Inequality - A Follow Up

“An imbalance between rich and poor is the oldest and most fatal ailment of all republics.” -

Plutarch ancient Greek biographer (c. 46 – 120 CE)

 

Now do not get me wrong, I am all for making money and this blog is not meant to bash on those who are doing well.  Furthermore I am not in the least bit pro-socialism, even after a close friend of mine spent more than a decade of my life trying to convert me from capitalism.  Sadly he died and in large part due to the inadequacies of the social system in which he lived.  No I am pointing out as the above quote states that massive inequality is the undoing of capitalism and that unless there is a change to the structural system in the United States trouble will ensue.  Interesting that the quote dates back to 46AD.  I guess nothing ever changes!

 

What I am referring to specifically is the inequality between the small business entrepreneur and the large multi-national business.  The later has access to massive amounts of cheap capital while the former is unable to raise money and when they can the money is incredibly expensive.  Now I understand that the less risky the loan or investment the lower the interest rate.  This is a natural occurrence and I agree that investors should be rewarded according to the level of risk that they take.  So for example if you plow your life's savings into starting a business and it works, you should be rewarded with large amounts of wealth.

 

On the flip of this, if you invest in a low risk investment such as Treasury bonds that have limited chance of default, then your reward or return on that investment should be minimal.  The dichotomy comes when you have a small profitable company that has a rock solid history and is able to back the investment with collateral that is also rock solid but is penalized as the market shuns that investment class for the large corporation.  Now a normal penalty would be in the range of 2 to 5 percent but currently that spread is anywhere from 10 percent to infinity (the company cannot find funding anywhere). 

 

The reason for this is that the banks and the markets are open to plowing billions of dollars towards the likes of Apple and IBM (considered low risk) but not towards smaller businesses (considered high risk) in order to protect themselves from another financial catastrophe while they get their house in order from the last one.  The amusing part to this is that never in my life has the spread been so wide and unless this spread narrows (money is made available to the small business) soon, the inequality will result in just the financial catastrophe that they are trying to protect against.  It is like playing rugby or football and trying not to get hurt, it is a sure thing that you will get pounded.  A better strategy is to get amped up and drive yourself into the opposition and surprisingly you come off the field intact.

 

As I mentioned in my previous blog on inequality, small business is the driver behind economic growth.  They are also the driver behind employment.  Cutting this class of business off from capital is tantamount to having two sets of rules to the same game.  One set for the favorites and the other, a more onerous and unfair set, for the underdogs.  This creates a false barrier to entry and allows the large corporation to benefit at the expense of the small business.  In order to grow the economy you have to get the money that is being printed by the Federal Reserve into the hands of the small entrepreneur so that they can innovate, hire and grow us out of the malaise that we are in.  Leaving it to the large corporations is not going to provide the growth that we need but that is just what is happening. 

 

I spend my life investing and raising money and right now you can earn an amazing rate of return by doing your homework and investing in these rock solid small businesses.  Typically loans to these businesses can range from 9 to 15 percent and in my view the risk of the investment is more than compensated for when you compare the returns that you can get in the market.  Now to take this one step further if the banks loosened their underwriting criteria slightly and loaned these companies money at say 8%, they could then pass on those rates to their clients (you) in the form of a decent return on your CD, say 4% for a two year note.  Now everyone is a winner.  The sad part is that it is virtually impossible to get these loans from any institution and if they do lend the money they are certainly not passing along the extra income to the CD holder.   

 

To take this one step further, the market is pricing these large corporations based on future earnings.  The thought is that by lowering their borrowing costs their profits will improve.  Furthermore as the economy is being trampled it is a prime time to reduce headcount and work on improved efficiency, so lay off workers and get those that remain to do more for less.  Not a good equation as the result will be that these one off improvements to the bottom line will start to lose their impetus as time goes by.  The result is that the expected profit gains will not be met and the market will suddenly sell off.  Unless you get people hired, growth will stagnate and there is just so much you can do to your balance sheet before the effects are felt on the income statement.  A fundamentally sound market is based on sound economic fundamentals and continued weak employment numbers will eventually undermine everything.

 

P.S. 

Now I don't like to tout myself and my products in this blog (which is why I have put this after the blog post), but the example above is exactly what Fixed Rate Deposits does, issue loans to small low risk businesses so that they can grow, helping them stay afloat and hire people while passing along a good rate of return to the prudent saver so that they can make some money on their deposits.  A win all the way around.  So if you are sitting on some cash and want to earn a good rate of return on your money and reduce your risk to the market let me know and I will send you a brochure to review.

