United States At Blame for Eurozone Problems?

Recommended read this morning, the op-ed piece by Kenneth Rogoff, “The Global Fallout of a Eurozone Collapse,” in the Financial Times. (http://www.ft.com/intl/cms/s/0/e66a3d7c-9073-11e0-9227-00144feab49a.html#axzz1OaJbLwdu)

“It is ironic that the euro…is suffering from having an overly strong exchange rate, particularly against the dollar, and at precisely the moment when a huge depreciation would be most helpful.”

“I think it would be more accurate to say that markets are more worried... about the US’s lack of a plan A than Europe’s lack of plan B.”

“Unfortunately…the euro is looking very much like a system that amplifies shocks rather than absorbs them.  The UK, which of course did not adopt the euro, has benefited from a sharp sustained depreciation of the pound.  The peripheral countries of Europe are meanwhile stuck with woefully weak competitive positions and no easy adjustment mechanism.  European leaders’ plans to achieve effective devaluation through major wage adjustment seem far-fetched.  The only clean rescue for Europe would be if growth far outstripped expectations.  Unfortunately, post-financial crisis growth is likely to continue to be hampered by huge debt burdens.”

The worst of all worlds for this crisis…stagflation.

And, the United States continues to pound away creating more and more credit inflation for itself and the world…both in terms of monetary and fiscal policies.  (See my post about the Fed’s feeding of world inflation: http://seekingalpha.com/article/273506-cash-assets-at-foreign-related-financial-institutions-in-the-u-s-approach-1t.) 

“The markets are more worried about the US’s lack of a plan A…”

To me the world is seeing the current leadership in Washington, D. C. as little different than any group of leaders in Washington, D. C. over the past fifty years.   For the past fifty years the government debt produced by the United States government has risen at a compound rate of growth of more than 8 percent per year.  Economic growth has averaged a little more than 3 per cent every year for this same 50-year period.  

This is “credit inflation.”

And, the value of the dollar?

In 1961, at the start of this binge, the value of the dollar was pegged to gold.  In August 1971, President Nixon floated the dollar.  With the open capital markets that arose in the 1960s, a country could not independently follow a policy of credit inflation and keep the value of its currency fixed. 

Since the dollar was floated, the general trend in the value of the dollar has been downward with three exceptions.  The first was in the Volcker years of the early 1980s; the second was when Rubin was Secretary of the Treasury in the late 1990s; and the third was in the world rush to quality during the financial crisis of 2008-2009. 

The leaders of the United States have not had a plan to halt the decline in the value of the dollar for the past fifty years.  And, the Obama Administration is no different from any of the other administrations that preceded it since 1961. 

United States government officials have stated their support for a “strong” dollar throughout this time and yet have done little or nothing to stem the decline.

Again, “watch the hips and not the lips!”

And, the longer-term trend in the value of the United States dollar is still downward.

However, in an interdependent world, actions have repercussions elsewhere.  And that is what Rogoff is calling our attention to.  The policy actions of the United States government impact others.  And, the blanket government policy of credit inflation followed by Republican and Democratic Presidents over the last 50 years has come to dominate the world. 

Not only is it exacerbating the sovereign debt problems of Europe, it is spreading inflation throughout the world as the US dollars pumped into the US banking system by the Federal Reserve flow almost seamlessly into commodity markets throughout the world. (Again, see my post from yesterday.)

The irresponsible creation of debt and more debt does come to a limit.  And, as one approaches the limit, the number of options available to the issuer of the debt shrink in number as the desirability of those options also lessen. (“Debt Ultimately Leaves You With No Good Options,” http://seekingalpha.com/article/271651-debt-ultimately-leaves-you-with-no-good-options.)

The United States is experiencing this difficulty as we speak.  There are “things” the government would like to get into but can’t because there is no fiscal room for anything more, and there are “things” the government must get out of but don’t want to because they are in political favor. 

In a world of excessive debt, there are no good choices…period!

Rogoff goes on to talk about whether or not the world will succeed in forming a co-reserve currency system.  This would happen as the benefits of the co-reserve currency system were observed which would result in a trend towards the consolidation of currencies throughout the world. 

The current period of stress, Rogoff argues, is a period of learning.  “Having a smaller number of currencies is a phenomenon that makes a lot of sense economically, economizing on transactions’ costs and leveraging economies of scale.  The real question is whether common currency is sustainable politically.  My guess is that if the current slow patch in global growth does not quickly subside, we will not have to wait long for an answer.”

