Tuesday, August 18, 2020

Guest Post: @pdxsag on The End Game by Grant Williams and Bill Fleckenstein

This may become a new and recurring feature from our correspondent @pdxsag. He has volunteered to “sit through podcasts so we don't have to.” Although, he adds, you should still listen to them, because he is only going to review the podcasts which are excellent -- so excellent you don't want to risk missing-out on anything.

Grant Williams and Bill Fleckenstein started a series of podcasts discussing what and how the monetary “End Game” of the Central Banks' multi-decade bubble-blowing as an obvious martingale strategy will play-out. Their premise is that the present “everything bubble” is the final bubble and whatever comes next is going to be categorically different than the last 20 years of bubble and bust cycles. (22 years if you count the surprise rate-cuts to bail-out LTCM creditors; 26 years if you count the Mexican peso bail-out for Citibank and Goldman Sachs.)

Prior episodes have been better than excellent. They are the most thought-provoking podcasts I've come across. I liken them to Nova from it's golden-age in the 1980's. They are intelligent discussions, reliant on facts, and created for an above-average audience capable of entertaining complex questions that require complex answers. Notable prior episodes are: 
  • Episode #3 (iTunes): interview with Michael Green. The key take-away from this episode is that investors in passive ETF's (an increasing majority) should be more properly regarded as price-indiscriminate buyers and sellers. As ETF's hold de minimis cash balances, they will lead to vicious cycles as ETF investors both panic-sell and panic-buy (fear of missing out – FOMO). 
  • Episode #5 (iTunes): interview with Russel Napier. Napier is a market veteran and student of history as well. He has abandoned his long-held disinflation view and believes this year, 2020, will mark the beginning of a new secular inflation cycle. Specifically, he thinks inflation this year will hit 4%.
Today I will be reviewing the latest in the End Game series, an interview with Dr. Lacy Hunt: Episode #6 (iTunes): Dr. Lacy Hunt (5/5). If readers appreciate this review, I will go back and review episodes 3 and 5 as well. Let me know in the comments. If you already listened to these episodes and would prefer just a quick synopsis to spring-board to a discussion in the comments let me know that too. It would save a lot of time and effort.

Dr. Hunt is a PhD economist boasting 52 years of professional experience. He started his career at the Dallas Federal Reserve Bank, followed by work at Chase-econometrics, a subsidiary of Chase Manhattan where he did projects directly for David Rockefeller. He moved to Fidelity's mixed fixed-income fund in the 1970's, before joining a friend and colleague as a partner at a fixed-income hedge fund with the sole mandate to manage duration in US government bonds.

Almost immediately the remarkable thing about Dr. Hunt was how sharp he is. I am so used to our Boomer politicians and pundits with obvious years of alcohol abuse and talking-points pandering that it was a remarkable surprise to hear a 77 year-old with razor-sharp mental faculties that would clearly best most people of any age. It was also remarkable to hear an economist discussing economics in a scientifically rigorous fashion, rather than as propaganda in a feeble attempt to legitimize some political decision coming out of the uni-party in Washington DC.

Dr. Hunt's market success is notable for 1) side-stepping the 1970's bond bear market by going into cash and cash equivalents and 2) riding the secular bond deflation cycle of the last 30+ years.

Below are summaries I made of various key-points. Emphasis are mine. Occasional opinions interspersed within square brackets are also mine.

11 min: “Debt accelerations” (deficit spending and quantitative easing) do not lead to higher interest rates. Debt accelerations can only pull-forward demand, and thereby reduce future demand by a commiserate amount. This is unequivocal as the debt must be paid back with principle and interest. If the acceleration is not an investment that returns positive cash-flows into the future, future consumption must be reduced. This fact destroys the politicized Keynesian models used to justify deficit spending in order to pull us out of economic contractions.

12 min: Over-indebted economies' distinguishing characteristic is that the velocity of money falls despite stimulus. This leads to asymmetric monetary policy: decreasing rates will not stimulate growth, but raising rates or tightening lending conditions will shrink the economy. (Quantitatively annual velocity was $2.22 in 1997 vs. $1.30's today) Further, Europe, Japan, and China are each even more over-indebted than United States. (Quantitative velocities are all below $1.00/annum in those nations.)

