For the past 16 years, the world’s population has been living in a test tube. Various experiments have been run on us. Though they were pitched as advancements and were instituted with the best of intentions, the experiments proved themselves to be scientific procedures undertaken to…
- make a discovery that a common currency shared between disparate economic systems can produce unequal outcomes.
- test the hypothesis that artificially low rates will drive economic growth.
- demonstrate a known fact that excessive regulation harms economic growth.
Making a Discovery
The common currency of Europe, the Euro, came into existence in the 1990s and was broadly adopted as a replacement for the region’s sovereign currencies in 1999. It was thought that the furthering of the common market by a common currency would encourage free trade across country borders within the Union and bring about efficiency and prosperity. And it did for many. Unfortunately, the common currency had the unintended consequence of creating unstable and unequal outcomes in some countries. The global strength of the euro was driven by the economic fortunes of Germany, creating an even larger disparity between Germany and the less-than-productive countries of France and Italy. The Boston Consulting Group 2014 report on global manufacturing competitiveness calculated that European manufacturers were losing significant ground globally and had experienced a 10% increase in manufacturing costs from 2004 to 2014. The rising costs dampened economic activity as consumers found value elsewhere.
The European Central Bank in Brussels determines the value of the euro, eliminating the main lever available to sovereign nations within the EU to adjust their global competitiveness: currency devaluation. Without the lever, nations within the EU became powerless to prevent recessions from devolving into depressions. Austerity policies pushed by the European Central Bank only added weight to the shoulders of local governments, prolonging and deepening pains felt by their citizens.
Experiment Result: When someone controls your pocketbook, do not expect to buy what you want or need.
Testing a Hypothesis
We need to rewind the clock to the early 2000s to see the beginning of the easy monetary environment that culminated in this summer’s ultra-low rates around the globe. In response to the technology bubble and the terrorist attacks in the US, the Federal Reserve dramatically lowered rates, which appeared to be justified at the time. The problems began when the Fed was slow to respond to the improving economic environment in 2003. The intent was to spur economic growth through cheap money—cheaper than what was typically thought necessary.
Up to 2003, there had been a school of thought gaining acceptance: the setting of interest rates should follow a formula that accounts for economic growth and inflation. Referred to as the Taylor Rule, it enabled market participants to anticipate the direction and magnitude of interest rate movements, allowing for a more informed investment planning environment.
The graph below demonstrates that for much of the late 1980s and 1990s, the Federal Reserve followed the Taylor Rule. However, in the early 2000s, the Fed moved into a much more accommodative position and kept rates materially lower than what would have been desirable under the Taylor Rule.
Many economists have argued that the artificially low rates produced uncertainty among capital allocators, which has led to investment paralysis. As we have discussed in past articles, the low rates have also hit the older population, a group that has put away savings with the hopes of having the interest on their savings available to fund retirement. The artificial rates have not kept up with the inflation experienced by this segment of the population, thereby harming consumption for a growing percentage of the population.
The last week has seen a material shift in the market’s expectations for future rates. Though we have discussed that an artificially low rate environment runs counter to our observations of the underlying economic data, it wasn’t until anticipation of a renewed infrastructure spending program in the US began to build that the market began the normalization process in rates. Since last Wednesday, we have seen the US 10-year Treasury rate move from 1.7% to over 2.2%. The move has been felt worldwide as safe-haven bonds in Germany and Japan move into positive rate territory after an extended time offering negative yields.
Experiment Result: Low rates do not necessarily generate growth.
Demonstrate A Known Fact
The reasons are varied but the results have been consistent: the world has been experiencing an increase in the centralization of power on the political front that has culminated in increasing burdens on individuals and corporations. During the 2000s, the United States saw a steady rise in new regulations hitting almost all sectors, increasing the regulatory burden on many. Federal regulations grew to over 174,000 pages, having started the century at 138,000 pages. An April 2016 report by the Mercatus Center at George Mason University estimates that economic growth has been stunted by almost 1% per year because of the increasingly regulatory environment. The last two presidential administrations have been very active in producing over 350 major “economically significant” regulations, each carrying an anticipated cost of $100 million or more.
Europe has been no less active. The Treaty of Lisbon, enacted in 2007, increased the regulatory power of Brussels. It is argued that the increased regulatory drive has created extra costs for consumers. One popular example used in the UK during the Brexit vote was the prohibition of “bendy bananas.” A regulation out of Brussels stated that bananas should be “free from abnormal curvature!” And the people of Portugal are in a huff, because their tomato jam may no longer be called jam, as its sugar content is below the regulated minimum. A majority in Britain decided they had enough. Others within the EU will be voting over the next year to either reaffirm or break their commitment to the EU experiment.
China is the other interesting candidate for regulatory burden, though most Chinese regulation was based on the attempt to reduce corruption within the government and state-owned enterprises. The current president, Xi Jinping, took office in 2013 and began an effort to end corruption. In doing so, he increased his grasp on power by designating himself as the head of new national steering committees and directly driving the “Chinese Dream.” His desire to take on an increasing role in regulation is a change from prior leaders’ move towards increasing economic freedoms. Time will tell if this puts strains on the system.
Experiment Result: Regulatory burden slows growth.
The observations presented above have a common unintended consequence: a movement away from market forces, preventing price determination and restricting economic activity. We believe the experiments have run their course, and the conclusion by many is they have not produced the desired outcomes.
Conclusion
The expected shift in global political directions will inevitably cause disruptions and change within economic processes worldwide. We are witnessing an increase in economic volatility and are aiming to dampen its impact on client accounts through a modest position in cash. We are optimistic that a move away from the centralized manipulation experiments will lead to market-based price discovery and likely to a re-investment cycle that the world needs. However, there are many variables at play and understanding their movements and their impacts on all economic players is complicated. The engineers in us rely on the adage, “Hope for the best but design for the worst.”
Important Dates
- Italian Referendum December 4th, 2016
- US Federal Reserve Meeting December 14th, 2016
- Dutch General Election March 15th, 2017
- French elections April 23rd, 2017
Best regards,
The Auour Investments Team