit Isaiah’s words are a bit archaic to our ears, but they are nonetheless relevant. Dross is a word for the impurities that are cleansed from gold and silver and other precious metals. Normally, the dross is removed by fire to make the gold or silver pure. In Isaiah’s day, however, the government officials of Israel were doing the opposite. They were mixing a little silver with dross to continue paying for things they simply couldn’t afford. This was a form of inflation.
Governments are not benefactors. They only provide what they first take in taxation. Taxation can come in one of two ways. Either the government will extract the money directly from citizens, or it will create counterfeit money. While both options are taxation, both are perceived and accounted for in radically different ways. Income taxes, at least in our modern iteration, is levied in such a way that the wealthier pay more. Inflation, however, taxes people in almost the opposite way. As the price for everyday goods rises, those with the least amount of discretionary income are squeezed the hardest. Conversely, the wealthy benefit from the general rise in prices as their property appreciates and their debt obligations diminish. The wealthy suffer too, but to a far less degree.
The prophet Isaiah says that rulers who devalue their currency are “partners with thieves”. So far, Congress and the Fed have added close to $20k per person to the national debt in just the past two months. We and our children are on the hook for this debt in some form or another. Yet the government only managed to get $1200 to each adult American. The rest, no doubt, will find its way onto the balance sheets of large corporations and banks. These companies, in turn, provide generous donations to re-election campaigns. Isaiah was right – our rulers are partners with thieves. They love bribes and chase after gifts.
This is not the way you do it
One of the most common misconceptions in financial media is that “the consumer is 70% of the economy”. Many analysts and government officials take this to mean that if the economy slows down, it is because spending slowed down. This leads them to conclude that giving away money or making money easier to borrow (by lowering interest rates) will help grow the economy. If consumption is 70% of our wealth, we should encourage spending to spur economic growth.
Not only is this logically incorrect, but it is also statistically incorrect. It’s intuitively obvious that individuals do not become wealthier by spending beyond their means. In fact, that’s how they become impoverished. People become wealthier by earning more than they spend. Poverty results from a lack of production, not a lack of consumption.
Consumer spending does indeed equate to about 70% of Gross Domestic Product (GDP), which most people equate with “the economy”. But GDP measures the final sales of goods and services (i.e. final spending). It does not consider all the intermediate processes of businesses and producers. Millions of intermediate business activities that add wealth to our nation are not included in GDP.
If you doubt me, just try to go find a simple pencil growing in the wild. Pencils don’t grow on trees, as they say. They require many different steps, including excavating the lead, manufacturing the rubber eraser, harvesting the lumber, and then assembling all the pieces together. To count just the sale of a pencil in GDP is to miss all those intermediate processes which contribute to overall wealth.
Thankfully, the Bureau of Economic Analysis (BEA) provides a good measure of all these intermediate activities. Gross Output (GO) considers all the stages of production. According to GO, consumer spending is only 35% of the economy. This means that statistically speaking, production is about twice as important as consumption. Or to put it another way, producing a pencil increases wealth, which allows someone to buy it.
Source: https://grossoutput.com/gross-output/
Why is this important? Because everything the government is currently doing flies in the face of this simple fact. Handing out money to people won’t help them if they ain’t workin’. We cannot increase step 4 above if we are not doing steps 1-3. We need America to get back to work to produce goods and services. The longer these shutdowns last, the more severe and prolonged the damage will be to our well-being.
Investment Implications
“The first panacea for a mismanaged nation is inflation of the currency; the second is war. Both bring temporary prosperity; both bring a permanent ruin. But both are the refuge of political and economic opportunists.”
-Ernest Hemingway, “Notes on the Next War: A Serious Topical Letter,” Esquire, Sept. 1935
It’s important to understand the investment implications of both the economic turmoil and the government responses. Plan Financial always maintains a well-diversified portfolio for our clients. However, we are repositioning for what is likely to be a volatile period in major asset classes. Prices in stock, bond, and real estate markets will likely decline as economic conditions deteriorate and various credit bubbles deflate. Safe assets, such as US treasury bonds, will likely continue to do well as the economic situation worsens. Expect lower prices and probably lower wages across a host of various goods and industries over the next 12-18 months.
