Financial Repression, Central Banks and Boom and Bust Cycles

Banks, Global Economy, On the cover

The great debate in mainstream economics these days is centred in the weak level of investment and consumption seen throughout the current recovery. However, it strikes me as ironic that there is almost no debate in the Keynesian world about the diminishing returns of financial repression and the increasing loss of credibility of demand side policies.

There was a time in which the average citizen would see inflation as a fastidious side effect, as an anomaly caused by unclear factors. The veil was lifted in the last eight years. In the past eight years the US, for example, has seen the largest transfer of wealth from savers and the middle class to the government. $1.5 trillion in new taxes, $9 trillion in new debt and $4.7 trillion in central balance sheet expansion for a mere $3 trillion real GDP expansion.

Financial repression was the only tool to solve imbalances of the post-Bretton Woods world. But in the past eight years, financial repression was taken to an extreme never-seen-before.

Citizens may not understand economics and the forces that affect their wealth and disposable income, but they sure do perceive the hole in their pockets. Financial repression has obliterated the purchasing power of the currency and at the same time made it more difficult for the middle class to improve their wealth, as it becomes more and more challenging to save and the returns of those savings are slashed with the subsequent 600 cuts in interest rates we have lived in the past decade.

(Source here)

Keynesians will say that financial repression is a necessary tool to improve the economy and solve imbalances created by one or another financial crisis. What they always forget to mention is that those crises have always been caused by the artificial creation of money without any real support. The boom and bust cycles are more frequent precisely due to this constant and uncontrolled use of monetary policy to cover structural problems.

The same mainstream economists will also say that the unintended consequences of financial repression are offset by the so-called “wealth effect”. Yes, the value and purchasing power of money are distorted and devalued, but stock markets compensate that effect and house prices rise. There is a problem. The vast majority of the hard-working middle class do not play the markets, and the constant boom and bust cycles, added to a weakening of purchasing power, makes it increasingly more difficult for citizens to become homeowners. In effect, 80% of US household wealth is not in stocks, financial assets or houses, but in deposits, which are being eroded by the policy of destroying savings to artificially subsidize the indebted and inefficient.

Mortgages may be cheaper, but it does not matter when your credit profile is weak and your salary does not reach to cover the bills. Add to financial repression tax increases and the “wealth effect” is felt less and less by the backbone of the economy, small and medium enterprises (SMEs) and families.

The above chart shows clearly why the middle class and SMEs are left behind in financial crises. The abrupt change in money supply and the lowering of interest rates reaches the weakest parts of the economy last, but when it goes the other way round and money supply collapses, it is the middle class and SMEs who suffer first through the credit crunch and inability to cover costs.

Furthermore, the middle class is not only finding itself as the payer of the bill of each new credit boom cycle, but it also finds it increasingly more difficult to participate in the recoveries, because families and SMEs are suffering the increase in the tax burden to cover the deficits created by wasteful governments and the bailouts of rent-seeking industries -through massive subsidies- and inefficient financial entities.

Not only is it more difficult to participate in the questionable wealth effect created by financial repression, but it is more risky, because the average citizen is a conservative investor looking at the long-term, and is rarely able to actively manage a portfolio to preserve capital and hold on to gains.

This is the reason why mainstream economists scratch their heads when voters react against governments that boast of economic recoveries that the average family simply has not seen. Because when governments forget sound money as a key principle, and the importance of defending savers, the voter will react against the rulers, even if they do not understand that financial repression is an active policy, not a coincidence.

Think about this, today central banks are increasing money supply -printing money- at a rate of $200 billion per month… and we are not even in a recession. With stock market valuations at all-time highs and bond yields at historic lows globally, imagine the side effects when this ends.

Today’s savers need to look for ways to reduce risk and preserve wealth, beating the inflationist agenda, and that is extremely difficult because the small investor’s tolerance for volatility and understanding of valuations is logically limited. That is why more and more small investors, looking to protect their hard-earned wealth, will look at alternatives to deposits that are as far away as possible from the temptation of manipulating money supply of the governments. As the only monetary policy used in the past 50 years generates ever diminishing returns even for the objectives of Keynesians, the urgent need to return to sound money measures and protection of the middle class becomes critical. Because the next bust will not be covered with lower rates and more money supply after 600 cuts and $20 trillion of liquidity.

