Implicit in much economic comment of late is the assumption that, although the key monetary and fiscal policy decisions of recent years may fail to quickly restore healthy, sustainable economic growth, they are, at least, a way of buying time and that, eventually, things will improve of their own accord. A look through Frédéric Bastiat’s ‘broken window’ exposes this view as both deeply flawed and dangerous: flawed because it fails to consider the impact of policies on both the ‘seen’ and ‘unseen’ economy; dangerous because, if policymakers keep mucking around with the marketplace, the economy will not only fail to improve sustainably on its own; rather, it will descend into a vicious spiral of stagnation, capital flight and eventually an outright decline in living standards. Investors need to prepare for the challenges associated with a potentially static or shrinking economic pie.
How to Observe the ‘Unseen’ Economy
19th century economist Frédéric Bastiat was a great economist and also a great writer. It was he who penned the famous ‘broken window’ fable which is perhaps the most common-sense expression of the fundamental economic topic of ‘opportunity cost’ that is, the cost of forgoing one action in favour of another. For those not familiar, here it is:
Have you ever witnessed the anger of the good shopkeeper, James Goodfellow, when his careless son happened to break a pane of glass? If you have been present at such a scene, you will most assuredly bear witness to the fact that every one of the spectators, were there even thirty of them, by common consent apparently, offered the unfortunate owner this invariable consolation—"It is an ill wind that blows nobody good. Everybody must live, and what would become of the glaziers if panes of glass were never broken?
Now, this form of condolence contains an entire theory, which it will be well to show up in this simple case, seeing that it is precisely the same as that which, unhappily, regulates the greater part of our economical institutions.
Suppose it cost six francs to repair the damage, and you say that the accident brings six francs to the glazier's trade—that it encourages that trade to the amount of six francs—I grant it; I have not a word to say against it; you reason justly. The glazier comes, performs his task, receives his six francs, rubs his hands, and, in his heart, blesses the careless child. All this is that which is seen.
But if, on the other hand, you come to the conclusion, as is too often the case, that it is a good thing to break windows, that it causes money to circulate, and that the encouragement of industry in general will be the result of it, you will oblige me to call out, "Stop there! Your theory is confined to that which is seen; it takes no account of that which is not seen."
It is not seen that as our shopkeeper has spent six francs upon one thing, he cannot spend them upon another. It is not seen that if he had not had a window to replace, he would, perhaps, have replaced his old shoes, or added another book to his library. In short, he would have employed his six francs in some way, which this accident has prevented. [1]
In other words, following the destruction of the window, the economy is left with less wealth overall—it has one less window—despite an equivalent amount of work being done. The work of repairing the broken window is work which could have been put to making a new window for someone else; or put to any manner of other, ‘unseen’ uses. Naturally, we would all choose more wealth for less work, rather than less wealth for more.
What holds true for all individuals must also hold true for society at large: Government projects may appear to create ‘seen’ work, but only by diverting ‘unseen’ work from other, private-sector projects instead. Some government programmes, however, involve actually destroying existing infrastructure and then replacing it (eg ‘Cash for Clunkers’). Again, this creates ‘seen’ work but diverts ‘unseen’ work. Good economics must incorporate the opportunity costs of such actions.
The problem with modern, mainstream economics, however, it that it is now so thoroughly overrun by the never-ending assault of statistics and equations that its common-sense supply lines have been severed. Cut-off from common-sense assumptions, some mainstream economists go so far as to advocate a form of ‘militant Keynesianism’ in the misguided and also morally repugnant view that somehow destroying countries and then rebuilding them is stimulative of economic growth and, hence, is sensible economic policy. One read of Bastiat and such nonsense becomes so obvious that there is no need to employ a single statistic or equation to refute it (although it could and should be refuted on moral grounds regardless).
