Phinance Memo 2: The Jelly Doughnut
When you can stop you don’t want to, and when you want to stop, you can’t - Luke Davies
Last week we spoke about changing world orders. The US approaches its 300-year milestone that has historically marked the fall of many great powers, and we are at risk of economic decay. There are plenty ways that this time is different – I think of exponential breakthroughs in technology that make us more productive and improve quality of life (software, hardware, AI, medical, consumer). But there are plenty of similarities between the mounting challenges we face today and the challenges that have done in other great powers (again largely summarizing Ray Dalio):
Class Warfare: where the wealthy are decadent and apathetic and the poor grow resentful
Overextension: Military and foreign aid projects that drain national spending and morale
Corruption and Cronyism: Everyone wants a hand in the public’s cookie jar
Excessive Credit: Borrowing and spending like our best days are still yet to come
Please feel free to pile on in replies! I have thoughts on all of these, but again, not really an expert on any except maybe the excess credit. And here’s where we pivot into market memo mode because our markets are displaying symptoms of this problem. Since the ’08 crisis, credit has been cheap, available, and excessive - and now it looks likes the tide in the credit cycle is turning.
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At first, we had no other choice: banks and other traditional lenders went on the defensive through the crisis, so the Federal government stepped in attempting to plug the hole. The Fed opened the tap and let credit flow freely with expansionary monetary policy. Congress complimented the Fed’s action with fiscal stimulus policy.
Markets recovered to pre-2008 highs (which were already very high levels) by 2013. By that time crisis era stimulus had long passed through the system. Fiscal policy had run its course, and yet the Fed maintained the most expansionary monetary policy in history. Interest rates remained below 0.50% for the 8 years following the crisis until 2016. Along the way, the Fed tried to raise rates in 2013, at which point the Market threw a “Taper Tantrum.” Finally, right around Trump’s election the Fed gradually raised up to 2.50% through late 2019. Right before COVID, the Fed was dropping rates, reaching 1.50% before fully dropping to zero at the onset of the pandemic. Why were rates so low for so long?
To understand why the Fed remained expansionary we need to differentiate market conditions from economic conditions. The two are highly interrelated, but generally speaking policymakers care more about the more about the economy than they care about markets (Nancy Pelosi being the exception). Naturally, unemployment is a bigger priority than stock prices, though again, the two are very highly connected.
While market conditions recovered within 5 years, America’s economic recovery lagged. GDP growth, usually strong out of a recovery, averaged 2.1%. The labor force stayed flat at 155mm people, a decrease from 66% of the population to 63%. Meanwhile, wages shrunk at 1.1% annually. If you just looked at your portfolio everything looked back to normal, but on the ground, 37% of our labor force wasn’t working and those who were, weren’t getting raises.
Our economy had no momentum and this was with the most expansive monetary policy in history. Nobody could imagine where we’d be with punitive monetary policy and high rates. Well… not nobody. In fact, Ben Bernanke tried raising rates in 2013 - the market freaked out. This August 2021 Fed article tried saying this time is different but it was written way too soon – the market is freaking out again. Will we abort these current hikes like we did in 2013? The main difference, which we’ll have to hit on at some point, is that there was no inflation in 2013, hence no rush to raise rates. But here’s the real problem: from that point forward, our economy grew addicted to low rates and our jelly donut monetary policy.
A simple way to understand policy is to say that fiscal policy is typically best targeted directly at economic conditions, while monetary policy is best targeted directly at markets. The Fed itself considers monetary policy to be a blunt instrument. Low interest rates can incentivize investment to a certain degree, but rates won’t boost GDP where regulatory red tape affronts business expansion at every turn. Rates won’t boost employment in the face of stagnating population combined with an archaic immigration system. And rates won’t boost wages when a broken education system leaves workers untrained for a modern workforce.
We have been failing on a policy front for decades and surprise, our economy is suffering. So, in my view, the Fed cut a deal with the devil… by picking up the slack for our failed fiscal policy, the Fed has been bailing out congress with unsustainably expansionary monetary policy. Of course, this has done nothing to solve our economic problems, but our markets have never been better. More details to come!