17 min: Production function is technology interacting with cost of inputs:

Output = technology * (land + labor + capital) 

Economics is not accounting. Economics recognizes the economy is a non-linear system. The accounting mindset does not. The accounting mindset tries 1 trillion dollars of stimulus into a specific factor. If that fails to reach the desired output, it tries 2 trillion, then 4 trillion, etc.

18 min: Fisher equation:

interest rate = real rate + inflationary expectations

Investors are accepting lower real rates, and at the same time their inflationary expectations are dropping. [CBS readers are forgiven if they wish to refer to the it as Stagflationary Mark's Revenge.]

21 min: Errors in early models, including his own, were all from using too small a time-frame. Now they test their models against data from 1870 to present. 20-40 year time-spans are too short for any model to be valid. One must know their economic history to be a proficient modeler.

25 min: Adam Smith's 1776 'Wealth of Nations' one major flaw: price is determined by labor content. It is called the Labor Theory of Value. Premise of Karl Marx' entire argument relies upon Labor Theory of Value, which we know is wrong. Almost a hundred years later, in 1870, William Stanley Jevins conceptualizes the Demand Curve. Twenty more years before Alfred Marshall says price is determined by intersection of demand and cost. While economic theory was very slow in the early going, that is no longer the case. Economics modeling is tremendously better, and what was a “given” 45 years ago is as obsolete today as anything in technology from 45 years ago, despite popular opinion to the contrary. [I submit this is due to only useful idiots being given a platform by the mainstream media.]

27 min: 3 secular debt to GDP peaks since 1870: 1 in early 1870's (railroads); 1 in 1929-1930 (of course); 1 in 2008. 2020 will eclipse 2008 and become a new peak[!] exceeding both 1929 and 1870. In every instance debt came down – disinflation. In 1870 and 1930 disinflation was great enough to cross zero bound to become deflation – the GDP (denominator) contracts as well as debt (numerator). No exceptions: over-indebtedness leads to weaker economic activity.

Panic of 1838 (canals) was similar to subsequent ones, though data is incomplete so can't make a full comparison. President Van Buren was ill-equipped to handle the Panic... just as Grant in 1873... [and Obama in 2008... and Trump today.]

31 min: Fleck asks the Quadrillion dollar question (from Napier interview in Episode 5): Does Fed guaranteed debt hand-outs to banks (ie. PPP loans) kick the “M” such that the unproductive nature of the debt is overcome (ie. hyperinflation) Hunt: Fed used “exigent circumstances” rule to end-run their legislative restrictions, which they can kind-of, sort-of get away with once. This lending lets business that otherwise would have gone out of business stay in business, which people hail as an accomplishment. But we know that is actually counter-productive. We've seen it two dozen times in Japan and a dozen times in Europe. It is counter-productive for growth to have these marginal businesses still operating over the long-run. It blunts creative destruction, and it blunts moral hazard. Japan's stock market and economy have not done well. QED.

It is true the Fed has grown money the supply 25% YoY, the fastest in post-war history. But equation of exchange does not say GDP = money. Equation of exchange says GDP = money * velocity. Giving money to zombie corporations does not guarantee GDP will grow. Risk premium increase can overwhelm any drop in rate. It is more likely that it kills velocity.

37 min: One caveat: Fed bought corporate debt using “Exigent circumstances” exception. The legislative act that restricts Fed to government debt except in exigent circumstances could be changed to allow broader mandate, such as in Europe and at Bank of Japan.

37 min: Fed Reserve Act was re-written when we left the gold standard. Job fell to Senator Carter Glass of Virginia, “who was a pretty smart fella,” and he enlisted the help of the two leading monetary economists of the time: Irving Fisher of Yale and Charles Whittlesey of U Penn, Whittlesey gave Hunt his macroeconomic orals when he was getting his MBA at Penn. [I wonder if any of our current senators would rate as “pretty smart” in Hunt's estimation. I also wonder if any of our current senators would enlist credibly smart academics to solve any of our national problems today. I recall the academic architect of Obamacare was an MIT professor of economics, Jonathan Gruber. With his notorious claims that Americans are stupid and the lack of transparency in the Obamacare bill was a necessary feature for its passing, he seems more of a political hack than an intellectual heavy-weight. I wonder what Hunt's judgement of the quality of Gruber's academic research would be.]

