Two Schools that Need New Curriculums: We Need to Replace Keynesian and Austrian Economics with a Standard of Living Paradigm

As an Economics teacher of some extremely bright students, I frequently am asked by some of the strongest, "Mr. Lane, are you a Keynesian or a Classical Economist?"   My first reaction is a laugh because I have convinced my students that I am an Economist at all!  But hearing this question every semester, I finally have a decent answer, "Neither, I am a standard of living economist."

These days Keynesian economics by and large encourage government deficit spending and central bank policies that maintain low interest rates, with the goal of muting the magnitude of the business cycles.  While most skilled business people prefer periodic downturns and upturns in economic growth rates due to the business cycle, Keynesians prefer government and quasi-government agencies to act to mute such cycles.  In contrast, laissez-faire Classical economists encourage a default response to economic recession or economic acceleration that demands patience of both households and firms to let markets and human behavior adjust to excesses and shortages.  As anyone who even periodically notices current events knows, Keynesian enjoy-today "because we're all dead eventually" economics is currently en vogue globally, but at some point the pendulum will swing toward the Classical school.

Despite the dominance of these two camps, in working with my students every day, I am becoming more optimistic that the a new camp may emerge:   Standard-of-Living economics.   If policymakers would pick and choose from existing policy options while carefully considering the potential long-term impacts of such options on the average citizen's potential to increase their standard of living over coming years, then it is more likely that policymakers will choose options that provide such a setting.  Unfortunately, I haven't seen or heard much about monetary or fiscal policy focus on standard of living mobility since the very early months of current Federal Reserve chairman, Janet Yellen, took office.  Hopefully these great students I get to teach will be part of a movement to shift economic policy toward upward social mobility tools and paths for the masses, rather than muting the natural business cycle associated with a capitalist economic system.

Why there might not be a surge in inflation . . . or not.

Historically, the amount of money that has been created and in circulation, relative to the amount of gross domestic product (GDP) has had a fairly constant relationship.  Today, the United States real GDP is approximately $18 trillion annually.  There is U.S. money in circulation of approximately $1.4 trillion, which is a ratio of approximately 13 to U.S. real GDP currently.  Following the strong economic growth of the post-World War II era, in 1975, the United States GDP was approximately $1.5 trillion, according to the World Bank, while U.S. money in circulation was approximately $75 billion, which was a ratio of 20.  Additionally, in 1950, the United States GDP was approximately $250 billion, while U.S. money in circulation was approximately $25 billion, which was a ratio of approximately 10.  Expansion in the ratio of money-in-circulation to United States GDP suggests that the United States became more efficient with putting new available money to work, while a decline in the ratio would suggest that new money came into circulation, but was used in a manner that was less productive than the existing uses of available money for investment.

                                                                        $ in billions

                YEAR               1950               1975               2000               2015

                  GDP                $250               $1,500         $10,000           $18,000

                 Money               $25                 $75                 $600            $1,400

                 Ratio                    10                   20                   18                   13

                Sources:  U.S. Federal Reserve Bank of St. Louis.

The above table shows that from 1950 through 1975, the increase in money in circulation resulted in a greater increase in real (inflation-adjusted) GDP.  The primary driver of the increase in money in circulation is when banks create new money in the system through loans when there is a proposed productive use for that money in the form of business expansion, construction opportunities, equipment replacement requirements for consumers and businesses and sometimes governments.  During this time period, a tripling of the money in circulation resulted in a six-fold increase in real GDP.  This suggests that the new money created, mainly through new credit creation in the form of bank lending, generated very high productive and economic-expanding returns.  Similarly, the roughly flat trend in the ratio of real GDP to money from 1975 to 2000 also suggests highly productive money creation at or near 1975 levels.  However, in the more brief period of 2000 through 2015, the GDP-enhancing impact of new money created has fallen; approximately $800 billion of new money in circulation more more than a 100% increase, and yet annual real GDP increased by approximately 80%.  This suggests that the new money in circulation, again largely generated through new lending from banks, was not as stimulative to economic growth as such money supply increases in prior periods.  This suggests that more money is chasing incrementally less productivity, which can be inflationary.

Going forward, the United States banking system currently is flush with lending capacity, as there is more than $3 trillion of available lending power that, due to the multiplier effect, represents approximately $15 trillion in potential new money creation capacity.  In the absence of incremental real GDP growth at a minimum ratio of 13 dollars of real GDP growth for each one dollar of money creation through bank lending, such new money creation would be inflationary.  Therefore, in a scenario that our money in circulation increases from approximately $1.4 trillion to $16.4 trillion without U.S. annualized real GDP expansion from approximately $18 trillion to $213 trillion, inflation will likely result.

