In the following piece I want to lay to rest any notion that the accepted state of the economy has anything to do with any other than perception. My hope is that by the end there will be very few that can continue to believe there is anything left to the idea that the underlying economy is either strong or improving; a perception substantiated by current market valuations rather than a reality substantiating current market valuations.
But remember the idea that perception is reality is a force to be reckoned with in that perception not only deceives but can create a temporary self fulfilling prophecy. This is the very basis of the danger of perception. For it is perception of thick ice that leads us to the middle the of lake but reality that takes us to the bottom. And so it is in the perception that the true danger of reality can hide. I will limit the discussion today to economics but make no mistake, the putrescence via the dislocation between perception and reality extends to every nook and cranny of modern American and the Western world.
I recently listened to a fairly impressive speech on television but unfortunately tuned in after the introduction. It was a representative of the indigenous nations of North America. The speaker discussed many issues and wrapped in the well being of all people so it was very inclusive and, as I said, very impressive. However, toward the end of the speech the lecturer made a point to place blame, for much of his subject matter, on capitalism. Such a disappointing and trite end in an otherwise interesting and persuasive set of arguments.
While this speaker was just some obscure orator, there are much more prominent ‘authorities’ of public policy constantly making similar disappointing claims on perceptions for the public to digest. Guys like Paul Krugman are incessantly twisting and mutating Keynesian economics to mean full on, full time government control of the economy while decrying capitalism as some evil force meant to destroy all but the top of the food chain. But at the same time we have those profiting from the current system too twisting perception that indeed our system is capitalism at its finest.
Capitalism is, in its most honest and basic form (i.e. its true and only form), simply the trade off of something for something else, with the value of trade being determined by supply and demand dynamics on both sides of the transaction. That’s it. And so then it becomes a very difficult task to understand how that can be the evil force so many around the world attribute to capitalism. It is also a very trying task then to see how the current system has anything to do with capitalism. But as does Krugman with Keynesian economics the definition of things that most don’t understand very well can be easily mutated for public consumption to make a particular stance seem much stronger than truth would merit. And there is that other evil term that goes hand in hand with capitalism, merit.
Again, merit is something just about all of us understand innately. I don’t care how compassionate one wants to see them self, everyone gets annoyed when people take something that seems to have been earned by someone else. For example, standing in line at the “I love trees”, T-shirt booth, if socialist A were to, for no reason, bud ahead of socialist B who has been patiently standing there for 3 hours, this would be a problem for all but the very best of us. And this really explains merit.
There is an inherent understanding by all, that socialist A didn’t deserve to be ahead of socialist B. In other words, socialist B earned their place in line ahead of socialist A and so has every natural right to expect socialist A not to jump the line. I say natural right because this concept is so woven into the reality of existence that it is a natural right. It doesn’t preclude socialist B from kindly given up his right to be ahead of socialist A in line but the right is his prerogative to give up or keep. If you understand and agree with that proposition then you understand and agree with capitalism and acknowledge it is a natural system. But I would argue capitalism has been replaced by economic cannibalism.
Capitalism has an inherent way of avoiding dead weight losses via efficient resource allocation, while Cannibalism feeds on dead weight losses. To be clear these dead weight losses are losses to labour (i.e. the consumer) in the current system (but can be otherwise, for instance with regulated pricing). Similar to monopolistic pricing, in a cannibalistic economy profits to the producer increase despite a reduction in output. While monopolies are difficult in the current regulatory world, the Fed has created a similar earnings scenario for corporations by allowing a reallocation of funds away from operations and into a guaranteed secondary stock market that provides no benefit to the economy (or to labour).
Yet there is an active perception campaign that is taking us out to the middle of the lake. Specifically, we are being led to perceive an expanding and thus improving economy despite the reality of contraction. In fact, this focus on creating an ideal perception has become the main strategy of American policymakers. The historic alternative being a focus on building an ideal reality. This focus on perception is the putrescence of politics and it is an incredibly dangerous game for we the people.
The very question of how is it that our ‘capitalistic’ society has become so seemingly unbalanced highlights the dislocation between perception and reality. Very simply, our society is no more capitalistic than it is democratic. This is where the effort to understand and be aware is an obligation of citizens. To be a wantonly foolish citizen is to be an immoral citizen. If we hope and expect to have a fair and just society, which does include the economy, we must work for it, that is, we must earn it.
Society, with it’s rules and regulations is man made, and so by definition comes without natural rights. And that is good because nature can be cruel to the weak. However, we can design the rules and regulations to mimic our natural rights where ideal and can curve them where compassion is perhaps lacking in nature. But again, such a design requires a moral citizenry, meaning, in part, an aware citizenry.
By simply accepting the story as told without regard to integrity of truth we allow ourselves to become feed for those controlling the story and thus the system. That is, our sweat equity becomes their wealth, our might becomes their weapon and our efforts become their strength. In effect those controlling the story eat the just rewards of all those around them. And that is exactly the system currently in place. You will find it impossible to reconcile the description of the existing system against the nature of capitalism. The two systems couldn’t be further apart, in fact, each is the antithesis of the other.