Fed debt is NOT currently legal tender. Fed credits are commercial banks' debits and do not necessarily flow into the economy as unencumbered spending. Hunt concedes some people do want to change this legislative restriction, and he's not sure what will happen. It is a risk that would change the whole picture... Gresham's Law. That would be a game-changer [aka. End Game – Napier's position is that it is de facto already happening].

Hunt thinks that will never happen under Powell. It would take a new Fed Chairman, which soonest for that is 2022, plus the usual legislative process so, 2023-24 at soonest. Discussed in the post-script starting at 1 hr 6 min. Fleck counters that snowballing economic conditions [I think he means a >20% market sell-off] would change everyone's mind in a NY minute.

Hunt: McKinsey in 2010 studied 24 cases of over-indebtedness in advanced economies since 1900. In every case over-indebtedness was solved with “austerity” – multiple year increase in savings rate, ie. living below one's means. [I don't understand his point with this. I can list 4 hyperinflations in that timeframe off the top of my head.]

42 min: Hunt refers to a central bank switching from lending to spending operations as “Crossing the Rubicon.” [Could Stagflationary Mark be Dr. Hunt's nome-du-cyber?]

43 min: Grant brings up (more directly) Russell Napier's argument that the PPP loans which enlisted commercial banks to hand-out money which will never be repaid is that step-function which will end the 30 years of disinflation. Hunt responds that they were relatively small in comparison to the size of the economy and transitory. Concedes it's laying the foundation, but the current steps themselves are insufficient.

45 min: Fleck asks ok then, how does Japan get out of their indebtedness? Hunt digresses (pleasantly) on David Hume, mentor to Adam Smith and perhaps greatest intellect of the Enlightenment. Hume spotted flaw of Labor Theory of Value on his deathbed! In 1772 wrote if you do not control public credit, public credit will control you... “when the State has mortgaged all of its future revenues, that State lapses into tranquility, languor, and impotence.” Then a diatribe on Modern Monetary Theory (MMT) and the something-for-nothing conceit that is implicit to it.

51 min: Hunt says he's had people say to him, “I've been told you're a bright fellow. Well, if you're so bright tell why can't you tell me what the fix is.”

52 min: Grant asks, what would make you change your mind? Hunt: Go back to the Fisher equation... it's telling us growth is negative. If Fed holds overnight rate at zero while inflation rate goes negative, real rates must go positive. However, there is private counterpart to the Fisher equation for private borrowers which incorporates the risk premium. As real rates go positive private markets risk premium increases which contracts economy (ie. Japan and Great Depression). It means Fed will have to relent and allow zero bound to crack. [I assume this means Hunt is still long duration and expects the 10 yr to go negative.]

56 min: Dollar weakness is misguided. US has best debt to GDP ratios, best demographics, and positive, albeit barely, lending rates. It's psychological, not supported by any fundamentals.

1 hr 2 min: Asteroid mining!

1 hr 3 min: Shout-out to Robert A. Gordon's book “The Rise and Fall of American Economic Growth” tremendous book that speaks to American production function over 1870 to 1970. America's hey-day of growth was driven by revolutionary inventions that enhanced productivity. Some new revolutionary tech invention would change our current dynamic which would enhance demand for natural resources and alter the current production function, but no idea where it would come from. Evolutionary technology changes won't do it. They do not enhance demand for resources and labor. Contrast with build-out of electrical grid, highway system, chemical and pharmaceutical industries.

1 hr 14 min: Fleck remarks Hunt makes economics sounds like a legit science, whereas most of what we hear as economics is pablum. [I completely agree, and so what's the Fed's excuse! It's impossible to believe they are ignorant to all of this.]

1 hr 16 min: Grant notes the problems and the required solutions are getting more complex by the day. [This is something I've mentioned too. The can-kicking Boomers have done for the last 20+ years has made the problems categorically harder to solve, and at the same time our ostensible meritocracy is the weakest it's ever been.]

1 hr 17 min: Fleck says everyone wants a painless solution, but such do not exist. [This is the utter failure of the Boomers, and will go down to their eternal shame. Whenever confronted with a tough problem they chose whichever solution was short-term most advantageous to themselves, regardless of the long-term, and entirely predictable consequences to the country and her future generations.]