Daniel Lacalle is a PhD in Economics, fund manager and author of Escape from the Central Bank Trap (BEP), Life In The Financial Markets, and The Energy World Is Flat (Wiley).

Special thanks to Robert Elway. Images courtesy of @RoslandCapital1 

How CEOs can avoid the central bank trap (CEO World)

Global Economy, Interviews, On the cover, Sin categoría

This article was published in CEO World

We live in strange times. In the past eight years the US has created more money than in the previous fifty years combined, and at the same time interest rates have never been so low. However, total real gross investment in the OECD as a whole only returned to the pre-crisis level by 2014 and remains sluggish at best. In the same period, companies have been increasing cash flow generation and dividends and buy-backs have soared.

Why is this happening?

Welcome to financial repression. Extreme liquidity and zero interest rates policies have come with a nasty addition. Tax burden. Not only price and value of money has been artificially distorted, but the tax burden in the OECD is at all-time highs.

Financial repression is achieving the opposite of what it intends to create. The mainstream economists will tell you that lowering interest rates and massively increasing liquidity will push economic agents to take more risk, consume more and invest long term. But it does not happen as expected. Companies are more prudent in their investment criteria, and families actually save more, increasing their deposits. Economic agents perceive there is something odd in the economy, even if they are not experts, and become more prudent in the face of what is clearly a distorted cost and value of money. The central bank trap, which I discuss in my latest book.

The fact is that financial repression in the past eight years has resulted in one of the largest transfers of wealth from families and businesses into government since the Bretton Woods agreement, $1.5 trillion in new taxes in the US added to $9 trillion of new debt and $4.7 trillion of monetary stimulus. This, in turn, has driven a weak recovery.

A CEO today should be excited.

The opportunities that the central bank trap has generated are enormous.

First, expensive acquisitions made by others lured by the liquidity trap will become the exciting value opportunities for the prudent CEO that has avoided falling into the mirage of cheap debt. In the past two years, takeover targets have sold for a median of 11 times Ebitda, according to Bloomberg, whereas the multiple was only about 7-9 times up until then. Transactions are getting ever-bigger and more expensive, pushing total goodwill to $6.9 trillion. I believe that the sobering factor of tighter monetary policies, added to the reality of challenges in the economy, will generate extremely attractive acquisition opportunities when the bubble bursts. Of course, some CEOs have been very prudent making bolt-on acquisitions while preserving cash and strengthening the balance sheet, and some multiples are justified by realistic growth estimates, but many of the acquisitions that rose in multiples only due to cheap money and low rates will be the write-downs for some, and subsequent opportunities for the prudent manager.

Second, prudent CEOs have been right focusing on total shareholder return via dividends and buybacks in a period of weak growth and increased uncertainty. This has led to a historic high level of cash preservation and a clear mentality of focusing on return on invested capital. For a CEO, correct capital allocation is the main concern, and what better capital allocation than dividends and its own shares if there are no evident growth opportunities elsewhere? This period has seen an unprecedented decline in interest rates, but any CEO knows that perpetuation of overcapacity and large imbalances have also meant that the weighted average cost of capital (WACC) of most industries has not fallen. Instead, WACC has increased globally due to the poor growth and higher risk attached to the equity part of the equation. Therefore, the prudent CEO will not take this rise in WACC as an anomaly, or ignore it, but understand why equity risk premium rises –uncertainty on future estimates, constant downgrades from international agencies of their expectations-.  As such, a prudent CEO will analyze capital allocation opportunities with the view of preserving the value of his or her company, while placing investments in areas where conservative estimates allow a comfortable return on invested capital above its WACC. This strategy will help the CEO navigate an uncertain world where economic cycles have become shorter and more abrupt, as I explain in my book. There is no need to stop investing, rather the opposite, just analyze opportunities that enhance value while keeping a firm eye on shareholder return. We are seeing an improvement in growth and inflation estimates globally in 2017, but we need to pay attention as well to the imbalances that come with those expectations: Perpetuation of overcapacity, higher debt and higher taxes.

