As I look toward 2020…
I have been hunkering down, reading some stuff, and came across some themes that I just wanted to write about.
Why are economists wrong so frequently? Why do economic forecasts look so silly, so frequently, when you look backwards? How did economics find itself wedded to so many mathematical models when the models themselves start with so many behavioral assumptions?
Let’s start with some general answers. There is a reason why economics is referred to as the dismal science. It is a science; but it is a behavioral science, not a physical one. We can generally explain human behavior. But we cannot predict it very well. Richard Thaler, a highly accredited economists, wrote a book, Misbehaving: The making of Behavioral Economics, which plowed through this subject with much glee. OK, this much was easy, and you knew this anyway.
Let’s go a few steps further. The WSJ has been writing on this subject a fair bit this month. It started with the question, “ why are interest rates so low, growth so sluggish, but unemployment and stocks so good.” As economists tend to do, they offered several theories:
- One is a theory of debt overhang. The idea is that the shock of 2008-2009 still hangs over decision making, leading to more of an emphasis on paying down debt, than accumulating it. This may be especially so with regard to consumer/household debt. (With regard to debt to savings, households have been behaving quite well.) With a focus on saving, more debt is available, looking for borrowers, and either forcing down the cost of debt or at least keeping it level. (Corporate debt, on the other hand, at $10 trillion, is at an all-time high, by some measures.)
- Two, Larry Summers, ex- Harvard President, ex Obama advisor and Clinton advisor, offers a theory he calls secular stagnation. It starts with slow population growth. It proceeds to examining the investment behavior of the huge social media companies and many tech companies. Summers says, unlike their predecessor large companies, these folks are not big investors. Maybe he is right. In 1Q, 2019, Apple reported having over $230B cash on hand. By Q3, Facebook, which is pure services, was over $52B, Microsoft at about $136B, and Alphabet at $121B. (Apple was below half of what it had in Q1 by Q3, 2019.) His third point is increasing inequality, which distributes more and more economic value to people who are already very wealthy. These people, says Summers, tend to save, not spend. (See below for confirmation of economic gains between 1980-2016 that went to people already rich by world standards.)
- More on Summers: he says that these three changes have created huge implications:
- Low interest rates equals less fuel for Central Banks. How do we get out of the next recession without beinbg able to lower the cost of money?
- Governments can run huge deficits because government debt is not crowding out private investment – the way we used to describe this a few years ago. In fact, he says governments should keep spending because the private sector isn’t. Furthermore, he says, leave your hands off entitlements because if you move against them people will just save more in defense.
- Further, this situation encourages more protectionism.
- Yet more on Summers: The results of all of this don’t exactly conform to what Summers might expect. The stock market is way up, unemployment is way down, and job growth is strong, especially for the people the Democrats say are left behind – the lower middle classes. The lower 50% are seeing real wage increases between 7-10%, the highest growth in many years. This doesn’t look very stagnated. (See below for how the middle class has experienced the past fifteen years, which is not good.)
- Three, there is a theory that the Natural Rate of Unemployment is much lower than economists thought. The natural rate of unemployment is the lowest unemployment rate the US can sustain without running out of labor and/or pushing up the rate of inflation. Years back, economists always thought that real full employment was at about 5% unemployment. Apparently, this theory offers that the 5% number is too high.
What did we just learn? Not a great deal, me thinks. Are we being told that government deficits are the only thing driving the economy? Might we venture out a bit and conclude that all of that private sector cash on hand may be the fuel that pulls us out of the next recession, especially given that governments don’t have any fuel? (Certainly Warren Buffett’s often spoken notion, that he’ll hold on to his cash until assets get cheap and then he’ll buy like crazy, would support this view.) But what about the debt overhang? In fact, US Corporate debt is at a record high, standing at about $10 trillion, or about 47% of the annual GDP. However, let’s push back a bit. Since when do we compare debt to operating revenue? Usually, on our balance sheet, we compare debt to assets. A recent estimate of US assets putsthem at over $227 trillion. About $100 trillion of this was household net worth, obviously a much more important number then gross assets. The remainder are assets held by non financial institutions. (Generally speaking, the data comes from the Federal Reserve.) If you buy that, debt is 4.4 % of assets. So, maybe there really is a lot of debt overhang. (Caveat: these are fun models, but it would certainly be challenging if you ever had to monetize this level of assets, or even portions of it, in the short run. On the other hand, we haven’t even considered the hard assets owned by the Federal Government alone to off-set its $21T in debt.)
