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DARWINISM OR CREATISM ?
By CHARLES GAVE
December 2012
Natural selection or intelligent design?
• Tongue in cheek, I believe that there are only two schools of thought when it comes to
economic growth:
1. Either one is a Darwinian (Austrian), believing in the natural process of creative
destruction.
2. Or one is a “Creationist” (Keynesian) believing that an all mighty God (the State),
serviced by an altruistic Clergy can intervene in the economic process and create tons
and tons of free lunches, the free lunches then leading to a higher and higher standard
of living.
• My goal in this presentation is simple: I want to show that far from helping, the Clergy’s
intervention leads to lower growth ,lower standard of living and lower wealth for everybody,
but the very rich, and of course, the Clergy itself.
• I will start with the damage done by artificially cheap money while the second part will be on
the disasters created by a never-ending growth in government spending.
• Finally I will try to draw some investment conclusions, which may not be as bearish as one
might think.
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When the creationists play with the cost of money
In their religious books , the
first commandment of the
Creationist Prophet is
“thou will proceed to the
euthanasia of the Rentier”.
This means that to have
economic growth we need to
have negative real rates
(shaded green on the
graph).
So the “creationists “were
obviously in power in the
1970’s and again since
2000 since we had long
periods of negative real
rates then and now.
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The US is experiencing a structural slowdown
The first thing that I have to gauge if
negative real rates lead to a higher
growth rate is first to define the
structural growth rate of the US
economy and where we are
compared to the historical growth
potential.
The classical way to do it is to
compute a long-term trend, measure
the deviations from the trend, call
these deviations the “output gap” .
However, I prefer a simpler and less
volatile way. I compute the 7-year
moving average of the annual
growth rate of the GDP in real terms.
On both measures, from 1970 to
1982 and again from 2000 to 2012,
there is a very visible collapse of the
US growth rate. So the question n
must be: what happened that led
to these two collapses ?
And my answer will be: the
Creationists tried to improve things.
And made a mess out of it.
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Negative real yields make for very mediocre results
The great Prophet told his
true believers that if they
acted on his advice,
(maintaining negative real
rates) the economy would not
stagnate or remain at a sub
optimum equilibrium, since
the hated “hoarders” would
be punished.
However, if one looks at the
historical results of this
policy, the only times when
the US economy did not
return “normally” to it 3 %
long-term growth and
instead kept falling was when
we had negative real rates.
So maybe tampering with the
cost of money is not such a
bright idea after all?
Let us have a look of why the
prophet may have been
totally wrong.
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Negative real rates and the race for scarcity
Negative real rates lead to
the outperformance of zero
duration assets (scarcity
assets such as gold, silver,
oil, food, etc) over long
duration assets (machine
tools, investments) since it is
impossible to compute the
present value of a long
duration asset (false price on
interest rates).
A proxy for the value of all
productive long duration
assets is the S&P 500, which
underperforms badly during
periods of negative real rates.
The problem is that
investments in scarcity assets
never lead to an increase in
productivity.
Negative real rates thus lead
to a misallocation of capital
into unproductive assets and
from there the growth rate
falls.
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Negative Real Rates & Commodity Prices
•When the ‘REAL” rates
are negative, then the
normal way to save is to
move into REAL assets
•Commodity prices start
going through the roof
and the correlation rate
between these
movements move to 1
•This leads to massive
“external shocks” to the
economy
•And of course makes
the little fellows poorer..
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Negative real rates means falling household incomes
With the rise in price of so
many necessities (oil, food,
etc) created by negative real
rates, the median income in
the US either goes nowhere
or goes down.
As such, the negative real
rate policy seems to hurt first
and foremost the “little
people” and the middle class
as well as aggravating the
widening gap between the
poor and the rich.
Talk about the dangers of
unintended
consequences….
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Negative real rates is a socially disastrous policy
The nefarious math of
negative real rates:
More money going in gold
and scarcity assets than in
the S&P 500 = misallocation
on a grand scale.
Misallocation of capital
= lower income, higher
unemployment, higher
inflation
=
higher misery index
To sum it up, negative real
rates favor the ‘rich” and
kills “the middle class”
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Negative real rates boosts the equity risk premium
Negative real rates prevent
the discount mechanism to
operate properly, since
nobody has any idea of what
the “true” price of the risk
free discount rate is.
As a result, the price of long
duration assets collapses.
Shares today have a higher
risk premium than in the
1970’s, which is
unbelievable.
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Negative real rates debase the currency value
Negative real rates always
lead to a fall in the USD
starting roughly 12 months
after the beginning of such a
policy.
Although it should be noted
that the USD also tends to
go up during US recessions
(shaded grey in the chart).
The decline of the US Dollar
is of course bad news for the
US consumer (as if falling
incomes and higher
unemployment wasn’t
enough…) .
It has also many
consequences for the rest of
the world, most of them
negative.
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A weak US$ leads to an improving CA deficit
An artificially weak US Dollar
(another false price) leads to
a massive improvement in
the US current account ,
especially ex oil ex China.
Someone will have to be on
the other side of this
adjustment. As such, the
countries which have lost
some 4% of the US GDP
over the last six years may
thus have a foreign trade
constraint, while in a
recession.
This lethal combination can
transform a garden variety
recession into a full blown
depression, as in the
1930’s .
An “improved” US current
account is an unmitigated
disaster for the rest of the
world.
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A improving US current account is very bad news
As shown in the chart, all
major financial crises have
occurred with the US CA
“improving” year on year.