Third, CEOs should be excited about the opportunities that digitalization and robots offer. We are moving towards an age where there are lower capital requirements to deliver stronger earnings growth and efficiency and productivity will likely soar. Embracing change and leading the process is a critical element for CEOs to succeed. Another important recommendation to escape the central bank trap is to lead this change looking at higher innovation and investment in research and development. The biggest mistake a CEO can make in this environment is to follow the trap and increase spending disproportionately on subsidized areas or rent-seeking businesses. Low interest rates and high liquidity might lure many to poor productivity sectors, but these are the ones that will suffer the most when the tide turns, and it does. However, high value-added, superior productivity, technology differentiated companies with strong brands will not only gain market share and value, but thrive in complex economic cycles.

Most CEOs have behaved impeccably in this zero-interest-rate, massive liquidity environment. They have ignored the dangerous siren call to take excess risk and more debt and have focused on strengthening the value of their companies while reducing imbalances and creating an environment for a better, more sustainable growth model.ost companies did not follow their incentive to overspend and take more debt. But no government or central bank committee has more or better information about where and how to invest than CEOs and their teams. It is easy to “demand” more investment from companies when the person doing so has no skin in the game. Now, the evidence is clear. The majority of CEOs did the right thing.

Now it is time to look at the future forgetting artificial monetary mirages and demand-side policies. The successful and prudent CEO will adapt and lead change focusing on productivity, technology and added value. And will reap the benefits of absorbing those that believed in growth by government decree and the illusion of the monetary laughing gas mirage.

The future belongs to those CEOs that focus on real fundamental trends and ignore the central bank trap.

Daniel Lacalle is the author of “Escape from the Central Bank Trap” (2017, BEP) ,“Life In The Financial Markets” (Wiley, 2014) and “The Energy World Is Flat” (Wiley, 2014, with Diego Parrilla).

France post-elections. Careful with optimism

Europe, Global Economy, On the cover

The French presidential elections have shown several evidences .

The second round will again put a moderate candidate, Macron , against a far-right one, LePen. This happened years ago between Chirac and LePen’s father … The big difference is that, then, the combination of extreme-left and the far-right did not add more than 40% of votes.

The euphoria of analysts ahead of a second round that concentrates the moderate vote in Macron cannot make us forget that the French society has reacted to the fierce and interventionist statism of Hollande increasing the support to more ultra-interventionist radicalism.

The disaster of the socialist party – pledging unicorns, making stimulus plan after stimulus plan and raising taxes over and over- has been spectacular. Not only has ultra-left-wing and ultra-right-wing populism not stopped, but Socialists have legitimized and fed it by repeating to citizens that the magic solutions of eternal expenditure and constant imbalances were viable. Between the diluted populism of Hamon and that of the totalitarians Melenchon or LePen, many prefered the original.

The decline of the center-right comes after many years of renouncing to its principles of free market and low taxes, surrendering to copy the Socialist party. This has made Fillon, besides the scandals, appear as not credible in its proposals of reform, among other things because he has been in high positions of responsibility and those same reforms were delayed to perpetuate the interventionism that he now criticizes.

Both Hamon and Fillon have requested their voters support for Macron  in the second round, which leads to a high probability of a moderate victory.

What about Melenchon? The far-left candidate lost, but has refused to request the vote for Macron, proving that the extreme left candidate’s calls to defend France from the National Front were just political tactics. Melenchon’s economic policies are very similar to LePen’s.

The inability of traditional parties to respond to the real concerns of the people, including the terrorist threat and immigration, and their historic failure to implement reforms, has taken its toll .

When you make a race to see who is more socialist, it ends up backfiring and benefiting the one that promises unicorns.

