The QE policy of the Fed has generated a large amount of criticism, but what if the economy can't stand on its own two feet without it, that is when it generates insufficient growth and employment without expansionary monetary policies?
Many think that even if this is true, it's the temporary result of the deleveraging process in which households decrease borrowing and spending in an effort to restore balance sheets, hit with the $9 trillion crash in house values, and banks cutting lending to restore their balance sheets.
However, what if the condition is more structural? We have already previously pointed out that in the decades prior to the 2008 crash the economy could only achieve reasonable employment and growth levels by ever increasing debt levels, and this situation was, in our view, mostly caused by stagnating median wages.
Our thesis was actually rather simple, stagnating median incomes and growing incomes at the top causes a situation in which demand structurally falls below output as higher incomes have lower propensity to consume. This situation was masked eluding even luminaries like Krugman) by the fact that the US didn't see an increase in the saving rate (in fact quite the contrary happened).
We argued that Krugman was missing rising household debt, and he finally caught up on that this week.
So with all that household borrowing, you might have expected the period 1985-2007 to be one of strong inflationary pressure, high interest rates, or both. In fact, you see neither - this was the era of the Great Moderation, a time of low inflation and generally low interest rates. Without all that increase in household debt, interest rates would presumably have to have been considerably lower - maybe negative. In other words, you can argue that our economy has been trying to get into the liquidity trap for a number of years, and that it only avoided the trap for a while thanks to successive bubbles.
The economy in a permanent liquidity trap of which it only emerges when low interest rates create another asset bubble. Apparently, there are strong deflationary forces at work that keep the economy in this new normal state, but what are these forces? Candidates are (by no means mutually exclusive and partly overlapping):
- New workers from emerging countries (China, India, etc.) exerting downward pressure on wages in developed countries
- Trade, developed countries flooded with cheap imports from developing nations exerting downward pressure on prices
- Rising inequality, we've already described the basics above
- Technology automating away middle income manufacturing jobs and enabling and empowering higher paid knowledge workers
- Demographics in the developed world, slowing investment demand
- The success of monetary policy itself in anchoring low inflationary expectations since the early 1980s
The result of these forces is a savings glut, low investment, deflationary pressures, low, perhaps even negative real interest rates, which creates the risk of asset bubbles. You can find some of the policy consequences here (and here) but what are the consequences for investors?
- The main one seems to be that low interest rates are here to stay, they are the new normal. Even if there will be some tapering, the Fed (and other central banks in advanced countries) are still likely to keep on buying at least some assets, and super low interest rates seem to be in place for the foreseeable future.
- Since companies are flush with cash and profits, but face a dearth of investment opportunities due to tepid demand and deflationary forces, they will return ever more to shareholders in the form of buybacks and dividends.
Both provide considerable tailwinds for stocks, no wonder they're up so much. But if business investment doesn't pick up, productivity growth will slow, and this is the economy's single most important metric, and stocks will increasingly diverge from their traditional valuation range, increasing the likelihood of sudden downward lurches or even full-blown crashes.
Are there things that can be done about these developments? Here are just a few suggestions (each would merit a separate article, if not a whole book):
- Reinstate a form of Fordism in which the link between wages and productivity growth is re-established
- Curtail the financial sector in order to force more funds to the real economy (for instance, curtain margin debt, much stricter capital requirements, reinstating Glass Steagall, regulating shadow banks and derivatives markets, stuff like that)
- Engineer higher inflationary expectations
- The public sector as employer of last resort (that is, massive investments in infrastructure, education, science, etc.).
- Helicopter money
None of these are without costs or problems, drawbacks, easy to implement or necessarily popular. We could just try to live with the new normal instead. It's good for shareholders, at least until the next crash.
However, asset bubbles and crashes are not the only risks. The deflationary forces could take over if not met by countervailing policies. A world of falling prices isn't so good for shareholders witness what happened to Japanese shares after they hit a record of almost 39,000 in December 1989(!) after which the economy gradually became stuck in a deflationary trap which it only recently is trying to emerge (accompanied by a huge rally in the Nikkei).