While economic expansion from $18 trillion to $213 trillion may seem unlikely, and therefore may stoke inflationary panic, there are some checks that naturally reduce the potential for inflation.  First, banks scrutinize loan requests and have capitalistic profit-seeking motivations for limiting loans to strong-return investment opportunities.  Second, if banks begin to see existing loans produce less-than-productive returns through loan quality deterioration, the money multiplier will fall from the maximum of the formula: money multiplier = loanable funds * (1/required reserve ratio);  if the required reserve ratio is 20% for most banks, then the maximum money multiplier would be 5, but in times when loans do not perform well, banks will slow lending due to profit goals, and new money creation will slow until higher productivity opportunities arise.  Third, if the pace of credit creation is methodical over many decades or even a century, then the odds that the $15 trillion of potential incremental new money created does in fact generate an incremental $195 trillion of real GDP probably is greater.

In summary, it would be overly speculative, and probably irresponsible, to stoke the flames of inflationary panic that some gold bugs tend to rely on with regard to money creation as a definitive driver of coming hyper-inflation.  However, the decline in productivity of new money creation from roughly 20 dollars of incremental real GDP to 13 dollars of incremental GDP for each new dollar created does warrant vigilance.  In the context of a highly-Keynesian global economic environment, where foreign central banks are using the Great Recession-induced U.S. experiment with quantitative easing in unprecedented levels, such vigilance seems even more warranted than otherwise.

What does the recent heightened financial markets volatility mean (if anything)?

In one episode of my favorite show, Seinfeld, Jerry Seinfeld sells his shares of a stock when the price falls below the price he purchased the stock, while his buddy George holds on and the stock makes George a small fortune in George's context.  Jerry's girlfriend at the time reminds Jerry that he wouldn't have made his ill-timed sale if Jerry had listened to her when she told him that "stocks fluctuate."  Like most comments from women to Jerry on the show, this comment ended the relationship.  And while it is true that markets "fluctuate," recent intra-week, intra-day, and even intra-pre-market so-called fluctuations have been in excess of 2% on many days during these past few months.

It is hard to know what this heightened volatility means, but based on 2007 and 2008, I would not be surprised if this heightened volatility is signaling that there is a high level (relative to historical averages) of financial leverage being used to buy financial assets.  In addition, the increase in the size of the financial derivatives market is likely to blame as well, as is the increasing size of the exchange-traded fund (ETF) market, which must amplify the impact of any gyrations in the financial markets as selling or buying of securities may beget more selling and buying of such securities as investors re-size their ETF holdings.

My sense is that heightened volatility is associated with near-term downside in financial markets indices, and that opportunities for long-term value investors to buy world class businesses at bargain-basement prices relative to the businesses' free cash flows will arise soon.

What are the financial markets (equity/stock, bond/debt/credit, commodity) good for?

During the workweek of August 24, 2015 through August 28, 2015, the well-followed and well-covered (by the press, at a minimum) Dow Jones Industrial Average index and the Standard & Poor’s 500 index experienced daily increases and/or decreases in excess of 2%.  Even though most market observers probably would not think that a 2% change in the price of a certain stock from $100 to $98, or from $100 to $102, was a big change to worry about, such percentage changes so many days in a row in the equity indices seem to generate massive euphoria or worry amongst market observers.  I am not sure if such euphoria or worry is rationale or irrational.  But I do believe that the financial markets are extremely important and useful aspects of our society.

Starting with the bond markets, which sometimes also are referred to as the credit or debt markets, is probably the easiest place to begin explaining why the financial markets are so important.  The bond markets, and specifically the integrity of the bond markets and the prices and yields of bonds, are of paramount importance in a capitalist society because the interest rate that investors demand for lending money to a borrower provides real-time information to potential investors about the risk of default (not meeting financial obligations in a timely/scheduled manner) of a given borrower.  When functioning properly (with brokerage firms making a profit on making markets in bonds and investors buying and selling bonds that meet the investors return requirements), the bond markets act as a risk-siren and opportunity-siren (frequently in the exact same bond security, but to different investors), providing information that enables risk-averse and risk-inclined investors and lenders to select organizations to provide capital to; moreover, when the markets are functioning with integrity, the lent capital (also referred to as ‘temporary’ capital) is usually more stable for the borrowers than if the lender is ill-informed of the risk characteristics of the borrower and therefore seeks to end the lending relationship.  Therefore, it is critical that the information that borrowers provide to the debt markets is accurate.  If not, and such inaccurate information is used by lenders, which provide critical capital to borrowers that have smart ideas for that capital to generate higher returns than the interest rate that the lender charges the borrower, lenders may lose faith in the integrity of the information that borrowers provide.  For example, if securities industry analysts assert that a borrower has a strong ability to make interest payments and repay principal when such ability is actually quite weak, then lenders will re-price risk rapidly, and in the case of the U.S. housing financial crisis of 2008-2009 lenders when information systematically lacked integrity, and lending sources may cease lending to massive components of an economy.  As such, the efficient and generally accurate pricing of repayment risk of borrowers is critical to economic stability and economic growth in a capitalist economic system.