The Macron challenge… if he wins

Now the problem of France is to recover the dynamism lost in an economy that Macron himself described as “sclerotic” . There are many doubts about his true reformist agenda, evidenced by his actions when he has been minister. But we have to give him the benefit of the doubt. He faces a radicalized parliament, with traditional parties in disarray.

Reducing corporate tax, cutting labor costs, carrying out a labor reform similar to the Spanish one, and immigrant integration policies are part of Macron’s proposals, but we must wait to see if he wins the second round and if he has the support to implement them.

The challenge is enormous.

Just fifteen years ago, Germany and France had similar deficits and debts. Germany took the road of reforms and France the “ostrich policy”, ignoring its imbalances, attacking its own waterline with confiscatory tax and spending policies to sustain a hypertrophied public sector.

The last time France had a balanced budget was in 1980, and since 1974 it has never generated a surplus, public debt reached 96% of GDP, the economy has been stagnating for two decades, unemployment stands at 10% (with 23.6% youth unemployment ) and in 2017 it still has a current account deficit of 6.5 billion euros while the Eurozone has a surplus. Germany, on the other side, has a budget surplus, growth, much less unemployment (3.9%) and lower debt (71%). The French candidates have blamed the country’s problems on external enemies, from ‘globalization’ to ‘the euro’, however, comparisons with Germany destroy those arguments. It is hilarious to listen to LePen or Melenchon, the Ying and Yang of extremism, blaming France’s problems on “budget cuts” or “austerity . “

In a country where public spending exceeds 57% of GDP, where public administration spending has grown by more than 13% since 2008 and 22% of the active population works for the State, local governments and public entities, talking of austerity is a bad joke. In addition, France has spent tens of billions on ‘stimulus plans’ since 2009 . Specifically, 47 billion euro in 2009, 1.24 billion to the automotive industry and two ‘growth plans’ under the Hollande mandate: 37.6 billion euro (‘investments’) and 16.5 billion (‘technology’).

Blaming the French stagnation on “neoliberalism”, “austerity” or “the euro” is like an obese person blaming his overweight on lack of more donuts.

The problem is economic “dirigisme” -interventionism-, which stifles the potential of a rich nation that should not be satisfied with having better economic data than the periphery of Europe. France should be compared to the world’s leading economies. The problem that the next president of France faces is that, repeating the mistakes of the past, the country will not regain the dynamism of a nation that should not be content with secular stagnation and perpetuating imbalances.

Unfortunately, the results of these elections have shown us that a large part of the electorate thinks that “dirigiste” socialism has not worked because the country needs a lot more of it. A large part of the electorate prefers to believe that two plus two add up to twenty-two and that they will be richer if they take more money from those who produce to give it to those who do not.

Last night the European project may have won, and many will be relieved, but this cannot make us forget the most important thing: Legitimising the populist message is not the way to combat radicalism. It fuels populism.

Daniel Lacalle is a PhD in Economics, fund manager and author of Escape from the Central Bank Trap (BEP), Life In The Financial Markets, and The Energy World Is Flat (Wiley).

Image courtesy Google

“I am very positive on the US as a nation” (Interview in Vendome Magazine)

Global Economy, Interviews, On the cover, Sin categoría

Please read the complete interview here.

One of the top 20 most influential economists in the world, investment manager, best-selling writer… He makes complex economy issues look simple and debunks phony political leaders on live TV. Born in Spain, but living in London, Daniel Lacalle spreads uncomfortable truths about the international economy:

Are you positive regarding the USA’s economic future under Trump?

I’m very positive about the USA as nation.

I believe that we usually imbue the economy, especially the USA’s, with a presidential veil that doesn’t exist. America’s economy doesn’t depend, as it typically happens in European economies, on what president A or president B decides; it’s a very free economy and it’s much more attached to the interests of thousands and thousands of companies which don’t have any kind of relation with the State. I believe the Trump Administration is being demonized in a very aggressive way because the media and analysts, in general, don’t like the character himself, Donald Trump. I think we should discern between the character and reality. Just like it happened with Obama, but the other way around. With Obama, there was a “media lover affair” with the character. He was a very attractive, convincing and politically correct character, and due to that almost romantic relationship between the media, economic analysts and the government, there was a tendency to enrapture and sweeten his economic policies. The opposite is happening to Donald Trump. He hasn’t been there for a long time yet, but people tend to add a negative tone to everything he proposes from an economic point of view just because it’s him when, actually, many of his policies have been successfully applied in the past by previous presidents; that’s why I believe we need less Manicheism with the character, without failing to criticize him for the things we don’t like, but there’s no need to be so biased with American presidents.