I am intrigued with Summer’s first speculation that stagnation is partially a function of slow population growth. In my academic training, my deepest discipline is economics. 80% of my economic studies were focused on price theory, a really great decision-making tool – Pareto Optimality being perhaps the most perceptive of economic theories, and the hard core basis for all deal making. I have felt for years that the three legs of the economic stool – growth, resource allocation, and resource distribution – would eventually need a forth leg to either support growth, or replace it. Can the world depend on population expansion for the next 100 years to drive our economies? If so, everything we hear about the causes of climate change are a damn lie – and I don’t think they are. If not, economics needssome new tools. (Where is Adam Smith when we need him? Or David Ricardo? Or Irving Fisher? Or Friedman, for that matter.)
Perhaps the writers in the WSJ were thinking the way I am because they then proceeded to write another article addressing the lessons from the 2008-2009 period, and how they applied during the decade just concluded. (If you want to stop reading, the short answer is that they did not apply very well.)
The S & P grew on average at .95% per year between 2000-2009. (Of course, a 40+% drop during the recession didn’t help that average very much.) Expectations in 2009 were minimal: significantly lower global returns. Emerging markets would lead the way. What did we get? Low interest rates. Low inflation. Stronger dollar. Strong stock market. Reasonably strong bonds. Growth stocks were the best value. Large company stocks beat out small company stocks. Global stocks lagged. About no one expected any of this.
I guess now the investing public pretty much agrees that the market has no-where to go but up; because investors have made a huge move away from actively managed stock portfolios, in which they have net invested $160 Billion, to index funds, in which they have net invested $3.76 trillion. (When I see that many people betting on this kind of an outcome, it tells me that the future must be otherwise.) In addition, current investors seem to be all over private equity and even venture capital. Opps!
What do we draw from all of that? While we need to learn from the past, we don’t build forecasts on the past. And where the herd is running, well, be careful. The herd has a terrible habit of being wrong, or perhaps, simply very, very late. Why? It’s quite simple. Most of the herd is not following an economic principle. They are following their feelings, and their feeling is that all of these other people must be right.
But, if you are still with me, let’s go to one other source, and a somewhat different one. The source is Foreign Affairs, which devoted an issue to the Future of Capitalism. In this case, we are reviewing articles that experts sometimes took months to research and write. One of them caught my interest. In this article – “How Poverty Ends”, by two MIT economists – the authors were trying to understand what drives economic growth?
They start by looking at the data between 1980 and 2016 which describes what has actually taken place in the developing world. The statistics are astonishing. The average income of the bottom 50% earners nearly doubled. They captured 12% of the growth in global GDP. (See below for the share the 1% captured.) 700million people now live in extreme poverty – $1.90 per day – compared to nearly two billion in 1980.
There have also been massive improvements in quality of life even for those who remained poor, as measured by maternal mortality rate, infant mortality, access to primary education, and other factors. Most of these gains were tied to economic growth.
Since the end of WW II, economist have been so focused on this linkage between GDP growth and rising standards of living that they have developed a sub industry in economics studying economic growth. Following are the key takeaways from the article:
- Our authors says that “ the uncomfortable truth is that the field of economics still doesn’t have a good sense of why some economies expand and others don’t.”
