Sheila Blair made comments today suggesting the economic conditions we are suffering from are a hangover from the credit crisis, and in many ways she is right, but she is right for the wrong reasons. The tail does not wag the dog, and although we might like to assume that the credit crisis is what caused this mess, some also point the finger at the lawmakers. The truth is that it is neither of those.
In fact, slow growth was going to come with or without the credit crisis, and it will continue with or without QE programs. Neither QE nor the credit crisis governs real economic conditions, but instead it is a simpler part of what was once defined as supply and demand that matters.
In order for the economy to grow people need to invest in it, and in order for them to do that they must also have money to invest. Without immediately bringing "reason to invest" into the equation, a simple focus on the "having money" part is extremely interesting.
The Investment Rate, a study produced in 2002 that spans all of the years between 1900-2030, defines the rate of change in the natural amount of new investment dollars available to be invested into the US economy and it is this critical element that truly governs economic growth over longer term periods. More details about the Investment Rate can be found on Stock Traders Daily.
Longer term economic cycles are based solely on the amount of new investment dollars available to be invested into the economy over time. One might argue that the printing of money creates new investment dollars, but that is not true. It sure creates a surplus of free cash, but the definition of new investment dollars does not reside within the balance sheets of the banks and financial institutions that are benefiting from these QE programs, examples include Bank of America (BAC), JP Morgan (JPM), Citigroup (C) and Wells Fargo (WFC), but instead new investment dollars come from individuals.
It is true, we, as a population, govern economic cycles, and over time there are more people, we spend more money, and therefore the economy will continue to grow. But this natural rate of growth that will eventually come back again also will experience natural periods of weakness, and it is that which is the defining characteristic of the US economy today. It is a natural state of weakness and unavoidable.
The credit crisis, instead of being a reason for this mess, was actually caused by the free flow of new investment dollars as that is also defined by the Investment Rate. The Investment Rate peaked in December of 2007 - we knew it would peak there when this macroeconomic work was created in 2002 so we were prepared for it, and at that time the Investment Rate told us that there was a longer term top in the amount of naturally driven new money available to be invested into the US economy. Another way of putting it is that the economy was flush with natural liquidity.
The credit crisis was fostered by the natural existence of new investment dollars, and furthered by bad legislation and greed, but greed is also a natural part of the peaks in the Investment Rate. When the natural rate of new investment dollars is peaking people are willing to assume more risk, and that is exactly what we were witness to leading up to the 2007 top.
Now, once again by taking their eyes off of the ball, investors are thinking that QE programs will save the day, and change the course of history, when instead they cannot prevent the inevitable. The reason that the excess $1.5 trillion of cash in the system, soon to be $2.5 trillion, is not working to better the economy is that the most important part of our economic system does not have new money to invest.
The economy is all about people. People have less new money to invest into the economy, The Investment Rate shows this clearly - this definition of new money has never been wrong (since 1900) at predicting major economic cycles - it tells us that weakness is here to stay (for a long while), but it also tells us something else.
The rate of the decline of the slope of The Investment Rate gets much worse right now. Yes, it peaked in 2007, but between then and now it only trickled lower. That is exactly why the market has been able to recover (it fell too much in 2008), but this time the declines that lie ahead will not have that same immediate snap-back.
The Investment Rate tells us that continued economic weakness will exist, it gets much worse starting immediately, QE programs cannot stop this (they are trying to prevent utter collapse), and that leads us to believe that the next major decline will not have the same snap-back as the 2008 collapse has had.
Next time it will be much worse because it will not be event-driven like the credit crisis was. Instead based on a realization that the economy and therefore corporate earnings are simply not growing at a rate that warrants the multiples that exist today, investors will soon ask why they are paying up for risk. Coupled with fewer and fewer new investment dollars, multiple contractions will be a brutal truth and almost impossible to overcome in the not too distant future
This has nothing to do with the elephant in the room, but when we add in higher taxes and lower government spending the case for a depressionary environment can also be made.
For conservative investors the appropriate action given this environment is to protect your wealth. For more aggressive investors, participate on the short side. We are doing it very methodically right now.