It’s a very typical mistake of the media and of the consensus analysts in Europe to sweeten and deify the Democratic presidents and to demonize in an almost caricatured way the Republican presidents because, in Europe, right-wing and left-wing are usually closer to each other than the Democrat and Republican Party.

Very few news media outlets or analysts are in tune with the values of America’s Republican Party. I believe that polarization over the perception of presidents is a little bit fake, first of all. I remember when George W. Bush spoke at a reception where I was too and said that, after a month in the White House, receiving all the advisers who told him what to do, with whom he had to negotiate what and with whom he had to approve what, he told his wife “Let’s go on vacation because I can’t do anything”. In the USA’s economy things such as a regimental presidency where the president says “Do this” and everyone responding “Yes, sir” don’t exist; it’s an economy where advisors and State secretaries have their very own opinions and they defend them. It’s also a civil society with its institutions and what’s called “checks and balances”. Therefore, we should be less biased or actually, less “personalist” when it comes to analyzing American politics and economy from the point of view of a character.

Did you foresee the victory of Brexit?

No, and curiously I perceived a clear difference in the absolutely devastating messages coming from some news media outlets which didn’t even considered the possibility of a victory of Brexit. However, and these are things that are important to learn as an analyst, in the day-to-day and in the conversations with citizens, something different was perceived than what news media outlets and consensual economists tried to show as the only possibility, the NO. Something didn’t quite add up. The experience of that error when it comes to analyzing the risk of Brexit helped me a lot in the American elections shortly after.

I went to the USA and I thought “Wait, everyone is saying there’s an 81% chance that Hillary will win. 81%?!” – they didn’t even consider another option.

I remember an anecdote: I was watching on TV a show with Bill Maher and Ann Coulter. When asked who they thought was going to win the elections, she said Donald Trump. Both the audience and the other commentators in the table burst out laughing, which made me think “Hold on, something’s going on here; we might make the same mistake”. We must be much closer to citizens to understand not what the confirmation bias tries to perpetuate, which is: since we get together with people of the same class and the same media we all decide that the consensus must be this… and then we’re wrong.

 

The victory of Brexit really saddened me. It still does, because I understand the reasons why the UK wants to leave the EU, but it makes me sad because I think the UK was a force that exerted an important balance in the UE by keeping away the interventionist agenda of some countries.

Is there a short term positive future for the UK?

Yes. I believe I must be intellectually honest: just because I didn’t want the UK to vote for Brexit, doesn’t mean I won’t analyze where I was wrong and, especially, that I analyze in an objective way that we were wrong.

I remember that the affirmations of consensus analysts and experts was that simply due to the decision of the UK to vote Brexit the economy was going to plummet, hundreds of thousands of jobs were going to disappear and there was going to be a debacle. That hasn’t happened.

If we aren’t intellectually honest when it comes to analyzing, like it happened in the USA, where analysis was completely optimist and biased regarding the American economy as if it was all wonderful, and if we don’t analyze properly, instead of learning from the mistakes, what we do is justify ourselves with another premise like “Oh it came out this way because dumb people and rednecks voted it”.

Do you think Madrid has potential to become the new “City” after Brexit?

Well, if didn’t believe so I wouldn’t be supporting it (laughs). I think it has a lot of potential, but us, the citizens of Madrid and the institutions, must want it and show the merits. If I didn’t believe it, I wouldn’t support it.

The role that fills me professionally the most is all that hast to do with spreading and explaining my thesis, opinions and analysis. I think it’s very valuable and, in addition, you learn a lot from that process of divulging and listening to other people’s questions and criticisms. I find it very positive and rewarding.