Beyond the immediate crisis, however, we see a different landscape. At some point, the monetary madness and lack of productive investment will lead to higher rates of inflation. Oil, having briefly hit -$40 per barrel in the futures market, is a good example. The price of oil went down and is likely to stay down for several months. But as the old saying goes, ‘the cure for low oil prices is low oil prices’. At some point, the damage to the productive side of the industry will show up bankruptcies. Fewer producers mean less supply. And finally, less supply means higher prices.
This doesn’t just apply to the oil market. Lots of industries – from farming to finance to manufacturing – are going to experience lower productivity. Combine the lower supply of various goods with the creation of trillions of new dollars, and rising prices looks inevitable. In an environment of both monetary inflation and financial instability, the world’s oldest and most stable store of value is likely to do well. For this reason, gold is an important component of a well-diversified portfolio.
There is, admittedly, a lot of uncertainty in the markets. The true damage of these lockdowns to the global economy is yet unknown. What happens this summer when businesses reopen is any one’s guess. Whether COVID-19 will come back for a “second wave” in the fall is to be determined. Who wins the White House in November is up in the air. But one thing is certain: the government will continue to provide money for nothing and checks for free. You can take that to the bank.
A Post-Script Note On Governance
Benjamin Franklin once said, “Those who would give up essential Liberty, to purchase a little temporary Safety, deserve neither Liberty nor Safety”. Franklin originally penned that statement while defending the liberty of government to tax its citizens – something I find quite humorous. Franklin viewed the security of the nation as aligned with the liberty of its government to exercise authority.
Of course, in one sense that is true. The more liberty a government takes in expanding its power and influence, the more “secure” the nation is likely to be – at least from the perspective of government officials, of which Franklin was one. Those who love power like to make sure things are working just as they think they should. And in order to ensure their plans succeed, they need to ascribe to the governing institutions as much “liberty” as possible. In a multitude of ways, the casualty of those expanding government liberties is the rights of individuals.
Franklin, speaking as a government official, failed to see the irony – this statement applies more to individuals than it does to governments. The more liberty a government assumes to itself, the less liberty its subjects retain. But, as our founding documents point out, our liberties are given to us by the Creator. Governments do not grant us rights – they are only established to protect them.
Why is this important?
For weeks governors and mayors across the United States have asserted their authority to shut down businesses and force people to stay home. With the best of intentions (to protect us from a serious viral threat), they have expanded their liberty to provide for our safety. They see no conflict between the two. Franklin – in many ways a champion of individual liberty – may well be rolling over in his grave, but he only has himself to blame.
The American people have a slightly different perspective on these shutdowns. We see these actions by government officials as having taken away our essential liberties to provide us with a little temporary safety. Some Americans are pleased with the trade-off, some are indifferent, and some are appalled at the constitutional violations. But what isn’t being discussed is a more fundamental principle in this debate; namely, a question of the ultimate purpose of civil government.
Is the civil government’s role to be a threat to those who violate other people’s rights? Or is the civil government supposed to regulate all kinds of activities in order to prevent the possibility of our rights being violated? The way in which each of us answers these questions will determine a lot about our conduct as citizens. Franklin no doubt was in the former camp in many respects. And yet, he saw the liberty of good governments as harmonious with the security of a free society. He, of course, lived in a different world, where perhaps that synergy was more common.
Good government or not – and being no civil servant myself – I beg to differ with him on this issue. Real-world examples may help or hurt one’s case, but I am concerned with the principle of the thing. If we as citizens are willing to trade our liberties for a little security – no matter the issue at hand – we are likely to end up with less of both. And, as Franklin said, we would deserve it.