Investment strategies in this time of transition (I)

In my post of July 29, 2008, “Understanding the Economy” I discussed two possible interpretations of the current economic situation. One interpretation concentrated upon demand side changes in the economy whereas the other interpretation concentrated upon supply side changes. I argued that it was important to get the correct interpretation because the policy prescriptions would be different in each case and would produce substantially different results.

I gave two reasons for focusing upon the latter explanation as the cause of the business cycle and stated that it was important to create policies that provided supply side stimulus rather than policies that just attempted to stimulate demand. If the United States focuses on demand side stimulation, the argument is that this will just exacerbate inflationary pressures with little or no response in terms of increased output. Any governmental efforts need to be aimed at stimulating supply so that output can increase without undue pressure on prices.

A similar proposal has been presented by Kenneth Rogoff of Harvard University on Wednesday July 30 in the Financial Times, “The world cannot grow its way out of this slowdown.” (See http://www.ft.com/cms/s/29a40a90-5d6f-11dd-8129-000077b07658,Authorised=false.html?_i_location=http%3A%2F%2Fwww.ft.com%2Fcms%2Fs%2F0%2F29a40a90-5d6f-11dd-8129-000077b07658.html&_i_referer=http%3A%2F%2Fsearch.ft.com%2Fsearch%3FqueryText%3Dthe%2Bworld%2Bcannot%2Bgrow%26aje%3Dtrue%26dse%3D%26dsz%3D.)

Rogoff argues that “if all regions attempt to maintain high growth through macroeconomic stimulus, the main result is going to be higher commodity prices and ultimately a bigger crash in the not-too-distant future.” He goes on to say, “In the light of the experience of the 1970s, it is surprising how many leading policymakers and economic pundits believe that policy should aim to keep pushing demand up.”

Furthermore, Rogoff states, “Commodity constraints will limit the real output response globally, and most of the excess demand will spill over into higher inflation.”

In other words, pumping up aggregate demand at this time is not going to get a supply response and hence almost all of the increase in aggregate demand will go into prices increases. Not a very pretty view of the future.

My description of this scenario was presented in the earlier post. In this post I want to examine investment strategies for the two different scenarios. Since we started on the demand side responses and believe that policies aimed at spurring on aggregate demand have the highest probability of occurring, let’s begin here.

Demand side programs, according to the scenario presented by Rogoff (and myself), will have more impact on increasing inflation than they will on increasing output. As a consequence, investor focus should be on protecting oneself from rising prices. (Sounds like the seventies doesn’t it!)

What to look for? More tax rebates (already being discussed); support for housing (already being discussed); keeping interest rates low (already being discussed); and other programs and policies being presented by presidential candidates and Congress.

Investment strategy? Where are your inflation hedges? Gold…commodities…housing seems to be out this time (it was a great hedge in the 1970s)…inventories…paintings…rare coins…

Obviously, these types of investment do not do a great deal to contribute to increasing output or stimulating productivity. This is what happened in the 1970s as the focus changed and people pulled back from investing in innovations and capital that resulted in increases in productivity and which also created positive externalities that spurred on the economy.

Demand side strategies at a time like this divert attention away from productive investment and toward investments that hedge against inflation and contribute little to resolving the underlying economic problems that plague the United States (and the world). But, demand side strategies are very popular with politicians because they can allow the candidate to talk about help to the ‘disadvantaged’ and the ‘little guy’ and beating up the ‘bad guys’. And, they promise faster results. Furthermore, when investors hedge against the inflation that is created, these same politicians can blast the ‘wealthy speculators’ for driving up prices which additionally harm the less well off. And, this is what happened during the years of the Carter administration.

Rogoff concludes his analysis with this warning: “In policymaker’s zealous attempts to avoid a plain vanilla supply shock recession, they are taking excessive risks with inflation and budget discipline that may ultimately lead to a much greater ad more protracted downturn.”

What about supply side policies? Not as easy to do and certainly not as easy to sell! First off, the fiscal authorities must take pressure off the monetary authorities by exerting discipline over the government’s budget. The irresponsible behavior of the current administration must be overcome by bringing the deficit under control. Doing this will help strengthen the value of the dollar, something that will help the performance of the United States economy in the longer run.

The attention of the monetary authorities must be focused on keeping inflation at a low level. What finally got the United States out of the malaise of the 1970s? Some tough policy actions on the part of Paul Volcker and the Federal Reserve that broke the back of inflation (even though this is not what Jimmy Carter really wanted). Inflation is counter-productive to economic growth, productivity, and innovation. We cannot get a supply side response as long as businesses and investors focus on inflation. Keeping inflation at a low level will also contribute to the strength of the dollar. (See Fred Mishkin’s last lecture before leaving the Fed: http://online.wsj.com/article/SB121726587261090311.html?mod=todays_us_page_one; and http://www.federalreserve.gov/newsevents/speech/mishkin20080728a.htm.)

