“The triggering device in financial instability may be the financial distress of a particular unit. In such a case, the initiating unit, after the event, will be adjudged guilty of poor management. However, the poor management of this unit…may not be the cause of system instability.”
As Hyman Minsky wisely observed decades ago, after financial instability ensues, people will focus on the failure of the “triggering unit” rather than on the systemic problems as the primary cause. Today’s unemployment rate number in many respects highlights the pervasive systemic instability in the US economy that many are experiencing. That being said, not all is lost.
In this particular crisis, what Hyman Minsky labels the “triggering unit” can be pluralized. Everyone with an agenda has their own pet “triggering unit,” whether that be Lehman Brothers, Freddie (NYSE: FRE) and Fannie (NYSE: FNM), bad policy-makers (too many to name but Bush, Obama and Rubin are a good starting point). In reality, no one of these so-called “triggering devices” are the real cause. The real problem is far different in nature, and in order to address it we need to acknowledge its root cause.
A Secular Shift in Credit
The nature of this crisis is of credit. This is not your typical post-World War II recession. I’m sure many have heard that said before, but yet despite that, many fail to think about our problems today in a different light. In 2006-07, what happened was far more than just the bust of the sub-prime bubble. 2007 marked the point in which the United States shifted from the secular expansions of credit to the secular contraction of credit. As much as the Federal Government is trying to expand its own debt levels to make up for the contraction of credit in the private sector, its actions are far too constrained to generate enough of an impact. Today’s jobs number clearly highlights that fact.
Deflation in the private sector is the equivalent to the destruction of dollars. As credit contracts, the supply of dollars circulating through the system shrinks. In each rotation through the system, each dollar produces a correspondingly smaller positive multiplier on economic activity at large, what we call a slowdown in the velocity of money. Not too long ago, in my writeup on The Nature of the Beast: A Look at the Ongoing Debt Crisis, I used the following chart (borrowed from Steve Keen’s “Are We ‘It’ Yet?“) to highlight the aggregate debt levels in the various sectors of the US economy:
To date, the goal at the Federal Reserve and with fiscal policy has been to provide the fuel necessary to stem the destruction of dollars in the private sector: the Fed has unleashed a host of initiatives to increase the money supply in the economy, while the government has tried to expand its own balance sheet and take on more debt in order to counteract the destruction of credit in the private sector. While these were the correct initiatives to undertake, clearly not enough has been done yet to date.
The Dual Mandate of the Fed
The Board of Governors of the Federal Reserve System and the Federal Open Market Committee 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.
Our economic policy in this country is designed such that the primary goal is the maintenance of full employment. Economists historically recognized that there is often a relationship between price level and full employment, therefore, in the formation of our central bank–The Federal Reserve–policymakers issued a mandate that the new central bank shall strive for both “maximum employment” and “stable prices” using interest rate policy as the primary means through which to achieve said goal.
St. Louis Fed President, James Bullard, a noted inflation hawk on the Fed Board recently put out a paper saying that a “quantitative easing program offers the best tool to avoid [a deflationary] outcome.” This is significant for two reasons: first, it is an explicit acknowledgment that the risk to the price level nationally is not inflationary, but rather, is deflationary; and second, if inflation is not a concern for the Fed in these times, then the focus not only should, but MUST shift to counteracting unemployment. Such is the requirement of the dual mandate: if not one, then the other.
Today’s unemployment number makes it explicitly clear that deflation is a very real and serious threat to our economy. Anyone talking about Weimar-style inflation in the future, really needs to get a better grasp as to the state of credit in our economy. With a shrinking work force that has little wage bargaining power altogether it is rather difficult for inflation, let alone rampant inflation, to take hold of the economy. There is simply no mechanism through which the velocity of money can accelerate in our economy. As much as the Fed may be printing money, there is simply far too much destruction of money in the heart of our economy–the private sector. Helicopter Ben will continue to print so long as this status persists.
What Investors Should Look For
It is our job as investors to identify the most likely policy outcomes. All in all, today’s unemployment number doesn’t change things that much. We knew that it would not be a pretty employment picture this month, and as a result, the market’s reaction so far is not nearly as drastic as it could have been.
Following this report, it is increasingly unlikely that the Fed withdraws the “extended period” language from FOMC Statements any time in the near future. Why is that? Well Ben Bernanke, as a scholar who focused much of his academic career on studying the nature of economic panics is a believer in the use of language as a policy tool. The presence of the “extended period” language, while not a formal policy in and of itself, makes clear to our economic actors that inflation is the desired policy outcome. What is significant is that this could add significant momentum to the movement for Quantitative Easing 2.0.
While deflation is a significant risk to the economy at large, and an enemy of equity investors, there are clear pockets of strength that still stand to benefit on the equity front. As we have highlighted on this blog for some time now (in both our earnings recaps and our deeper look at last week’s GDP data) there is real and substantial investment taking place in enterprise systems and technology. Innovation is one of the best ways to both find a safe haven amidst deflation, and ultimately to cure (or mask the symptoms) of persistent deflation.
What many missed amidst the depths of the crisis over the past two years is that a fundamental shift in the nature of how we incorporate technology into our everyday lives is taking place. Since the depths of that crisis have passed, that trend has only accelerated. I remain particularly interested in cloud computing, alternative energy and biotechnology as focal points for a constructively built portfolio (read my take here on why I am particularly fond of tech). These sectors are beneficiaries of unique fundamental trends that are in many ways far less prone to the woes of deflation than cyclical stocks with more end consumer exposure.
Additionally, emerging markets remain incredibly attractive. I recently highlighted Chile as a “hot” investment prospect, and I am equally enamored with India. Whereas the United States is concerned with creating inflation, these intriguing emerging markets are concerned with cooling inflation. Inflation is a risk in its own right; however, the exportation of deflation from the US over the long run will help quell some of the inflationary pressures in emerging markets. The sources of growth for these areas–mainly resource wealth and a growing middle class–remain promising for the long run.
Disclosure: Long ECH, IFN