1 hr 18 min: In the final wrap-up Fleck and Grant contrast the views of Napier and Hunt and suggest it would be great fun to have them both on an episode to debate. [To my mind, Napier and Hunt agree far more than they disagree. The disagreement is when and whether to expect Fed monetization. Hunt is saying it hasn't happened in any meaningful sense, and until it does you have to stay invested on the disinflation trade. Napier suggests it's happening right now under our noses. We're seeing it across the board in asset inflation and there is no evidence that policy-setters are going to slow-down or change course from their current trajectory. Pretty clearly the majority of market participants are in Napier's camp, but I think it's going to take a “snowballing economic crisis” as Fleck called, >20% market sell-off as I call it, to make anything official. I think that “crisis” is going to washout everyone that tries to leverage themselves in an attempt to front-run the Fed. The Fed needs a fig-leaf for their monetization scheme.]

[I found another interview of Dr. Hunt from 2014. A transcript is provided, though I haven't read it yet. It will be interesting to see how his arguments back then compare to what has transpired and what he is saying today. I rather suspect nothing has changed... because nothing has changed... which is what David Hume foretold.]


Stagflationary Mark said...

Since I was mentioned, I thought I’d throw in my two cents (not adjusted for inflation).

Although stocks are very richly priced, I should buy them anyway because the real yield on long-term TIPS is negative. There is no alternative.

Although the real yield on long-term TIPS is negative, I should buy them anyway because stocks are very richly priced. There is no alternative.

Oh, wait. I am sitting in cash patiently waiting for 2021 so that I can once again buy more long-term I-Bonds with 0% real yields and/or EE-Bonds guaranteed to double in price in 20 years. I’m also using cash to bring future purchases forward. Never mind. Maybe there is an alternative.

The government wisely limits how many I-Bonds and EE-Bonds I can purchase in a given year, but fortunately I’ve been a believer in savings bonds since 2000. Had the government let me, my entire investment net worth would be sitting in I-Bonds purchased that year. Paid/paying 3.4% over inflation for 30 years. And hindsight shows that 2000 was an excellent year to take advantage of it. The 0.0% offered for I-Bonds purchased today is still a good relative value compared to long-term TIPS purchased today though.

Investors in high-flying stocks probably aren’t going to believe me when I say that it continues to get harder and harder to make money off of money. I guess we’ll just have to agree to disagree and see what the long-term future actually brings. One thing we can say with certainty. There is no money to be made buying long-term TIPS today and holding to maturity. Only pain. The only real debate is what the future of the stock market is (and the housing market too).

And now, this bear once again opts to attempt hibernation. Winter is coming. *cringe*

Ahmed said...

He's also on hidden forces podcast with Sentry around 2017.

MrGotham said...

Please do more of these. Very good.

Robert Neely said...

I would like you to continue these analyses/synopses.

CP said...

This is excellent and summarizes my take away as well on why I hesitate to embrace the “Brrr” theme: “I think that “crisis” is going to washout everyone that tries to leverage themselves in an attempt to front-run the Fed. The Fed needs a fig-leaf for their monetization scheme.”

CP said...

New readers, also see last night's post, "The Biggest Heist of All Time: Tesla Will Probably Join the S&P 500":


ec0nstudent said...

This is great, please do Mike Green's episode.

robert smith said...

Please, please do Russell Napier episode!

Allan Folz said...

Well, the people have spoken... Russell Napier coming up next. :) Though, it probably won't be until late next week at the earliest.

Thank you all for the kind words and encouragement.

Anonymous said...

Great stuff! Please do Mike Green's and Russell Napier's episodes!

Unknown said...

Thanks for doing this! This is a big help. Can anyone point to resources for the retail investor for guidance moving forward. what to do when 60/40 made in passive funds becomes troubled.

Anonymous said...

Thanks for these.

The attractive thing about indexed ETFs and funds is that there's no other place for UMC plebes to put money. Property rights have eroded to the point where it is quite risky to buy rental properties, especially while competing with huge REITs and ChiCom investors. You can't keep money in the bank. If you keep it in dubloons, you can get robbed.

Your other option is rolling money into a business and competing with huge monopolies or employees who want to sue.

Thus ETFs. Buyers are definitely price-insensitive.