Capitalism inherently optimizes the allocation of available capital between profits and labour. But by creating policies that reward operational contraction (whether it be the ability for monopolies or for risk free returns in a secondary market) and by incentivizing investors and management in the short term, capital allocators will always divert capital to profits and away from labour. This is a pure example of economic cannibalism in that investors and C-suite managers are filling their bellies from the meat of not only labour but also future investors and managers; an incredibly short sighted strategy.
Warren Buffet, often perceived as America’s most beloved capitalist, is perhaps that grandest example of a economic cannibalist. Let me give you give you a couple examples of how Mr. Buffet has zero respect for or interest in capitalism but practices economic cannibalism as a normal course of business.
With his BNSF rail company generating significant profits transporting oil across the Midwest, Buffet lobbied hard and fierce against a pipeline being built that would create a more efficient method of delivery. He lobbied all the way up to the president of the United States. Not only did he lobby to get his way but he aligned himself with the Environmentalists no less. Touting trains are safer and more efficient than a pipeline for transportation of oil is mythical at best. But truth is irrelevant when it comes to cannibalism. The truth is simply that Warren is willing to eat any competitive benefits to the end consumer to fill his own belly. He does so not by being more competitive (capitalistic) but by purchasing ideal legislation for himself (cannibalistic) with all lost gains to the consumer from denying a capitalistic process being digested directly by him.
Step forward to today and we find Buffet this time fighting against the Environmentalists and casinos to protect his bets on energy profits (MidAmerica’s purchase of NV Energy) in Nevada by lobbying to eliminate credits to folks that are net suppliers of renewable solar energy back into the grid. Clearly, if people are adding to the existing power supplies using renewable sources of energy generation they should receive credit for those supplies. However, that would eat away at the non-renewable energy profits being generated by Buffet’s energy plays.
What it means is that nonrenewable energy companies like Buffet’s holdings need to quash the more competitive (albeit smaller) renewable sources and do it via purchasing favourable legislation rather than by being more competitive (hard to compete with the efficiency of the sun once the cells are in place and paid for). This is quite obviously anti-competitive and thus anti-capitalistic. The truth is that Warren is wealthy and unethical enough to eat the meat of all those competitive benefits of renewable energy supplies into the grid simply to keep his own belly filled.
And look I’m not trying to have a go at Buffet in particular he just is an easy target to make the point. In reality there are a million examples at all levels and in all facets of the economy but the point is that capitalism has very little to do with America today. Let me say that again. Capitalism has very little to do with America today and so we need to get this idea of evil capitalism out of the public discourse.
Our system could be considered an immoral system in the sense that it is materially unethical and inefficient, based on massive resource misallocation but it cannot be considered capitalism. Now I’m certain you are asking yourself if this is going anywhere or is this just some theoretical moral point being made?? Ok, let me bring this back to the here and now tangibility of the average American.
Part of being an American profiteer today is getting ahead by any means available for which one will not go to prison nor pay 100% of their ill gotten gains in fines to the Treasury’s General Fund. Just refer to the libor, FX, MBS or gold market manipulations that have so far found guilt but no one of any relevance prosecuted or broke. The facts speak loud and clear to a system designed on economic cannibalism. But because a picture is worth a 1000 words allow me to provide a few charts to make the point slightly more succinctly how this impacts we the people.
The following is a visual of economic cannibalism in its most obvious form, understanding the idea that capital must go to either profit or labour. It is apparent that while labour once sat at the table with profiteers, today, labour has become the meal.
What we find in the above chart (source: Bloomberg/ Allocated Bullion Exchange) is that while corporate profits (dark blue line) and S&P valuations (light blue line) have historically correlated positively to real incomes, in the new Fed manipulated and highly cannibalistic economy, corporate profits and market valuations are actually feeding on incomes i.e. labour and thus on their own source of subsistence as labour is also the consumer. Purely cannibalistic activity. But due to the short term nature of today’s investor and managers, long term health has no place in strategy discussions.
The next chart I’ve presented previously but it is perhaps the best representation of how earnings growth is simply an illusion/perception created by operational contraction. You see while historically stock valuations grew with increased sales meaning operational expansion (i.e. non-temporary increased expected future cash flow), in the new cannibalistic economy, markets are thriving on lower sales i.e. contracted operations i.e. contracted labour i.e. temporary earnings growth.
I simply cannot disseminate the above chart enough. It is at the heart of the giant con I’ve been discussing for the past year. Consumers are not spending more (i.e. real sales are down) because they have less income. When one reads between the lines of the above chart one understands that the growth in market valuation has come via earnings growth, which has come by eating corporate operations (cannibalism not capitalism). In effect, reducing economic activity by reallocating capital away from operations (capex and labour) and into profits via dividends and buybacks, corporations have created the perception of growth (expansion) leading to increased stock valuations when in fact the opposite it true.
The next chart dispells the perception that because the defined unemployment statistic is falling more people are working. This is truly unbelievable to me that people still talk as though we have had any sort of an improvement in labour over the past 6 years.