Other supply side policies are still needed to spur on a recovery, but these will not result in programs that generate a short term payoff, something, of course, that politicians do not like. But, it must be remembered…it took us a long time to get where we are now and it will take a long time for us to get back ‘on track’. People must remind the politicians that they turned their heads aside for a long time allowing this economic dilemma to arise…and they are not going to be able to get us out of this mess with a wave of a magic wand!

It seems to me that there are at least two aspects to creating the platform for the next period of expansion. First, we must go through the economic transition to get our financial legs back under us, both in our financial institutions, but also in non-financial areas as well. Second, we must go through the technological transition that will result from the advent of new sources of energy. And, this transition will impact almost every sector of the economy. The important thing here is that the government must introduce policies and programs that will support the PROCESS of transition and which will not impede that process by shooting for specific OUTCOMES.

What to invest in given a supply side response by the government? Well, this is a time of transition and that means we must look into areas in which the transition is going to take place. One possible source for investment is in companies that are getting back to basics and bringing their focus back into the areas that they have or can establish sustainable competitive advantage. Here we can look for turnarounds, restructuring firms, and acquisitions to gain scale, customer captivity, or create barriers to entry. Second, we look toward those innovators that are working in the energy field to construct technologies or market structures that might create sustainable competitive advantage. This means that the scope of potential investments may be quite large, but the focus will be on future market structure. I will write more on these in the next two posts.

Interpreting the Economy

It is very important to understand the state of the economy and the possibilities for the direction of the economy in the future. This understanding is important, not only for policy makers, but also for businesses and investors. It is my view that many analysts are still trapped in a way of thinking that does not really reflect what we are facing at the current time.

The basic tendency is for people to look at the aggregate demand side of the economy to discern what is going on and what should be done to improve economic conditions. This is because the basic paradigm of modern macroeconomics is based upon the work of John Maynard Keynes and this model focuses primarily upon the demand side of the economy. This model was developed for two practical reasons. The first was to create a model that would allow nations to conduct their economic policies independently of one another. The impetus for such a model grew out of the situation that existed in the world at the end of the First World War and the Paris Peace Conference of 1919. There was great concern at that time about the success of the Russian Revolution and the growing fear that revolution might spread to other nations through labor unrest if workers were not kept gainfully employed. This fear along with the dysfunctional efforts at the national level to handle reparations and achieve peace highlighted the need, to Keynes, to focus on full employment and to allow a nation to act independently of all the chaos being experienced in international relationships. (For a reference to this view see Donald Markwell, “John Maynard Keynes and International Relations,” Oxford University Press, 2006.)

The second reason was the need to find a way for a government to act to achieve high levels of employment and thus avoid labor unrest. Keynes grew cynical about the ability of a central bank to impact output and employment when it was really needed. The only way he saw out of this problem was to develop a model that could explain how the fiscal policy of a nation could produce the aggregate demand that was necessary to spur a nation on to high levels of employment. Keynes gave very little attention to aggregate supply assuming that businesses would respond to demand: if demand were low, output would be constrained and workers would not be hired; if demand were high, output would be expanded and workers would find employment available.

The model that focuses primarily on aggregate demand came to predominate economic thinking in the post World War II period and continues to permeate the culture of macroeconomic policy making. If a problem seemed to be one of inflation, policy makers could concentrate on slowing down aggregate demand and take the pressure off of prices. If the problem seemed to be one of slow economic growth then policy makers could stimulate aggregate demand and create greater economic growth in the future. Right now when we seem to be faced with both an inflationary situation and slow economic growth we see that policy makers are talking about the monetary authorities raising interest rates, to ward off inflationary pressures, and further tax rebates (to follow the first round of tax rebates) to stimulate the economy.

Ask yourself this question: what are the conditions of demand and supply that result in rising prices and a slowdown in the rate of growth of the economy. Take a two dimensional graph and place the rate of growth of the economy on the X-axis and the rate of increase of prices on the Y-axis. Then draw a demand curve that is negatively sloped from left-to-right on the chart and a supply curve that is positively sloped from left-to-right on the chart. Now, you are only going to move one of the curves. Which curve, when you shift it, can result in a decrease in the rate of growth of output and an rise in the rate of increase in the price level? Only a shift backwards and to the left of the supply curve can give you this latter result!

Could it be that the shock to the economy is coming from aggregate supply and not from aggregated demand? It sure could. I believe that more and more data analysis is pointing to the conclusion that maybe fluctuations in economic growth are not necessarily coming from the demand side of the economy but are coming from the supply side instead.