Looking Through the Broken Window
Let us now peer through Bastiat’s broken window at the current economic situation. As we know, the recent poor performance of the US and many other developed economies is the result of the massive boom-to-bust cycle that began in the mid-2000s which is itself the indirect result of the US Fed’s decision to hold US interest rates at extraordinarily low levels for a sustained period of time. There were other contributing factors, to be sure, such as sharply expanded US housing subsidies (eg Fannie, Freddie) and mercantilist exporting policies in China and various other developing economies around the world. Yet neither housing subsidies nor mercantilist policies could have had anywhere near the same overall economic impact had Fed monetary policy not enabled them in the first place. [2]
Now the Fed of course has, continues, and no doubt will continue to deny this for at least as long as it remains under the current leadership. Official Fed excuses have ranged from “We couldn’t possibly have seen this coming,” to “There is just no connection between our monetary policies and the boom and bust cycle(s) of recent years.” Both types of excuses are demonstrably false.
The first one is demonstrably false because so many economists predicted precisely the sort of bust that was coming (although they were not always correct in their estimated timing). Now, to be fair, most of those prescient economists reside outside the economic mainstream. But consider: The economic mainstream is, not coincidentally, largely Fed-trained and Fed-associated! How is that? Because most US university economics departments are run by professors who have either worked for the Fed at some point in their lives or have been associated of Fed officials at one time or another. Indeed, the Fed’s capture of US (and even foreign) economic academia is breathtaking in scope, as pointed out in a Huffington Post study back in 2009. [3]
As for the second, it is easy to show the historical connections between interest rates, money and credit growth, and boom and bust cycles. However, as the Bernanke Fed doesn’t really care much about money and credit growth, focusing rather on the estimated rate of consumer price inflation (CPI), it fails to see such connections.
At least two Nobel laureates in Economics would beg to differ. The late Milton Friedman reminded the profession that “Inflation is always and everywhere a monetary phenomenon,” by demonstrating a link between money growth and prices. Thomas Sargent has shown in his research that particularly large increases in consumer price inflation, including the dreaded hyperinflation, ultimately derive from large increases in government fiscal deficits (as these are eventually monetized).
In my own view, there is a simple way to connect fiscal deficits, money and credit growth and consumer price inflation. To paraphrase Charles Dickens, “Consumer prices are inflation past. Money and credit growth are inflation present. Fiscal deficits are inflation future.”
By focusing on ‘inflation past’, the Fed is steering the economy along a perilous road while looking through the rear-view mirror. Common sense informs us that this can be rather dangerous (and in case I’m mistaken, this qualifies as ‘reckless driving’).
We don’t even need to look through the broken window to see much of the damage that the Fed has wrought. While the CPI may be close to the Fed’s target—gee, isn’t that nice?—the US economy is performing poorly. Following the horrific recession of 2008-09, GDP growth has remained far below that of past recoveries (if indeed one can even call recent economic performance a ‘recovery’). Jobs growth has been nearly non-existent and millions of workers have now dropped out of the workforce. The housing market has yet to recover. By some measures, house prices have now fallen back to where they were in 2002, before the housing bubble began to form.
2002! Think about that for a minute. That was a decade ago! The stock market has not fared much better. Asset prices in general have not risen for a decade. And what about incomes? Well, outside of the relatively unproductive public sector, where pay rises and generous, guaranteed pensions and other benefits are practically mandated by law, median income growth has stagnated. Yet the cumulative increase in the CPI over the past decade has been 28%, implying a dramatic decline in living standards.
So let me get this straight: Over the past decade, the wealth of the country has failed to increase and real, inflation-adjusted incomes for most have decreased. A lost decade. What on earth caused this? Was there a major war? A series of natural disasters? Did Bernie Madoff make-off with even more than we know? Where, oh where has all the hard work of the past decade gone?