In contrast, the stock market is driven (or should be driven) by quite different dynamics.  In almost all cases, but with a few variations, owning a share of stock represents a residual interest in the earnings of the stock issuer.  Shareholder rights to proportional earnings of a company are subject to more fluctuations than bondholders contractual legal rights to cash flows of a company.  As such, stocks probably should be more volatile in price ranges than bonds because more factors may affect the perception of the potential residual earnings power of an organization, and such factors will probably change more often than the factors that affect perceptions of organizations’ ability to repay borrowings, which rank much higher in an organization’s capital struck than the ‘permanent’ equity capital that stockholders provide to corporations.  For example, a corporation, AFTER meeting its obligations to bondholders and other creditors, may decide to invest in building inventory or adding to research and development expenses, rather than paying out more profits to shareholders; few, if any, organizations would intentionally put research and development expense or inventory build-up ahead of paying obligations to bondholders or other lenders – if an organization did that, it would probably only get the chance to do that ONCE because the bond market participants would penalize the borrower severely through demanding higher interest rates or by suing in the legal system.

After working primarily in the financial markets for almost 20 years, I live in a town where many of the residents work in the financial services industry, and I teach many of their kids at the high school level.  I also am fortunate to continue to interact-with and consult-to some outstanding professionals in the financial services industry.  These people and their organizations are very important to our capitalist society because they play a role of helping price loans and risk, which drives investments or in some cases prevents investments.  Their work fuels economic growth and regulates what entrepreneurial and business growth opportunities should be pursued and which should not.  I think it is very important that we continue to encourage some of our best and brightest young people to keep improving upon the integrity and efficiency of these vital tools of our capitalist society because the financial services industry and our markets ARE very good for society when these markets function with integrity and efficiency.

Currency Policy Trends and the Widening Wealth Gap

The global currency markets are simple in a completely free markets.  By "simple" I mean self-correcting when there is not government or financial services industry intervention that is not associated with private sector transactions related to a productive economic objective, such as Wal-Mart buying lightbulbs manufactured in Nigeria;  when Wal-Mart buys from a non-domestic U.S.A. manufacturer, two transactions occur:  (1) Wal-Mart authorizes payment for the good produced in Africa and payment is sent to the manufacturer's bank account, and (2) either Wal-Mart's bank or the manufacturer's bank converts Wal-Mart's U.S. dollar payment into local currency such that U.S. dollars are sold, and local currency units are purchased.  Such a pair of transactions results in a marginal weakening of the U.S. dollar currency because that currency has been sold and converted into the relatedly-purchased non-U.S. dollar currency.  When this occurs, all other things equal ("ceteris paribus" in economic speak) all goods and services produced in the United States become slightly less expensive to buyers using foreign currencies and goods and services produced in the home country of the producer of Wal-Mart's good or service become incrementally more expensive.

When the above-explained mechanism occurs with private sector actors (Wal-Mart, the foreign manufacturer, and the banks) all behaving in a self-interested manner aimed toward their goal of generating a profit, the currency markets generally provide a valuable role in societies as a regulator of trade and a measure of the attractiveness of various possible non-domestic sources of goods and services.  As a positive externality, foreign competitive goods force domestic producers to maintain competitiveness in quality, and may in fact force superior product innovation, as I believe has occurred in the case of German automobiles.  For multi-year periods and possibly multi-decade periods, Germany's post-WWI-reparations-driven fear of currency weakness has probably played some role in its high-quality automobiles and high-quality manufactured products track record more broadly.

In contrast to the benefits of free market currency externalities, when nations intervene in currency markets (such as the recent trends globally), protectionism rears its ugly head with regard to quality of goods and services produced in the absence of other nations responding.  Moreover, if other nations do respond with protectionist currency actions, those domestic workers without assets whose nominal values are correlated positively with currency weakening actions may experience a negative impact on their standard of living as their nominal expenses rise more rapidly than their nominal wages.  Thus, currency wars likely benefit politicians and currency bureaucrats who are seen as 'protecting' their employers and citizens jobs, but in reality drive further widening of the wealth gap.

So that is enough on currency at this time.  I believe that we have been in a currency war globally for more than a year since the European Central Bank began quantitative easing.  More recently, the Chinese Central Bank has joined the party.  At the same time, sociologists around the world seemingly write endlessly about the growing wealth gap.  And yet few, if any, relate the growing wealth gap to currency policies.   I think that lake of intellectual connection will dissipate in coming quarters and years.

Week of 8.10.15: The Most Interesting, but Under-covered Event of this Week - U.S. Treasury Bond Auction Demand

The most interesting, but under-covered, newsworthy item of the week was the weak auction of U.S. Treasury bonds during this past week.  While one weak auction does not make a trend, this is an area worth some vigilance, given the U.S. federal budget levels that require periodic debt re-financings or pure new issuances to fund deficits.  The weak demand is by no means a trend, but merely a data point.

A Philosophy

Absolute Value is a philosophy.  It is a practical philosophy because it relates investing decisions to economics, which some believe is an academic arena.  However, over the course of most of history, as I have read it, all investment opportunities are ultimately valued relative to the perceived risk-free investment opportunity.  Currently, as of August 14 in 2015, the 'perceived' risk-free interest rate is reflected in U.S. Treasury bonds, and specifically the 10-year U.S. Treasury Bond that yields roughly 2 - 2.5% in recent months.  In my view, successful investors will have proprietary processes for evaluating investment opportunities relative to the currently-perceived 'risk-free' rate of return.