What are some pieces of evidence that seem to show that movements in the supply side of the economy might dominate what happens to an economy in the short run? Real consumption expenditures, for example, tend to move in a procyclical fashion with real Gross Domestic Product over the business cycle. Real gross investment is also moves with real GDP as do real wages and the real price of rental capital. Interest rates also tend to move in the same way. If aggregate demand dominated economic activity then one would not expect these variables to move in a procyclical fashion. Furthermore, inflation tends to move in a countercyclical way: actual inflation tends to be above the trend rate of inflation when the actual growth rate of real GDP tends to be below the trend rate of economic growth. All these results support the conclusion that shocks to the economy come from the supply side, not from the demand side!

Given how comfortable we have become with the models in which shocks come from the demand side of the economy, these results seem to be counter-intuitive. However, we need to look at these results very carefully because how we interpret them is very, very important for not only the governmental policies that we support, but also for the economic and financial decisions we make given the choices that government policy makers implement.

If the government acts to stimulate the demand side of the economy as a result of a negative supply shock then the basic result will be more pressure on prices with very little of the stimulus being transferred to increasing output and employment. In fact, there can be a second round effect of such inflationary stimulus. We saw in the 1970s that increasing inflation resulted in people and businesses investing so as to hedge against inflation. Most of this hedging turns out to be counter productive to the productivity of the economy. When people begin to focus on protecting themselves against rising prices, it inevitably causes them to lose their focus on good business practices, practices that include increasing the productivity of capital. Thus, this secondary effect can further slow down economic growth by causing an additional backwards shift of the supply curve. This is exactly what happened in the 1970 period of stagflation.

There are a lot of things that can produce a backwards shift in aggregate supply. We don’t have time in this post to go into them, but I will devote some time to this analysis in future posts. However, the efforts to stimulate economic growth without putting pressure on prices are dependent upon whether or not we can identify the factors that have caused the shift and the incentives that can be set up to encourage people and businesses to increase output and further stimulate economic growth. Thus, in order to create more economic growth without setting off further inflationary pressures, care must be taken to identify what has caused the shift in supply. This will allow policy makers to devise policies that will get business, once again, to focus on what they do best.

The problem…supply side policies tend to be those that create enhanced incentives for businesses. Creating such policies without taking into consideration the problems that people have in finding work, in paying their debts, and in holding their heads up, is a sensitive issue. Policy makers must find the right balance of programs to stimulate business activity while not creating too much aggregate demand that will only exacerbate inflation. This is not an easy task!

One final issue…are we in a recession? I am not going to use the standard definition of a recession associated with the National Bureau of Economic Research which focuses major attention on two quarters of negative growth in real GDP. To me the important consideration is the relationship between the trend rate of growth of real GDP and the actual rate of growth of real GDP. To me, the concern is over how far the latter growth rate falls below the former. If the actual growth rate falls below the trend growth rate by 1.5% or more, then this could be defined as a recession. That is, if the trend growth rate of real GDP is 3.0% and the current actual growth rate is 1.4%, then one could argue that the economy is in a recession because actual growth is 1.6% below trend growth. Real GDP has grown at a compound annual rate of 3.0% over the 1977-2007 period. The year over-over-year growth of real GDP from 2007-I to 2008-I was 2.5%. This would indicate the United States economy is not yet in a recession.

Prospects for Stagflation

There has been a lot of talk recently about the United States economy entering a period of Stagflation. Stagflation can be defined as a period of time in which economic growth remains below historical averages while significant inflation is present. A period like this is looked on as the worst of two worlds: the low economic growth results in a higher ‘natural’ rate of unemployment than in more normal times; and the economy still has to deal with an inflation rate that erodes earnings and causes an allocation of resources favoring wealth protection and not productivity. A period of Stagflation tends to be self-perpetuating because the lower productivity results in slower growth and the slower growth exacerbates inflation which further stymies productivity, and so on.

Stagflation also puts the Federal Reserve System “in a box”. If the Fed attempts to ease during such a period, the argument goes that its efforts will tend to go into further inflation. If the Fed attempts to restrain inflation, it will only worsen the unemployment situation. The monetary authorities are faced with a real dilemma.

One of the problems in understanding how Stagflation can occur is that people tend to focus on aggregate demand factors when studying economic fluctuations. If economic shocks come from the demand side, a slowdown in demand translates into slower economic growth which is accompanied by higher unemployment and lower inflation. But, this is not how we define Stagflation.

Instead, Stagflation comes about due to a supply side shock which produces both a slowdown in economic growth and higher rates of inflation (for a given amount of aggregate demand). But, how does this come about?