Q&A

I have had a number of questions regarding my last blog "QE3 is Here" so this blog is dedicated to answering some of these so that we can see the differing opinions regarding the money printing press that is the Federal Reserve.

Steve – I’m no economist, but tell me if I am incorrect in dumbing this down – as I understand this.

1)     The banks have been sitting on these toxic, essentially worthless mortgage backed securities.

2)     The Fed says, hey Mr. Bank, we’ll take them off your hands/books at no cost

3)     …and we hope that this will help you feel a little bit better now so you can bloody well start making it easier for your customers and potential customers to take out loans

4)     …which in turn means more spending on business start-up, cars and so forth – from the loans

5)     And the Fed believes that people take out loans not necessarily in good times, but in weak times because in weak economic times people need loans if they want something tangible.

So if I am correct, then no money is being printed and as for the additional debt? Well, it moved from the banks to the Fed. And if the banks make more loans (and more money flows into the economy from the folks who took out these loans) then this begins to offset the mortgage-backed securities (the debt) that the Fed took over from the banks.

Am I off base here?

 

Answer:  This is definitely the theory.  Pass the toxic debt from the banks to the Federal Reserve in the hopes that the banks lend again and the economy recovers.  This presents numerous problems though:

1. The Federal Reserve has as its mantra that it "shall maintain long run growth of the monetary and credit aggregates commensurate with the economy's long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates and provide price stability in the form of inflation control." (from the Federal Reserve Act)  The idea is that with price stability you maintain a healthy economy as businesses are able to plan for the future based on this price stability and this in turn will keep the economy at full productivity and low unemployment levels.  The problem is that their current policies are not creating jobs but are creating a massive wave of debt that will somehow have to be repaid.  As we will see below this has boxed them in!
2. It is one thing to create a loose monetary environment to stimulate the economy, it is an entirely different matter when you are taking on the toxic assets of banks.  This creates morale hazard whereby bankers are rewarded for taking large risks but do not feel the consequences of these risks as they end up being shouldered by the Federal Reserve and by default therefore the tax payer.  I have argued that the Federal Reserve has crossed the line by taking this junk off the banks hands as they are not in the game of saving banks and companies.  The market needs to take care of itself but by coming to the rescue of these companies the Fed has created a morale hazard that is not in line with what they have been established to do.  Transferring the problem to the taxpayer while the bankers walk away from the problems is not their job!  It undermines their credibility and creates a bigger mess later and this is just what is happening.  Let the market wash the slate clean by impacting the banks, the bankers and their investors but not the tax payer.  Transferring toxic debt over to the government who cannot default on this obligation is not what makes capitalism work as the people that took the risks are not taking the pain.
3. If they are trying to stimulate the economy then providing financing for job ready projects would be a far better use of funds than taking toxic debt off the banks hands.  Another potential help would be to cut the student debt load or at least the interest charged on those loans to zero.  The banks pay nothing so why not the students?  The young are the demographic that acquire the most assets and keeping them swimming in debt at high interest rates while providing the bankers with financing at no cost makes no sense. Another idea is to issue more build America type bonds that target projects that hire people to repair the country's infrastructure.  This would get people to work and help the country rebound far quicker.  However now you have to deal with the politicians which is why neither of these will happen in the near future but it is these types of structural changes that need to be made to the political system to stimulate growth rather than blindly pumping more debt into the system.
4. The type of financing provided by the Federal Reserve to the banks is not able to be controlled.  It is given to the banks at no interest and they invest where they see fit.  This is why you see the stock market rising, oil prices shooting higher and other commodities spiraling higher.  The consumer feels the upward movement in these prices and this crimps demand for other goods and services slowing growth further.  Slow consumer spending reduces growth and means companies will cut back further creating a vicious spiral that is not solved this way.
5. The mountain of debt that is being created will crowd out the private sector and will create another drag on growth.  Just as the consumer suffers from too much debt, governments are eventually hamstrung by a mountain of debt and this debt and the cost of servicing the debt slow economic growth creating a drag that lasts for decades, just look at Japan.  This crowding out is already creating a drag on GDP growth and I doubt that the economy will grow faster than 2% per year until this debt burden is under control and to me that is decades away if ever.  Allowing these banks to suffer at the expense of their investors and themselves creates a clean slate and makes it a far easier path to prosperity. 
6. Letting banks fail is part of business.  If bad banks fail this creates a vacuum which is quickly filled by new "good" banks (banks with no toxic debt).  These new banks are keen to lend as they are effectively gaining from the other banks poor investment strategies.  By lending money to consumers at low asset values they ensure that they are stable and are able to function in the normal way regardless of what happens to the other banks.  This is capitalism and is how it should work but by saving these institutions they have created morale hazard.  This has resulted in banks and institutions that are too big to fail which has, in my opinion, been created directly by the Federal Reserve overstepping their bounds and sticking their head into places where they should not.  Certainly at the peak of the crisis it was imperative to save the financial system but since then the market should have taken care of its problems while the Fed concentrated on using the tools at its disposal to create jobs and not support poor businesses.