Well, looking through the broken window, what do I see? I see empty McMansions and other, more modest homes. I see empty retail and other commercial space. Where McMansions and other homes are occupied, I see multiple flat-screen televisions and other electronic and white goods made in faraway countries many Americans can’t find on a map. I see all manner of stuff produced elsewhere that Americans have consumed. In the driveway or on the street, I see car after car, many quite new, the result no doubt of that ‘Cash-for-Clunkers’ subsidy to the foreign and domestic auto industry and, of course, leases, a form of debt.
Guess what folks: That is where your hard work went. Instead of building row after row of fancy, overpriced homes, we could have built factories incorporating cutting-edge technologies to make goods for consumption at home and export abroad. With the incomes from the jobs so provided, we could have built much new transport and other infrastructure and upgraded that in need of modernisation. And guess what else: We could have saved. We could have paid down debt. WE COULD HAVE DE-LEVERAGED RATHER THAN LEVERAGED OUR ECONOMY! The cumulative opportunity cost of our boom-to-bust binge is so unbelievably large it boggles the mind. And we have hardly begun to pay the ultimate cost of these monumental misallocations of resources: The trillions in bailout funds now floating around the world as US Treasury securities represent a claim on future taxes that are going to have to be paid by US households.
Yes, through the broken window I see American families who have not only mortgaged their homes, but their children’s futures. In fact, given the colossal size of the sums involved, even the grandchildren are going to be on the hook. Just how do you think the as yet unborn are going to feel about being taxed for the misdeeds of their grandparents? Well they won’t be happy about it, I assure you. What they do about it is going to be rather interesting, to be sure, for those of us still around to see.
‘Financial Repression’ As Seen Through the Broken Window
Carmen Reinhart, research fellow at the Peterson Institute and a former Fed economist, re-introduced the term ‘financial repression’ to the economic mainstream in a 2011 paper titled, The Retirement of Government Debt. In this paper, she defined financial repression as:
[A] way of describing emerging-market financial systems prior to the widespread financial liberalization that began in the 1980s. However, as we document in this paper, financial repression was also the norm for advanced economies during the post-World War II period and in varying degrees up through the 1980s.
Ms. Reinhart then goes on to describe the ‘three pillars’ of financial repression:
- Explicit or indirect caps or ceilings on interest rates, particularly (but not exclusively) those on government debts.
- Creation and maintenance of a captive domestic audience that facilitates directed credit to the government.
- Other common measures…are (1) direct ownership of banks and (2) restricting entry into the financial industry and directing credit to certain industries. [4]
More recently, Ms. Reinhart has written a brief article updating the methods of financial repression observed today and speculating about those that might be employed in future. In general, she sees financial repression becoming more widespread, more pronounced and more varied in terms of methods and instruments employed. There is little in the article with which I would disagree. [5]
That said, I would like my readers to consider what both the original paper and the article do not say. For all the detailed discussion of financial repression, she neglects to peer through the broken window to survey what effect it has on the economy.
Let us take each of the ‘three pillars’ in turn. First, we have already seen the damage that can be caused by keeping interest rates artificially low. If we are now going to see even more aggressive measures to keep interest rates low, then unfortunately we are going to suffer further associated economic agony in future.
Moving on to pillar two, given the massive relative growth of the government sector in recent years, I would be concerned by policies which are now going to channel even more resources away from the private and into the public sector. Three of the ten wealthiest counties in the US are already in the Washington, DC, commuter belt, where house prices have yet to fall meaningfully from their peaks and where the unemployment rate is sub-5%. No doubt that’s rather nice for federal workers, lobbyists and associated private contracting firms, but let’s not forget who pays these salaries and benefits: the taxpayer present and, increasingly, future.
Finally, let’s consider pillar three. Not only is the government protecting the financial sector from insolvency with taxpayer guarantees; it is protecting it from competition, the one thing that might actually make it more accountable and efficient. (“Competition is merely the absence of oppression,” Bastiat once wrote.) And financial repression is also going to direct resources away from certain industries to those favoured by the government. If you think lobbying in DC is a problem today, just wait until a few more years of financial repression have passed.