In terms of economic growth I would argue that two things contribute to the possibility of a slower expansion. First, there is the restructuring that most financial and non-financial firms are going through right now. When firms are going through the process of restructuring they lose focus as to what they really should be concentrating on. I know this sounds contradictory, but my business experience points to this very thing happening at a time like this. When you are restructuring you are concentrating on getting back to basics, eliminating those things that you shouldn’t be involved in and retrenching into those things that you should be involved in. (Should you sell businesses, something that takes time and attention?) Also, financials need to be cleaned up. (Perhaps new capital needs to be raised, something that takes time and attention.) Furthermore, expenses need to be trimmed, people let go, and superfluous efforts eliminated (all taking time and attention).

During such times, executives do not focus on creating or sustaining competitive advantages because their focus lies elsewhere. Achieving and sustaining competitive advantages are what produce exceptional returns over time. But, achieving and sustaining competitive advantages takes time and effort since the primary sources of competitive advantage result from things like barriers to entry and from customer captivity. Barriers to entry come from economies of scale and research programs that create a continuous competitive flow of innovation. Customer captivity comes from building customer relationships through product and service quality and support. A firm generally has to restructure first before it is able to concentrate on these paths to better than average performance. And, since building competitive advantage must be very intentional, it must be the primary focus of management.

The second factor that contributes to slower economic expansion is the impact that inflation has on economic performance. As we saw very clearly in the 1970s, an inflationary environment results in managements directing attention away from longer-lived more productive investments and into shorter-term assets that act like an inflation hedge. Such investment slows down improvements in productivity because productivity improvements tend to be more prevalent in longer-term assets than in short-lived ones. The threat of higher inflation results in lower productivity growth.

Both factors, loss of focus and reduced productivity growth (each of which tend to reduce innovation), contribute to slower economic growth and a less vibrant business environment. This re-focus also results in a change in business leadership. As the culture of businesses change due to different economic environments, management leadership tends to change as well. Promotions and hiring’s go to managers that are more risk averse and less dynamic and this contributes to a slower pace of economic expansion.

On the policy side, both monetary and fiscal policies are directed to stimulate aggregate demand. The general prescription for monetary policy is to lower interest rates (or at least not raise them) and speed up monetary growth. On the fiscal side , a general effort is made to cut taxes and/or increase government expenditures. If the above analysis is correct, both efforts will go to produce more inflation rather than stimulate production, and this, as we have seen, will just contribute to making the situation worse.

If we think we are entering a period of Stagflation, then we must be sure that we understand where the economic shock has come from…the demand side or the supply side. If Stagflation results from a supply side shock then pursuing demand side remedies will only make the situation worse. If Stagflation is coming from the supply side then the government must create more appropriate policy responses fit to meet the needs of the times.

If Stagflation is a supply side problem then we must look at the behavior described above in order to come up with appropriate actions. First of all, inflation is an enemy and its fire must not be fanned! (This even ignores the impact that inflation potentially has on the value of the dollar.) Any policy actions that encourage inflation only create a cumulative problem that just adds fuel to the fire and makes the inflationary spiral that much more difficult to stop. It is hard for policy makers to fight inflation at a time like this because voters and politicians are clamoring for more economic growth and less unemployment.

The second part of the problem is not only difficult but slow to unwind. Also, there are two components to this second part. The restructuring of businesses, both financial and non-financial, must take place and it must take place in as orderly a fashion as possible. This takes time. It has taken the American economy quite a few years to get into the situation it is now going through and getting out of it will be painful and time consuming. Adding to the normal adjustment process is the added problem that the United States, as well as the world, is also in need of moving away from fossil related energy sources and moving into an age of cleaner and more efficient energy sources that are not fossil related. So, we are going though an adjustment related to the financial excesses of the past decade or so as well as an adjustment related to the absence of a sound energy policy in the developed world.

The other thing that must be avoided at this time is the move to a more inner-directed management. For the economic growth rate to increase and unemployment to drop, managements must strive to create sustainable competitive advantage by focusing on what they do best and innovating in order to keep ahead of their competition. Costs must be contained, not through cutting back on expenses, but, through economies of scale achieved in the application of core competencies and increases in productivity. This too will take time and the intentional efforts of business leaders and entrepreneurs.

To combat Stagflation we must have monetary policy and fiscal policy working together. Monetary policy must work to keep inflation moderate. Fiscal policy must work to create an environment that encourages the improvement of productivity and risk-taking. Yes, there needs to be a safety-net for Americans that are hurt by unemployment and economic dislocation. But, if Stagflation is a supply side problem, the resolution to the problem must come from stimulus programs that impact the supply side of the economy.