Excerpt from the Hussman Funds' Weekly Market Comment (3/17/14):
During the past 14-year period, the S&P 500 has achieved a total return, including dividends, of just 3.3% annually. Even this outcome has been achieved only because market valuations have now been driven more than 100% above pre-bubble historical norms, based on reliable measures that are highly correlated with subsequent market returns (for a review, see It is Informed Optimism to Wait for the Rain). We emphasize reliability because there are countless measures that Wall Street analysts prefer to use, particularly those that make stocks seem reasonably valued. The problem is that most have very little relationship with actual subsequent market returns. When evaluating anyone’s valuation claim, you should always ask – how does this measure actually relate to subsequent market returns when it is evaluated over decades of market history?
Over the same 14-year period, real U.S. GDP has grown by just 1.8% annually, while real gross private investment has crawled at just 1% annually. The primary growth area of the economy has been total public debt, which has surged at 8% annually, driving the outstanding amount of total public debt to 99% of GDP.
Of course, the Federal Reserve has absorbed trillions of this debt, which has allowed federal debt held by the public to stay closer to 70% of GDP. As the Fed buys that debt, it pays for it by creating currency and bank reserves (monetary base) that must be held by someone in the economy at each point in time. In aggregate, this cash doesn’t represent an untapped economic resource that is waiting to be deployed, but is instead a receipt for economic resources that have already been deployed. The cash held by any individual (over and above debt that is owed) is simply evidence that at some point in the past, they consumed less than the full value of their own output, so that someone else could consume more than the value of their own output.
In the future, these IOUs can be used to claim new production at some point in time (which does not have to be immediate), allowing the holders to consume more output than they produce, but only by requiring others to consume less output than they produce. In short, all of this cash does not represent aggregate wealth. Instead, it is a placeholder that determines how future production will be allocated.
The Federal Reserve’s policy of quantitative easing has certainly had a massive effect on the form of the IOUs held by individuals and businesses. Following the massive government deficits of recent years, one would expect that the IOUs would be held as Treasury securities. But the Fed has bought trillions of dollars of that debt, and replaced it with currency and bank reserves. Regardless, holding the IOUs in the form of cash does little to provoke individuals or businesses to spend them. What the Fed’s policy has done, however, is to encourage investors to reach for yield in speculative assets in the hope of greater returns than are available on zero-interest cash.
Where does all this cash “go”? In aggregate, equilibrium ensures one precise answer: nowhere. Though any individual can get rid of their cash by buying stocks or other risky assets, the seller of those same assets then gets the cash. It doesn’t vanish, it only changes hands. Once a government liability is created, its form may change between Treasury debt, currency and bank reserves, depending on what the Fed does, but that liability will continue to exist in one form or another until the government runs a surplus and retires the liability from circulation. Meanwhile, the existing cash simply creates an ongoing game of “hot potato” from one holder to another.
The effect of QE has been to make this potato very hot, encouraging investors to chase one risky security after another, so that now nearly every risky asset has been driven to such rich valuations that their probable future returns match the zero return available on cash.
At this point, it should be clear that the mere existence of a mountain of IOUs related to past economic activity is not enough to provoke future economic activity. What matters instead is the same thing that always matters: Are the resources of the economy being directed toward productive uses that satisfy the needs of others?
To the extent that such desirable activities exist – whether as consumption goods or as investment goods like machines, the act of bringing them forward not only engages existing resources (such as factory capacity and labor), but also creates new income that can be used to purchase yet other desirable products. This is what creates a virtuous circle of economic activity and growth. Not quantitative easing, not suppressed interest rates, not speculation. The resources of the economy must be channeled toward activities that are actually productive, desirable, and useful to others.
When this doesn’t occur – when companies produce output that isn’t wanted, when capital investments are made that aren’t productive, when housing is constructed at a pace that exceeds the sustainable demand and ability to finance it – the act of production and the resources of the economy are wasted. That is really the narrative of the past 14 years, and is largely the result of repeated bouts of Fed-induced speculation and misallocation. Robert Blumenthal recently wrote an excellent essay describing the economic costs of such “malinvestment.”
At the moment that a person uses their labor to produce something of value to others, that person’s own income is enhanced, and the ability to purchase the output of others is also created. As economist Jean-Baptiste Say wrote, “A product is no sooner created than it, from that instant, affords a market for other products to the full extent of its own value… Thus the mere circumstance of creation of one product immediately opens a vent for other products.”