Latest Memo From Howard Marks: Economic Reality – Addendum

Addendum, June 13:  There’s been a lot of response since the memo that follows was originally published on May 26.  In the discussions that have ensued, I realized that I should have led with something like this:

Ultimately, economics is the study of choice.  Because choices range over every imaginable aspect of human experience, so does economics. . . .

How do individuals make choices:  Would you like better grades?  More time to relax?  More time watching movies?  Getting better grades probably requires more time studying, and perhaps less relaxation and entertainment.  Not only must we make choices as individuals, we must make choices as a society.  Do we want a cleaner environment?  Faster economic growth?  Both may be desirable, but efforts to clean up the environment may conflict with faster economic growth.  Society must make choices. . . .

We would always like more and better housing, more and better education – more and better of practically everything.

If our resources were . . . unlimited, we could say yes to each of our wants – and there would be no economics.  Because our resources are limited, we cannot say yes to everything.  To say yes to one thing requires that we say no to another.  Whether we like it or not, we must make choices.

Our unlimited wants are continually colliding with the limits of our resources, forcing us to pick some activities and to reject others.  Scarcity is the condition of having to choose among alternatives.  (Macroeconomics Principles, Libby Rittenberg and Tim Tregarthen.  Emphasis added)

Because of the above, we make economic choices every day.  Everyone knows choices like these are inescapable. 

Everyone, that is, except for politicians.  The politician promises better grades and more leisure time.  A cleaner environment and faster economic growth.  That’s what caused me to write the memo: in politics and government – unlike the real world – the word “or” often goes out the window, replaced by “and.”  No choices are necessary. 

A few months ago I saw a cartoon featuring caricatures of two primary opponents.  Under one it said “bulls**t” and under the other it said “free s**t.”  There’s bound to be a lot of the former in any election season, but economics tells us the latter is unrealistic.  I wrote this memo to help readers understand why.

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In 1977, responding to the difficult energy outlook brought on by the Arab Oil Embargo, President Jimmy Carter created the position of Secretary of Energy and chose James Schlesinger as America’s first “energy czar.”  Previously Schlesinger had served as Chairman of the Atomic Energy Commission, Director of Central Intelligence, and Secretary of Defense, and in his early days he taught economics at the University of Virginia.  I was tickled by a story – undoubtedly apocryphal – about his days in academia that made the rounds when Schlesinger was in his new energy post.

As the story went, Schlesinger was such a convincing evangelist for capitalism that two students in his economics class decided to go into business after graduation.  Their plan was to borrow money from a bank, buy a truck, and use it to pick up firewood purchased in the Virginia countryside, which they would then sell to the grandees in Georgetown.  Schlesinger wholeheartedly endorsed their entrepreneurial leanings, and they proceeded with great enthusiasm.  From the start of their venture, the former students could barely keep up with the demand.

Thus it came as quite a shock when their banker called to tell them the balance in their account had reached zero and the truck was about to be repossessed.  They contacted Schlesinger, and he listened attentively as they recounted their experience: they had, in fact, been able to acquire vast amounts of wood for $50 a cord, and they’d been able to sell all they had for $40 a cord.  How could they be broke?  Where had they gone wrong?  Schlesinger puffed on his ever-present pipe and said: “The answer’s obvious: you need a bigger truck.”

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While it certainly wasn’t the case with Schlesinger (despite what the above tale suggests), most ordinary citizens don’t have what it takes to figure out what is and isn’t economically feasible.  Since we’re in the midst of election season, with promises of cures for our economic woes being thrown around, this seems like a particularly appropriate time to explore what can and can’t be achieved within the laws of economics.  Those laws might not work 100% of the time the way physical laws do, but they generally tend to define the range of outcomes.  It’s my goal here to point out how some of the things that central banks and governments try to do – and election candidates promise to do – fly in the face of those laws.

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When I was in high school, one of my buddies convinced me to take a class in accounting.  I found the double-entry bookkeeping we learned to be logical, symmetrical and unambiguous.  After accounting I moved on to economics, and I found it equally logical.  The die was cast for my career in business.

Like the lesson of the Schlesinger story, the rest of economics is also pretty straightforward, and its laws are quite reliable.  If you buy for $50 and sell for $40, you won’t make money . . . period (or stay in business long).  That reminds me of a joke I used in “” in January 2000, one my father told me roughly 60 years ago:

“I lose money on everything I sell.”

“Then how do you stay in business?”

“I make it up on volume.”

For those of us in the business world, economics defines reality.  (You may think you’ve heard me poke at it, but what I deride is economic forecasting, not economics.  There’s a big difference.)  The realities of economics are the subject of this memo.  My primary methodology will be to describe ways in which people (and especially politicians) tend to propose things that conflict with economic reality, and explain why they’re unlikely to work.

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Let’s start with central banks’ attempts to achieve monetary stimulus.  When central banks want to help economies grow, they take actions such as reducing the interest rates they charge on loans to banks or, more recently, buying assets (“quantitative easing”).  In theory, both of these will add to the funds in circulation and encourage economic activity.  The lower rates are, and the more money there is in circulation, the more likely people and businesses will be to borrow, spend and invest.  These things will make the economy more vibrant.

But there’s a catch.  Central bankers can’t create economic progress; they can only stimulate activity temporarily.  GDP, or national output, can be seen roughly as the amount of labor employed times productivity, or the amount of output per unit of labor.  In the long term, these things are independent of the amount of money in circulation or the rate of interest.  The level of economic activity is determined by the nation’s productiveness.

Central bank actions can encourage or accelerate economic activity, but

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