Do you believe that political ideology influences the success of a country?

Absolutely. When you listen to an economist or an expert talking about economic policy or macroeconomic, monetary or fiscal policies saying that they’re only talking about economics and not about ideology, that’s the ultimate evidence that they’re lying to you.

There’s always an ideology and a personal stand that informs economic theories, analysis and recommendations.

Denying this is, first of all, lying; secondly, denying that you’re making an analysis and recommendations in what is an experience of systems, policies and, theories, you include a perception of what the benefit is for society. Economics is a social science, therefore saying that there isn’t an ideology behind its analysis is lying.

Have you ever considered working in politics as finance minister or have received any offer?

If I’m ever offered the honor of representing and supporting my country, I, like probably 90% of people, would consider it a real honor and would feel really proud. In any case, what I do is my professional activity. I believe it’s possible to influence and participate in society with your professional activity without being necessarily involved in politics. I have very good relations with political leaders and political figures and, furthermore,  and I believe it should be this way, many times we do a social function by sharing our opinions, our ideas and our recommendations with them.

Do you believe basic finance should be taught in schools?

Absolutely. It’s a deficiency of the education system that there isn’t basic finance and economy education. Not in economic policies and governments where political ideologies are included, but rather in finance management, the management of our savings, of our daily life, how to start a business… I think it’s absolutely essential.

Is it frustrating to you to find new political leaders who try to sell absurd economic policies and fool people due to that lack of economic education?

Rather than frustrating, it’s sad that it becomes politically profitable to present fake magic solutions.

I believe it’s important that society has basic knowledge so that when they’re sold fallacies such as “increasing taxes on rich people we can pay for all kinds of costs”, people can actually understand the mechanisms of the economy. I don’t think it’s a lost battle because all of us who are involved keep fighting, but when one analyses the last 600 years of the economy in the world, the tendency to turn complex economic problems into magic solutions that apparently nobody had thought about before and which are always wrong, is unfortunately politically profitable.

When you look back at the beginnings of your career do you think “what was I thinking”?

Of course! I remember when we were told that competitive devaluations were something great, and I remember because I suffered them when I started to work. While we were told from the academia or the Government that devaluations were positive for the economy, something didn’t quite add up. And what was it? How I was suffering in my own pocket and in my life the debacle that devaluation meant. I think this one is a very clear case of one’s evolution and how you realize things through empirical reality.

What made you choose a career as an economist? Did you always want to be one?

Yes. I love music and cinema. Particularly music, I’m a fanatic. Economy has always fascinated me. It fascinates me so much that one of the parts that I have always loved about music, for instance, has been the business side of it. The part related to how a recording studio works, the budgets of records, the tours, how you earn or lose money…

So did you ever considered working in the music business?

Yes, of course. When I was a youngster I thought I could be a rock star, but then I realized my lack of talent (laughs).

When you write your books do you target a particular section of the audience?

I target a general audience. What I strive to with my books is to make them accessible to the public, to make them interesting and to add rigorous analysis for the experts. What I don’t try is to dogmatize and step up to a podium to give lessons. I try to have a dialogue with the reader to bring that economic reality closer to everyone no matter their age or knowledge. To me, it’s very important to spread but not from the pulpit like “HA! Poor you, you can’t understand me”; if I can’t be understood, if what I’m trying to explain can’t be comprehended, that’s my mistake, not the reader’s.

 

My advice to economy students is: make mistakes. I would give them two recommendations: first of all, don’t think that filling up your CV with courses and masters will speed up or improve your options. Study, learn as much as you can, but work. Working gives you a tremendous perspective. One must make mistakes, and by this I don’t mean doing things the wrong way on purpose, but to take risks, take opportunities, go abroad… Don’t fall in that false comfort of a system that is very protective: family, etc. Take risks.

Daniel Lacalle is a PhD in Economics, fund manager and author of Escape from the Central Bank Trap (BEP), Life In The Financial Markets, and The Energy World Is Flat (Wiley).

Image courtesy Vendome Magazine