- For developing economies, terms like “ ‘grow faster’, or even ‘continue to grow’ are more expressions of hope than actionable policy recommendations.
- In 2006, The World Bank funded a Commission to study economic growth. In its final report, “the group recognized that there are no general principles for growth and that no two instances of economic expansion are quite alike.”
- One noted economist said this about the Commission’s work: “After two years of work by the commission of 21 world leaders and experts, an 11-member working group, 300 academic experts, 12 workshops, 13 consultations, and a budget of $4 million, the experts’ answer to the question of how to attain high growth was roughly: we do not know, but trust experts to figure it out.
One additional idea mentioned in these articles is some thinking regarding the use of GDP as a measure of growth. Perhaps this is an opening to a much larger discussion about what might replace or help economic growth as the primary driver of economic policy. The conversation rests on the assumption that growth, improvement, better situation, etc. are driven by economic expansion. Where does quality of life fit into this? And is quality of life a function of economic expansion, wealth creation, etc. fully, partially, or minimally. (Certainly it is a factor until you move, as an individual, well beyond economic sustainability. And immediately we make the GDP growthmeasure more relevant by adding in a non-economic factor which weighs on everyone and this is expectations.)
Some people tie the current strength of the US economy to the policies of the Trump Administration. In a recent serious appraisal (Steve Cortes, Real Clear Politics, also a CN&N contributor), a fair one I think, ten achievements for 2019 were discussed. Three of these centered on economic growth. This author credited the Trump Administration for the low unemployment and high job creation because of its (1) growth doctrine of economic nationalism and the diffusion of power. Impressively, those without a high school diploma “welcomed 9% wage acceleration in 2019.” The author added that confronting China has proven that (2) tariffs can be effectively deployed to force trading partners into a bargaining posture. This has proven that “tough trade policy can coincide with growth.” Yet another (3) reason for the strength of the US economy has been the “establishment of America as an energy superpower…which has driven domestic prosperity….and facilitates affordable energy to power the on-shoring manufacturing renaissance that has produced 500,000 new factory jobs.”
I am not sure what is to be learned from these three points. The energy revolution, built on fracking, started a very long time ago. Like all presidencies, his gets the credit for decisions made long before his time in office. The point, however, is the theory that economic growth can be tied to the astonishing success of a single industry. Can you forecast such an event? No one forecasted the Internet economy that sprung up in the late 90’s. No one forecasted its collapse. (Of course, having then shed bad stuff, it got back up and became the world we know today.) No one forecasted that a handful of so-called tech companies would disproportionately drive both the economy and the stock market for the past ten years.
What about the growth doctrine of economic nationalism and the diffusion of power. First, let’s pause and recognize that, since WW II, the US practiced a kind of economic globalism unheard of by any conquering country in world history. We opened our markets to the vanquished and to the impoverished. The United States concluded that this policy supported its best interests. An adjustment back toward the middle, somewhere between pure economic nationalism and pure globalism, was well in order. Have we become economically nationalist in almost three years under Trump? Well, based on the averages over the six months thru June, 2019, we will run a trade deficit of about $650 billion in 2019. That’s not particularly nationalistic. Of course, let’s be clear: we will sell almost $2.5 trillion goods to trading partners in 2019, and this is a good thing, I suppose.
Relative to the second part, the diffusion of power, I suppose the big question is whether there has been much of a diffusion. I don’t really know the answer to this question. (The best I can offer is data that shows that the rate of net new regulations in the Federal Government has materially slowed; but there has been no net decline.) In theory, diffusion puts capital allocation decisions closer to where the real data is collected regarding investment returns. But, we must also recognize that huge investments, or lack thereof, might have huge social externalities that private industry is in no way equipped to factor into their decision making. The spillover costs of a huge industry built on the production of fossil fuels comes to mind.
