April 15, 2016
By Steve Blumenthal

“Seemingly logical, but as I’ve pointed out in recent years – not working very well because zero and negative interest rates break down capitalistic business models related to banking, insurance, pension funds, and ultimately small savers.  They can’t earn anything!”

Bill Gross, Lead Portfolio Manager, Janus

“The unintended increase in the demand for physical cash caused by negative rates can lead to adverse economic effects.  When agents want to hold more cash, the velocity of money drops, the money multiplier no longer works: policies designed to create inflation feed deflation.”

-Tim Hayes, CMT, Chief Global Investment Strategist, NDR

My 18-year-old son, Matthew, came to me asking about how the economy works.  This summer he will be an intern and task one prior to his start date is to read “How the Economic Machine Works.”  There is much we can learn from history and it makes sense to study the research from some of the brightest amongst us.  From there, he and I will begin a dialogue.

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This past week I watched CNN’s Fareed Zakaria interview former Federal Reserve Chairmen Paul Volker, Alan Greenspan and Ben Bernanke and current Chair Janet Yellen.  The interview concentrated on how the Fed makes decisions on interest rates.  You can watch the interview here (jump forward 16 minutes for the start).  Following are several of their individual comments.

Yellen’s comments:

  • The economy is on a solid course
  • Not a bubble economy
  • Doesn’t see credit imbalances due to low rates
  • Relatively weak global growth, yet U.S. is doing well but with a drag from the global economy
  • Any measure of the labor market you look at shows broad improvement

Bernanke comments:

  • The risk of recession is more or less constant in every year
  • We are facing risks like what we’ve seen globally, productivity growth is only modest, which is also a problem but the domestic U.S. economy is moving forward
  • From a financial perspective, households are pretty strong
  • The housing sector is continuing to expand
  • I don’t see any particular reason why a recession is any more likely in 2016 than it was in 2015 or 2014
  • That being said, it is true that if recession were to start, the Fed is starting from a lower level of interest rates than would normally be the case, so the extent to which the Fed could cut is less
  • His reaction to that is that there other tools, such as forward guidance and QE. We are seeing experiments globally, so there are other tools that we can use.  The Fed is not out of ammunition.
  • However, we have learned that it is a mistake to put all of the burden on central bank monetary policy. What is needed is a more balanced policy (such as structural reform and fiscal policy from government), which would no doubt work even if the central bank is forced to the limit

Greenspan comments:

  • I think the major problem that exists is productivity growth across the spectrum of all countries has been below 1% over the last five years. How do we create a GDP growth rate (output per hour times the expansion in the labor force)
  • Unless we come to grips with the issue of productivity then we have no major advance in the future
  • He believes it is that capital investment, pretty much everywhere, has slowed down to a significant extent and, as a percentage of GDP, has been dramatically lower than where it has been historically
  • Monetary policy should not have the whole load of getting us out of this mess
  • Our problem is fundamentally a fiscal problem. Spending money only increases the debt.
  • The data importantly show that what we are facing with the demographics we have is an expansion of debt. Unless and until we address this issue, we are going to have problems that are not going to get resolved.

Volker comments:

  • There were recessions before there was a Federal Reserve
  • There are other factors at work in the economy that tend to produce ups and downs
  • And I wouldn’t worry too much about the present situation
  • He doesn’t think we are in a bubble economy but sees concerning areas
  • There is a lot of reliance on very short-term borrowing to make illiquid investments, a large part of it in the financial sector, without contribution to productivity or real investment is increasing risks in the economy

Fareed asks Bernanke how the Fed will unwind the $4.5 trillion dollars of QE assets it has bought since the Great Recession.  Bernanke said:

  • “Fortunately, I don’t have to,” as he gestured to Yellen (lots of laughter).
  • He adds, “Let me just say that the media has advanced a number of uniformed views on this subject.”
  • “In terms of the unwinding, it is a straight-forward process and the Fed has been very clear, at some point the Fed will simply stop reinvesting securities as they mature and let them roll off as they mature and over a period of a number of years it will just go down.”
  • In the end, all we have to show for it, besides the fact that they (NIRP, QE, messaging) have helped our economy recover, the Fed has sent profits to the Treasury of $500 billion which has reduced the burden on the taxpayer.
  • It has been on the whole a pretty successful policy and I don’t think the roll out (unwinding of the assets on the Fed’s balance sheet) will be problematic.

Reread that bold section.  It will be interesting explaining that one to Matthew.  You can listen to the entire interview and I believe it is worth your time, but I’d like to add that we are dealing with highly complex systems that involve billions of moving parts.  To this end, I liked what Greenspan said towards the end of the interview.

Specifically Greenspan said, “Monetary [policy] is largely economic forecasting and our ability to forecast is significantly limited and we have to keep the context of what we say in the context of what we know and this is a very serious problem that has always existed [for the Fed].  So how do you convey what you know and what is clear without going beyond into the area of forecasting beyond our knowledge?”

What I think I heard him say was, “The curious task of economics is to demonstrate to men how little they really know about what they imagine they can design.”  Quoting Friedrich Hayek of Nobel Prize in Economics fame.

These tools may both help and hurt.  If the Fed can pull off a soft landing, they can’t do it alone.  The fiscal side of the equation involves help from those that can create the structural lift.  You know, the guys and gals we are all disgusted with in D.C.

To get to what Ray Dalio calls “the beautiful deleveraging” will require all of the components of the orchestra working together.  Right now the brass section won’t work with the string section and the conductor is doing all she can do to make the music sound good.  There has been a great deal of experimentation.

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Just what is a business cycle (I imagine my Matthew will ask)?

The business cycle is the fluctuation in economic activity that an economy experiences over

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