(In his typical satirical style, Bastiat once proposed supporting candle makers by outlawing windows. While no doubt the candle makers would rejoice at such legislation, the glaziers would either go out of business or pack up and move abroad, as would any business that preferred the lower costs associated with sunlight—free!—rather than candles to light their workshop or factory floor.)
Firms that see this coming will pack up and go abroad, to less repressed locales. Oh, wait. Many of them have already gone! If you think the offshoring of recent years is just a one-off, think again. The wage gap between Asia/Latam workers and those in the US and Europe may be narrowing, but the repression/regulation/taxation gap is growing. Offshoring is not over, not by a long shot.
Through the broken window I see productive capital leaving US and European shores in droves and the capital remaining turning into an inefficient, unproductive, overregulated, mangled mess.
De-Leveraging As Seen Through the Broken Window
If financial repression is so damaging to an economy, then why would governments go about it in the first place? Why kill the goose that lays the golden egg? Well, as we know, politicians do what is politically expedient. Sometimes, by coincidence perhaps, the expedient is also economically sensible. More often, it is anything but.
As Reinhart and others who have weighed in will claim, the point of financial repression is economic de-leveraging. Through the measures described in the previous section, the real debt burden should erode over time, in large part through inflation. A de-leveraged economy should, other factors equal, be a healthier economy, so the thinking goes, as fewer resources are devoted to debt service payments, leaving more for investment or consumption. The problem is, as we have just seen, other factors are not equal and must not be ignored.
In a recent paper, legendary fund manager Ray Dalio offers his thoughts on de-leveraging, using several historical examples as a guide.[6] Much of what he writes lines up well with Reinhart’s main observations. He goes further, however, pointing out which de-leveragings were comparatively successful, and which less so. As an extreme unsuccessful case, he takes the German Weimar hyperinflation, something so horrible in both its immediate effects and future consequences that it makes one shudder at the thought that our current set of policy makers might lack the requisite skill to pull off an orderly, gentle de-leveraging.
But even if they do pull off a comparatively benign de-leveraging, say along the lines of Scandinavia in the 1990s, we can see through the broken window that there are nevertheless long-term negative consequences associated with financial repression.
Incidentally, the Scandanavian experience was less painful for several reasons. First, as relatively small, open economies, they were able to shift much of their financial burden onto other countries through currency devaluation. Second, they implemented structural reforms, including de-regulation and privatization, and introduced sharply lower marginal tax rates. Third, they benefitted from an economic boom in key trading partner Germany and much of eastern Europe, an important economic consequence of the end of the Cold War.
There is just no way that a de-leveraging in the US or Europe today could possibly proceed as smoothly. These economies are far too large to shift much of the de-leveraging burden onto the rest of the world. Specific to the US, as the dollar is the world’s primary reserve currency, trying to do so could be counterproductive. Were the dollar to lose its reserve status, US borrowing costs would soar.
The US is also moving in the opposite direction of the structural reforms that were associated with the Scandinavian de-leveraging. The assumed challenger to big-government president Obama is a big-government Republican. And unfortunately, with so much of the world over-leveraged at present, the chances are rather remote that the global economy is going to be booming over the coming decade, compensating for the US and European de-leveraging. No, the sad, realistic outcome is likely to be far less benign and could be rather nasty indeed.
Broken Window Investment Strategy
If we are to approach investing with a view through the broken window, rather than through the rose-tinted glasses of the economic mainstream, we are going to have to be defensive and focus on wealth preservation rather than generation. While I have nothing against the latter—I hope this report makes it rather clear that I abhor economic stagnation and wealth destruction—there are certain realities implied by a static or shrinking economic pie. We each have a piece and our goal must be at a minimum to prevent it from shrinking in size. Believe me, that will be challenging enough.