Finally, we revisit the use of tariffs as a way to spur domestic growth. Economic theory pushes back very solidly against this belief. (There are many non-economic reasons, for example, national security, to push back hard on China.) We need to remember that growth, allocation, and distribution are in fact three different legs of the economic stool. If a country worried about how a minority of its citizens might be affected by free trade, or how national security might be affected, that country’s policies would explicitly address these issues through, for example, redistributive policies, or national security constraints regarding what kinds of technologies should be put on the open global market. But, and this is important, you would never argue that the overall economic pie will be maximized by either no trade, or managed trade. Wouldn’t you always want to start with the largest pie possible, the most efficient use of global resources, and then focus on where that distributive outcome needs to be altered, to serve the public interest?
Some have argued that the Trump Administration is pushing the United States away from Free Trade to Managed Trade. In effect, this means that humans will be stepping in and making resource allocation decisions that beforehand were largely left to the market. This evolvement toward a new model is being pursued without any real national conversation. Interestingly, this is similar to the comparative models of capitalism being pursued by the United States and Europe, on the one hand, and by China and Russia, on the other. Ours is a form of Liberal Capitalism and theirs is a form of Political Capitalism. Ours is driven more by markets. Theirs is driven more by the State, namely, human decision making. How odd that the Trump Administration is showing less confidence in market driven capitalism than perhaps any administration ever.
From all of this, a few thoughts regarding tomorrow, and the day after:
- While most of the data look wonderful in the US for the past decade – the data listed above on employment and stock market – it is still the case that the big winners during the 1980-2016 period studied by the MIT guys was the top 1%. – the rich in the already rich countries, plus an increasing number of super rich in the developing world. While the lower 50% captured 12% of the gain, this group of 1% captured 27 % of the gain. “The people between, the 49% below the 1%, which includes almost everyone in the United States and Europe, lost out, and their income stagnated throughout that period.” Perhaps this explains the rhetoric in the US political dialogue, people talking by each other, one group saying things are awful and the other group saying they have never been better.
- We must remember that these groupings are not static populations. People move from the middle to the upper 10%, or down to bottom 50%. People also move downward from the upper 10%. The 1% are so rich that they may not move around as much.
- Policy is trendy. Is it not possible that we are moving into a decade that will place more emphasis on redistributive actions that has been the case during the past twenty years. And should not investors be mindful of this, and especially mindful that this would probably serve the public interest, and the interests of democracy.
- A great economist, Armen Alchian, a professor of mine while doing graduate studies at UCLA in 1969, used to warn us that we must always remember that cross time economic comparisons are always flawed. He called them specious. The world of twenty years ago is vastly different than the world of today. Back then you couldn’t buy an iPhone. Today you cannot live without it. Then, stage iV cancer was a death sentence. Today, this is simply not the case. The point: we put value on things today that did not exist then. Our weak dollar can buy an iPhone. Yesterday’s stronger dollar could not. So, which dollar do you want?
- While we do not know what drives economic growth, economic growth does occur. So many believe that the best thing you can do is make sure your population is prepared when the growth engine turns up. According to the authors of the Foreign Affairs article, you prepare your population by keeping them healthy, by providing general education at all levels, by injecting applicable content education, by investing in public infrastructure, by upgrading the consistency and predictability of the legal system and its courts, and by just making city-life more livable. Democrats talk a lot about these kinds of subjects and then tend not to do a lot. You cannot just throw cash at these objectives. Republicans tend not to discuss these things and not to address them. Shame on both.
- I think we are moving into a period where we need to think much harder about the differences between what we need to do and how we need to do it. Regarding the problems listed above, it feels as if the conversation today is always about the cash that should be thrown at these issues, and very little about how to effectively and efficiency manage productive outcomes from those expenditures. We may need to get back to a focus on how to get stuff done.
- There are a lot of ideas being tested in the Country, especially in California with respect to energy policy and activist government. We need to consider the possibility that some of these tests may work out very badly. On the other hand, some may work out, and will need to be replicated.
It has been an interesting exercise to think about all of this.