What we actually find is that declining unemployment historically resulted in increasing labour participation rate meaning as unemployed fell out of the statistic they actually were moving into jobs as one would expect. However, subsequent to 08 in the new perception economy, while the rate of unemployed persons (U6- red line) is falling those persons are not moving into employment as we are led to perceive but are simply no longer part of the defined labour force (blue line). In short, they simply no longer exist according to the unemployment statistic.
There is an abundance of evidence indicating the same reality. For example, the Fed still cannot raise rates despite a historically low unemployment statistic (U3 at 5.8%). Additionally, the instance of declining real wages and income is not a typical economic phenomenon during a tightening job market. Yet the perception is of a highly improved job market via a deceptive unemployment statistic which continues to be pressed and pressed very hard despite all of the evidence to the contrary.
Now let’s look at perhaps the strongest argument which I expect should alleviate any remaining doubt as to a choreographed perception based strategy. The fact of the matter is that markets have now completely lost any logical tangibility to real economic growth vs contraction. Allow me to crystallize the point with a chart that leaves no room for argument. In fact, I would love to have one of you permabulls reach out to me and explain this next chart.
I’m not sure there is a better depiction of long term market manipulation than the above chart. Note that we’ve experienced an economic collapse (white line) matching that of 2008, yet while 2008 S&P (orange line) sold off +45% the market today has traded slightly higher in the face of the equivalent economic collapse. I’ve added a vertical red line showing just where the pure market manipulation begins. Notice the market price pops at each unexpected economic downturn (post 2011) with absolute absurdity and blatant market manipulation.
But without this manipulation we are back to the chaos of late 2008. The reason is that a market sell off triggers a systemic failure of assets collateralising the banking system which in turn paralyzes credit. From an economic standpoint this manipulation holding market valuations constant is the only thing separating are experience today from our experience during the last collapse. Think about that for a moment.
The above chart clearly depicts two parallel worlds of perception and reality. The media picking up only on the perception and avoiding discussion of the reality. The market manipulation carries the perception which takes us further out onto the lake, each step adding to the depth of the lake bottom from which we will ultimately be forced to rebound or drown. Some may argue prolonging the inevitable is better but it is a weak argument in that the lake bottom is only getting deeper and thus increasingly more difficult to survive when reality finally bites.
Recently a friend clued me in on a great discussion by James Montier (h/t Ryan Bailey), who highlights an idea by 19th century economist, Michal Kalecki. Kalecki predicted back in 1943 that if the Fed were to attempt to maintain full employment by stimulating private investment (via some equilibrium interest rate), interest rates would end up negative and income would end up being subsidized. Well this is exactly what the Fed has attempted. Kalecki’s prediction is brilliant (albeit more complex than I have laid out here) and we have now seen both aspects of his prediction come true over the past 15 years. Negative interest rates are here and consumer debt has unquestionably become a necessary income subsidy if we are to maintain the perception output growth.
The perception is that GDP has continued to expand which implies that the American consumer (to include the government) has continued to grow. However, when one adjusts GDP for consumption by way of debt rather than income we see a very different story.
Now debt is neither a positive nor negative economic influence naturally but its influence will be determined by its effectiveness. Taking on debt for a good investment can create expansion of wealth and income. Taking on debt for a poor investment or consumption can create loss of wealth and income. The following chart shows how (inefficiently) debt is being used today to maintain the perception of a robust economy. The cost of doing so being an incredible loss of wealth and income.
You can see that for each dollar of debt we are taking on as a nation we are returning less than a dollar of output (red line). The result is a net contraction not just a slowing of output. And that is exactly what we saw in the previous GDP chart that adjusted out consumption debt i.e. a true contraction of output.
Perhaps an easier way to see this is the following chart. Very simply, below we are subtracting the periodic increase in GDP (output) by the increase in total public debt.
Notice that historically, only periods of economic recession (shaded periods) showed results materially less than zero. However, since 2008 almost all periods have less output than debt and to greater extents than ever before. This is the epitome of the perception state. Debt consumption is not growth. Debt consumption is at very best a zero sum transaction assuming 0% interest. However, debt consumption for 99.9% of the economy is a net negative (that is, borrowing costs are above 0% interest).
What that means is that for each period above with a negative result, real GDP is actually contracting. This is basic mathematics I’m afraid and so to all naysayers it is simply not an arguable point but cold, hard fact. And again the reality is depicted in the adjusted GDP figure in the earlier chart above. GDP has, in real – real terms, contracted significantly below where it was in 2007 when we account for the negative impact of debt consumption on long term output. The only way to offset that negative impact is to continue to print and distribute ever increasing amounts of debt for consumption i.e. income subsidies as Kalecki had predicted.
In summary, by accepting the story as told without regard to integrity of truth we have allowed ourselves to become feed for those controlling the story and thus the system. As the charts above clearly depict we have two distinct economic states. One is perceived and the other is real. The perceived state gets sole attention allowing the economic cannibalism to continue and draws us further out to the middle of the lake. And as the ice disappeared so quickly not yet 7 years ago it will again reveal itself only a perception created by policymakers for sycophants so willing to feast and profit on the rest of us and, perhaps more startling, on their own future well being.
By Thad Beversdorf, Chief Global Economist for ABX
