In yesterday’s Daily Reckoning, I made the comment that China’s policy makers might be able to turn to stimulus when the economy slows, but they can’t fire up people’s ‘animal spirits’. Once investor or consumer psychology changes, it generally changes for a while, regardless of official attempts to revive it.
And there is increasing evidence in China that housing may not be the great wealth generating investment that all and sundry once thought it was. Protesting property owners and developers dumping inventory are early examples.
I thought I’d explore this issue in greater detail today, because when it comes to the real economy (not just in China but in much of the developed world) animal spirits are pretty much non-existent.
Yet when it comes to financial markets, animal spirits are alive and well. Rabid, almost. (By the way, if you feel animalistic and want to have a punt on stocks, make sure you read small-cap analyst Tim Dohrmann’s essay below first. It tells you how to avoid the two main problems that small-cap investors always encounter.)
The irony is that monetary policy is the root cause of both raging and flagging animal spirits. Let me explain what I mean by that.
I’ll start with a comment that RBA boss Glenn Stevens made on the issue in a speech last week.
‘But the thing that is most needed now is something monetary policy can’t directly cause: more of the sort of ‘animal spirits’ needed to support an expansion of the stock of existing assets (outside the mining sector), not just a re-pricing of existing assets.’
Stevens is saying that monetary policy can’t encourage people to ‘support an expansion of the stock of existing assets.’ I would certainly agree with that. What Stevens didn’t (and wouldn’t) say, is why monetary policy is to blame.
What fires up the entrepreneur or the capitalist is an idea to satisfy demand coupled with the prospect of generating a decent return from turning the idea into reality. But when it comes to investing in the real economy, the prospect of making decent returns (given the risk taken on) isn’t overly compelling right now.
That’s why companies continue to focus on returning profits to shareholders via dividends and share buy backs, rather than investing in plants and equipment or research and development.
Financial market returns are much more compelling (and easier) than real world returns.
So real world animal spirits remain subdued because the prospect of a decent return on capital is low. Why is that? Well, since the 2008 crisis, economic growth has been sluggish and prospects remain weak.
OK, so why is that?
This gets to the heart of the problem. Too much debt!
As I mentioned yesterday, debt is simply future consumption brought forward. The presence of such a huge amount of debt inhabiting the global financial system tells you that much of today’s ‘missing’ consumption already happened…yesterday and the day before.
That’s why there’s a lack of ‘animal spirits’. The animals inherently know there’s not a lot of food out there, so they’re not going to expend a huge amount of energy looking for it. Monetary or fiscal policy isn’t going to provide the food; it can only make the path to it easier once it’s there.
And this is the problem with today’s monetary policy. It thinks the answer to low growth is to encourage more debt and spending. In other words, it wants to keep dragging consumption from the far distant future all the way into today.
It’s such a stupidly idiotic policy that it’s hard to believe that people seriously think it will work. The very reason for the absence of animal spirits is because of too much debt, yet the response is to try and increase the debt load!
I’m not just making this stuff up about animal spirits and debt. I researched the topic in depth for the last issue of Sound Money. Sound Investments., drawing on the work of long dead economists Knut Wicksell and Ludwig von Mises.
They’re not too popular these days, mainly because their theories don’t accord with modern day central banking. But their ideas are well worth your time and contemplation, because they accurately explain the world’s current economic woes.
So let’s turn to Wicksell first. His biggest insight was to come up with a concept called the ‘natural rate of interest’…that mysterious rate of interest that balanced out the needs of savers and borrowers and produced an economic equilibrium.
In more technical terms, Wicksell’s natural rate corresponds roughly to the aggregate return on capital in an economy…or to be more precise, the return on additional capital invested.
When the natural rate is high, it should bring out people’s animal spirits as they look to take advantage of high rates of return. When low, the animals hibernate.
That it’s low now is obvious. And Ludwig von Mises tells us why…
He said that the natural rate of interest (he called it ‘originary’ interest) was all about consumer preferences. That is, when people preferred to borrow and consume now, the natural rate would be relatively high. But when people preferred to save and not borrow so much, the natural rate would be low.
In theory, the natural rate would fluctuate as consumers’ preferences changed —that is, as they took on debt (leverage) and then paid it down (deleverage). Allowing consumer preferences to ebb and flow naturally would keep the economy in balance over a cycle.
But throw modern day central banks into the mix and you get a never ending debt boom. There is no deleveraging or debt reduction in such a situation, because the whole aim of central bankers is to keep the party going.
If you judge them on that basis, they’ve done a great job. But they are now coming up against some hard obstacles.
First, the natural rate appears to be so low that it’s impeding economic growth. That’s why the ‘recovery’ remains elusive. This makes sense because, after you take on a certain amount of debt, you’re progressively less inclined to take on more. Your preferences change from debt accumulation to debt repayment.
After 30 or so years of debt accumulation, the developed world is clearly close to its limits. The normal channel to fire up animal spirits following an economic slowdown is to lower market rates of interest below the natural rate. This provides an economic incentive to invest.
That today’s ‘low’ rates aren’t doing this tells you that the natural rate must be very low indeed.
So central banks can do all they want to try to encourage borrowing and spending, but if they can’t get market rates below the natural rate, they simply won’t succeed.
Meanwhile, over in the financial markets, punters love the cheap money on offer. While central bankers can’t make real investment happen, they are certainly encouraging speculative investment in the financial economy.
The real and financial economy can’t keep going their separate ways however. While they look to be doing their own thing, they still feed off each other.
That’s why the market greets ‘goldilocks’ data (not too bad, not too good) with applause, because it means no hike in interest rates, and no threat of recession.
It’s an unhealthy equilibrium, and certainly not one that can persist. Given the very low natural rate of interest, the developed world seems to be labouring under, my guess is that a recession is a more likely outcome than a rapid growth scenario.
Tomorrow, I’ll discuss what a recession catalyst could be.
For Markets and Money