In a sound money world, wealth preservation would be easy: Hold cash and government bonds. However, peering through the broken window, we see financial repression: interest rates that don’t compensate us for the current and future deficits and past money and credit growth, both of which imply higher price inflation down the road. I offer no specific predictions for when inflation will pick up materially or by how much. All I know is that a zero percent rate on cash or a 2% bond yield is woefully insufficient.
To purchase government bonds today is to speculate that some greater fool will buy those bonds off you at a higher price prior to the future surge in inflation expectations or, alternatively, that somehow the current financial repression and associated economic de-leveraging will have the opposite outcome of every single instance of repression and de-leveraging that has ever occurred with an unbacked, fiat-currency, rather than on a gold standard. History is so crystal-clear on this point I am repeatedly amazed by those who believe that the endgame could possibly be any different this time around. (This is not an argument against the occasional wave of asset deflation rolling through, something that clearly has been occurring since 2008 and that will most probably continue to occur from time to time in the coming years. But when it comes to consumer prices, please show me the deflation. Where in the world, exactly, has CPI been persistently negative, rather than just briefly so from time to time? That’s right, no where.)
With cash and bonds not providing credible wealth preservation, what about high-yield bonds or equities instead? While I see better relative value in both compared to government bonds, I am not terribly confident in my ability to value these or other risky assets in a world of manipulated interest rates; arbitrary government subsidies, regulations and tax uncertainty; and the future trade wars that normally accompany currency devaluation and generally weak global economic performance.
For those who are confident in their ability to value risky assets in this rabbit-hole world, be my guest. But be careful. If you don’t have inside knowledge, don’t think you can know just where financial repression is going. And if you believe that any modern corporation won’t be affected by trade wars, even one that appears at first glance to source and sell everything domestically, think again. I can’t think of a single supply chain that passes through a modern corporation and that does not in some way move across some border. (If you can think of one, please let me know!)
I have written about diversification so many times before I risk sounding like a broken record—it is about time someone updated this simile, no?—but the key to dealing with the pure uncertainty associated with financial repression and de-leveraging is to diversify as best you can across assets that are at least reasonably likely to retain their real, inflation-adjusted value over time, regardless of what specific form the repression and de-leveraging take. Gold and other precious metals have a demonstrated track record in this regard, as do certain other commodities. While industrial commodities naturally have a relatively high correlation to industrial demand and, therefore, the cyclical swings observed in the equity market, there is a far lower correlation between equities and precious metals. The supply-side uncertainty associated with agricultural products practically guarantees that their prices will have only a low correlation to equity markets.
Of course, in the extreme case that a currency hyperinflates and the prices of all real assets soar, then, yes, these correlations are going to increase. But isn’t that precisely the sort of diversification you should want? When the currency is reasonably stable, the diversification offered by a broad basket of liquid, tradeable commodities provides a store of value that cannot be suddenly, arbitrarily devalued by a financially repressive government. And in the event that such government causes such economic trauma that confidence in the currency collapses and a severe inflation or hyperinflation sets in, well, the benefits of holding real assets, correlated or not in price, are obvious. In many ways, this sort of strategy functions more like an insurance policy, albeit one with minimal premiums, than it does like an investment strategy. But once again, we are looking through the broken window here, seeking to maintain the size of our slice of a static or possibly outright shrinking pie.
[1] From Ce qu'on voit et ce qu'on ne voit pas (1850).
[2] One way of thinking about this is to consider that, were interest rates to rise in proportion to a given growth subsidy, then the pro-growth effect of that subsidy would be offset. But if interest rates are held artificially low amidst subsidies, then the subsidies will result in a net overinvestment and/or overconsumption boom, which must ultimately unwind in a bust. Hence the Fed bears ultimate blame.
[3] Please see “How the Federal Reserve Bought the Economics Profession”, The Huffington Post, October 2009. The link is here.
[4] Carmen Reinhart and M. Belen Sbrancia, The Liquidation of Government Debt, NBER Working Paper Series (16893), 2011.
[5] This article was published by Bloomberg News and can be found at the link here.
[6] This paper can be found here.
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