Steve

Ben has to keep printing money and buying bonds.  If he doesn't, there won't be as much of a market for those bonds and without buyers, the rates go up.  They can't risk that.  With $16 trillion in debt, an unbelievable number, each 1% increase in rate being paid increases the federal deficit by $160b.  That magnifies the deficit and could touch off a debt spiral we cannot get out of.  So, like Japan, the idea is keep rates low or non existent at all costs so the deficit doesn't balloon out of control.

 

Answer: I do not disagree with this comment, in fact I believe like the sender of the comment that the Federal Reserve is completely boxed in.  Without printing more interest rates are sure to rise and this will cause serious damage to the so called economic recovery.  However, more debt will eventually implode on itself and will result in a major financial calamity of the likes we have never seen.  Can they get themselves out of this hole?  My thought is that without structural policy changes it is impossible and looking to the politicians is looking at the problem but it really is up to them to solve this and I have little faith that either candidate will step up to the plate.

For all of these reasons I remain out of the stock market as money prinitng has created a false bull market based not on economic fundamentals but on the fact that there is nowhere to invest that produces a return.  Companies around the globe are ratcheting down their growth forecasts and are continuing to lay people off but the market continues higher.  That is not to say that some companies are not performing well, but it is a manipulated market that will hurt a lot of investors in the long run.  Stay away from trying to make a few dollars in the short run and focus on wealth preservation.

QE3 Is Here!

"All the perplexities, confusions and distresses in America arise not from defects in the constitution or confederation, not from want of honor or virtue, as much as from downright ignorance of the nature of coin, credit and circulation." - John Adams

"The great free nations of the world must take control of our monetary problems if these problems are not to take control of us." - John F. Kennedy
So it is finally here!  Yesterday after months of jawboning the Federal Reserve announced that it would buy $40 Billion of mortgage backed securities.  This is in addition to the $40 billion it is currently reinvesting through its "Operation Twist" program.  So the great balance sheet expansion continues.  The main reason sited for this was the fact that after years of trying, job creation is still languishing so the thought is that printing more money (after printing umpteen trillions already) will start to help the economy grow.

The move was applauded by Wall Street as they have been the direct beneficiaries of all this money printing.  The market rallied over 200 points and the market closed above its 52 week high and within striking distance of its all time high.  The new bond buying program is open-ended, which essentially means the Fed will have carte blanche in terms of how much monetary stimulus it feels is necessary to kick start the economy.  With today's announcement, the Fed finally acknowledged the reality that the unemployment rate will be very slow to come down and will likely not reach 7% until 2014 (this is their estimate and once again it is probably too rosy). In fact, the Fed said that without further stimulation economic growth may not be strong enough for sustained improvement in labor market conditions. Translation: the money printing is necessary to stave off the likelihood of another recession.

Wall Street is of the opinion that at some point in time the increase in asset values being manipulated by the Fed will result magically in lowering unemployment.  I take a quote from Peter Worden to reflect his and other stock traders opinion of the move (I have highlighted the more important pieces to bring them to your attention): "Ben Bernanke feels and logically so, that if the value of personal assets such as homes and stocks continue to show improvement, individual consumers will soon feel confident enough to step-up their spending. And thereby add the quintessential missing ingredient to this recovery."