There is an easy explanation
for this. An improving US CA
leads to a reduction in
liquidity outside of the US
and from there to an
international crisis.
Given that the US dollar is
still very weak, the likelihood
of an improving US CA is
high.
There is no exit from the
current crisis without the
Dollar going up.
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Why Negative Real Rates Always Lead to Economic
Disasters
•
They create ‘false price’s all over the world for interest rates and exchange rates. Since
all prices in an economic system derive from these two prices one way or the other, it
means that all prices are false, everywhere. This forces the entrepreneurs to stop investing
and to accumulate the maximum of cash in their books, waiting for the prices to return to
“market” prices.
•
They lead to a massive rise in oil and food prices, which is equivalent to a very regressive
tax increase on the middle class and from there to a lower growth rate.
•
They drive savings into “scarcity assets” and this leads to a fall in the productivity growth
rate, and/or a fall in employment, or both, and from there to a decline in the structural
growth rate.
•
They Favor zero duration assets and lead to a collapse of PE , very detrimental to the
growth part of the economy. They force the players to go finance themselves in debt
rather than in equity, which makes the system more and more fragile.
•
They allow companies that should not survive to survive (zombie companies) and from
there prevent the creative destruction from happening. This leads to a fall in corporate
profitability No destruction, no creation.
•
They allow the growth in government spending to be financed easily, which also leads to a
lower growth rate, and this is going to be our second part.
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Negative real rates leads to rising government spending
Needless to say, if we have
negative real rates “justified”
by a sub standard level of
economic activity, then the
politicians will feel obliged to
“borrow” and spend to
‘stimulate “ economic
activity.
This leads unavoidably to a
massive rise in government
spending as a % of GDP, as
evidenced by the chart.
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Rising government spending leads to falling growth rates
The problem is if course that
if the size of the government
as a % of GDP goes up,
then the structural growth
rate of the economy goes
down, as can be seen on the
chart.
When presented with this
argument, the disciples of
the prophet of Creationism
always say that “correlation
is not causation” and that
the situation would have
been much worse had they
not intervened.
Suffice to say that as long as
the government keeps going
up, the growth rate keeps
going down…
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The UK case study
In this chart, instead of using
the 7-year moving average
of the GDP growth rate , I
use the output Gap as
computed by the OECD.
The results are exactly the
same: higher government
spending leads to sub par
growth for the UK economy.
Indeed, every rise in
government spending (red
line going down in the chart)
leads to a bigger and bigger
output gap
How strange…how can this
be explained?
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Government spending & corporate profitability
Milton Friedman famously
stated that “there is no such
thing as a free lunch”.
Rising government spending
is nothing but free.
If the government size goes
up, corporate profitability
goes down
And with corporate
profitability stagnating or
going down, so does
economic growth..
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Rising government spending leads to falling stock market
valuations
With the structural economic
growth rate going down, it is
to be expected that PE
Ratios will follow, and of
course they do (see chart).
I have the same chart for
most countries and this
seems to be a perfect
example of the Ricardian
equivalence.
Borrowed growth achieved
by government spending
without the discipline of
market prices always lead to
lower P/Es.
Everybody knows that the
situation is
untenable…except the true
believers , of course.
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The Canadian case study
So far I have shown that an
increase in government
spending leads to lower
growth.
But is it also possible to
prove that a reduction in
government spending would
lead to a rise in the economy
structural growth rate? Yes it
is.
Here is Canada (I could also
show Sweden after 1992 or
Asia post 1998).
The big fall in government
spending which started in CA
NADA after 1994 preceded
a rise in the structural growth
rate by two years.
Interestingly, contrary to the
belief of the Creationists, this
reduction did not cause a
recession in Canada…
Maybe there is a causation
after all…
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The wonderful world of rising government spending
On the previous pages, I have tried to show that an increase in government spending automatically leads to a lower
economic growth rate. This is perfectly rational and in accordance with common sense and most non-religious
economic theory.
I am however, not saying that we would all be better of without a government. What I am saying is that most
governments in the developed economies have reached a point where any further increase is detrimental, rather
than beneficial. Indeed, what seems to emerge from this study is that government spending is like every thing else:
•At fist, government spending has a huge marginal return.
•Over time, and with the government growing , the marginal return of more government goes down.
•At some point, this marginal return falls to zero for any increment in government.
•Shortly after, we reach the point of negative returns, when an increase in government spending leads to a lower
growth rate. It cannot be otherwise
•And if we reduce government spending then , it leads automatically to a higher growth rate, without any recession.
And this is probalby where we are in most of the developed world
It thus follows that any reduction in government spending will lead to an increase in the structural growth rate of the
underlying economy, and any increase in government spending to a fall in the standards of living, an increase in
joblessness, probably accompanied by more demands for more government interventions…
This is exactly what Schumpeter foresaw in “Capitalism, Socialism and Democracy”
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Investment conclusion
The policies followed by the US today are massively counterproductive.
One cannot operate capitalism without a market determined cost of capital anymore than one can create
wealth through more and more government expenditures financed with borrowed money, since there is no
creative destruction in government spending.
It would not matter as much if these policies were followed by another country. But the US, controlling the
world’s reserve currency can export its bad policies and we see this every day in the race to the bottom for
exchange rates and the ridiculously low rates on government bonds everywhere.
Today I know for a fact that neither the bond markets nor the exchange rate markets are in a state where
prices are determined by genuine market forces.
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