So by piling more debt onto an already debt burden country the individual consumer will feel confident enough to spend money!  Who are we talking about here, the few thousand on Wall Street or the millions unemployed that have no money to spend either way?!  What a bunch of buffoons!  All the debt spending has not worked to date other than making oil and gasoline prices spiral higher and making stock prices reach for the stars.  Somehow another trillion will magically change everything and we will all have money ready to spend on useless junk to stimulate the economy.  To what end exactly?  So that we can then spend the next few decades of our life paying huge tax bills in order to pay off this massive debt burden.

But wait inflation to the rescue.  It will magically morph the debt into something manageable so that it will not be a problem.  But what if inflation remains muted for an extended period and heaven forbid that deflation occurs as that truly would be the death knell.  So what we now have is more debt and policies that are not producing jobs but if we continue to increase the debt level and remain wedded to the same policies we will somehow come out of this just fine.  Unbelievable!

Even the Fed agreed that we are slipping into a recession.  I believe that more money printing is not going to help us out of that in fact I believe that the drag of more debt will result in more and more regular recessions and slower and slower growth.  So if we are headed for a recession why is the stock market almost at its all time high?  Because the money being printed has to go somewhere and for now it is being pumped into the market as there really is nowhere else to go to earn a return on your investments.  This is a complete set up and will not end well and the more they kick this battered old can down the road the bigger problem they are creating.

Crossing the Line

“Such supplementary interventions [by the State], which are justified by urgent reasons touching the common good, must be as brief as possible, so as to avoid removing permanently from society and business systems the functions which are properly theirs, and so as to avoid enlarging excessively the sphere of State intervention to the detriment of both economic and civil freedom.” – Walter Bagehot

As the quote above mentions very clearly the State intervention is required but it is required for short bursts.  Thinking back to the beginning of the Great Recession, Federal Reserve intervention was needed to prevent a complete collapse of the financial system.  The Federal Reserve acted quickly and effectively and staved off the crisis.  Since that time they have remained involved in the economic “recovery” and it is their belief that unless they remain fully invested that the economy will crater.

The question is have they crossed the line?  The line I refer to is the line between required involvement to rescue the economy for common good or permanently removing systems and functions that are properly seated in the private sector.  This is critical to the long term viability of the general economy and is the reason that I continue to remain skeptical of the current market movements.

The question therefore is whether continued activity will continue to stimulate or whether it is just kicking a tin can up a very steep hill.  Take Greece for example.  They need to borrow money to stave off a default but no-one will lend them any money other than the ECB who ultimately underwrites the debt that Greece owes.  So effectively the ECB who is owed the money is lending more so that the insolvent country can continue to service their debt.  This is unsustainable in the long run unless there is a structural change to either the debt or the Greek government or both.

Looking at the Federal Reserve, saving the financial system was definitely a necessity.  Continuing to pour money into poor investments is not.  The second use of funds was done under the guise of stimulating the economy.  Bernanke who schooled himself on the Great Depression feels that the cause of the Great Depression was in large part due to the Federal Reserve cutting off funding too early.  He is determined not to repeat past mistakes and so has kept the foot hard on the gas-peddle for an extended period.  The result is a now mountain of debt and little in the way of success.  More importantly is that the economy now seems wedded to more money printing to survive and the ills of the past have not been corrected but have been glossed over with more money.

In my view the later portions of the so called quantitative easing have wasted an opportunity.  That opportunity was at their doorstep in the time of severe crisis but was squandered and now we have created a level of debt that has become a burden to the economy and is stripping away market opportunities that should be filled by the private sector. 

Furthermore the market is very fickle and at some point the low level of interest rates could spiral as it has done in Europe.  If this happens our current trillion dollar budget deficits will look small and trying to borrow your way out of that hole will not happen.   As I have argued before I believe that interest rates will remain low for longer than anyone expects but it certainly appears that we are squandering an opportunity to structurally fix the problem while these interest rates remain low by thinking that the only solution to the problem is to print money.  This is not the solution but is going to cause great problems in the future.  However in the meantime Wall Street celebrates any time they hear of more quantitative easing and this is a worry in and of itself as the Federal Reserve pats itself on the back each time the market goes up.

Their thought is that if the rich get richer (through asset appreciation) that the income will trickle down to those that do not have a job (through job creation from the rich) but this is not happening as unemployment remains stubbornly high.  In fact while there is a strong correlation between the stock market and job growth I would argue that job growth creates a strong market and not the other way around, however our leaders in their infinite wisdom believe otherwise.  Hold onto your hats as this will be a bumpy ride.