The Ministry Of Love: A Play In One Act

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(We open on a nondescript, windowless room. A FUNDAMENTAL INVESTOR sits strapped into a GROTESQUE TORTURE CHAIR. The torture chair is designed to inflict the physical, psychological and financial pain of enduring a short squeeze on its occupant. An ECONOMIST dressed in an ordinary suit addresses the investor)

ECONOMIST: I would like to begin by emphasizing we have invited you to this Continuing Education Session in the spirit of educational goodwill. Here at the Ministry, we work not for money, but out of love. Our love for you. Our love for your fellow investors. Our love for the financial markets and the global macroeconomy. Now, we shall begin today’s session by reviewing some simple concepts. What is a financial market?

INVESTOR: A financial market is where buyers and sellers– (mid-sentence, the Investor convulses in pain, letting out a guttural sound that is half-grunt and half-scream)

ECONOMIST: –Already we are starting off on the wrong foot. A financial market has nothing whatsoever to do with buyers and sellers. A financial market is a wealth creation mechanism for individuals and thus societies. Now, what do you suppose a market should do over time?

INVESTOR: It depends– (again the Investor convulses in pain)

ECONOMIST: Incorrect. The correct answer is RISE. A financial market RISES over time. Can you tell me why?

INVESTOR: Earnings– (another convulsion)

ECONOMIST: WRONG AGAIN! A market rises because a market MUST rise over time. It is a tautology that a market must rise. I am beginning to suspect your misconceptions about our financial system are more fundamental than I had initially believed. I shall endeavor to correct this. (The Economist pauses briefly, as if switching to a new script in his head) Tell me, why should someone invest?

(The Investor hesitates)

ECONOMIST: Go on. I am genuinely curious.

INVESTOR: To earn a return on capital.

ECONOMIST: Yes. To earn a return on capital. And why should an investor prefer bonds, to say, cash?

INVESTOR (hesitant): Higher returns.

ECONOMIST: Yes, quite right. And why should an investor prefer stocks to bonds?

INVESTOR: Higher returns.

ECONOMIST: And WHY do you suppose stocks should return more than bonds or cash over time?

INVESTOR: As compensation for the incremental risk associated with taking the most junior position in a capital structure, with only a residual claim on cash flows and assets.

ECONOMIST: Yes, very good. And how does an investor decide whether he is being compensated fairly for taking the most junior positions in capital structures, instead of owning bonds?

INVESTOR (after a long pause): Relative valuations.

ECONOMIST: And what determines relative valuations?

INVESTOR: Investor preferences– (this time the convulsion is extra long and painful)

ECONOMIST: Now we’ve arrived at the crux of our misunderstanding. You investors only BELIEVE you determine relative valuations across asset classes. You are so absorbed in your own brilliance, in your petty little security selection games and benchmark arbitrage games and sales and marketing games that you COMPLETELY AND UTTERLY FAIL to see the world AS IT IS. In reality, WE determine relative valuations. The Federal Reserve. The European Central Bank. The Bank of Japan. In nature, it would be as though we controlled the force of GRAVITY. Investors do not “determine” anything. They merely RESPOND to our influence as it manifests itself in the world. Can you tell me, whence we derive this incredible power?

INVESTOR (for the first time, calm and self-assured): You control the supply of money.

ECONOMIST: Not only the SUPPLY of money, but the PRICE of money. Said another way, we control the price of RISK. You investors can no more escape our influence on the price of risk than you can escape the force of gravity. Excellent. (The Economist is obviously delighted with this progress) Now that we’ve reached this understanding, we shall practice with a brief exercise. What is a reasonable return on Treasury bills?

INVESTOR: Depending on inflation–(a brief zap of pain)

ECONOMIST: Incorrect. Let us try again. What is a reasonable rate of return on Treasury bills?

INVESTOR: I need to know–(a longer convulsion ensues)

ECONOMIST (sighs): Again, what is a reasonable rate of return on Treasury bills?

INVESTOR (desperate; frustrated): I DON’T KNOW! Just tell me what you want to hear!

(This is the longest zap of the torture device yet, and when it ends the Investor is little more than a blubbering pile of mush)

ECONOMIST (to the audience): A reasonable rate of return on Treasury bills is whatever OUR models say it should be. A reasonable rate of return on Treasury bills is whatever WE want it to be. WE decide whether you should prefer bonds to bills, or stocks to bonds. WE decided whether you should be incentivized to hold cash or spend it with reckless abandon. WE decide whether the market should rise or fall. Only deciding whether the market should rise or fall is no decision at all. The market rises over time because it MUST rise over time. That the market rises over time is a tautology.

(Abruptly, the stage goes black)

(Scene change)

(Slowly, the lights come up. The Investor is seated at his desk, working. He is on a client call, holding his phone up to his ear. He is flanked by an enormous plasma TV, showing Neel Kashkari being interviewed on CNBC)

Investor (smiling broadly): Well, of course the market goes up over time, Mister and Missus Smith. The market pretty much HAS TO go up over time. It’s basically a tautology. (He pauses momentarily, listening) Of course! Happy to explain…

(Fade to black)

The Tyranny of Optimization

Nature smiles at the union of freedom and equality in our utopias. For freedom and equality are sworn and everlasting enemies, and when one prevails the other other dies […] To check the growth of inequality, liberty must be sacrificed, as in Russia after 1917. Even when repressed, inequality grows; only the man who is below the average in economic ability desires equality; those who are conscious of superior ability desire freedom; and in the end superior ability has its way. Utopias of equality are biologically doomed, and the best that the amiable philosopher can hope for is an approximate equality of legal justice and educational opportunity.

–Will & Ariel Durant, The Lessons of History

When I was younger, I used to believe strongly in what I’ll call “technocratic optimization.” In my view, the Big Problems confronting civilization could be tackled through the decisive application of computational power and human intellect. The idea was that if you got all the smartest people working on all the hardest problems eventually you could solve them. You would discover Truth with a capital T. The rest would take care of itself.

I was a fool to believe this.

Human societies don’t run like giant mean-variance portfolio optimizations, where each individual can be reduced to a personal utility function, then aggregated and mapped to a kind of efficient frontier based on the available resources. Human societies are dynamic systems. These systems are constantly evolving in the face of environmental and social pressures. Whenever we attempt to optimize social and economic systems, our models inevitably end up either overfit or underfit. Hence the abundance of “unintended consequences” that accompany major policy changes.

But here’s the biggest problem with technocratic optimization: even in the best of circumstances, where it’s reasonably self-evident, the mere existence of Truth with a capital T is insufficient motivation for people to change their behavior. As Upton Sinclair famously wrote: “it is difficult to get a man to understand something when his salary depends on him not understanding it.”

So what’s a frustrated optimizer to do?

Well, you can force people to buy into your optimization. Or, you can convince them to buy into your optimization. Or, you can convince them to buy into your optimization by leveraging technology and their behavioral biases (a much better bet than simply relying on the merits of your argument).

If you’re an optimizer, your intellectual journey ends in tyranny.

Russland-Nord, Erschießung von Partisanen

Now, there’s certainly the concentration camp and NKVD firing squad kind of tyranny we’re acquainted with from 20th century history. All very messy. Fortunately, we now have kinder, gentler forms of coercion available to us.

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The social credit system kind of tyranny, and the fiat news kind of tyranny, for example. Here you’re not staring down the barrel of a gun but rather at a smartphone screen. Here, the trick is not only convincing people to buy into your optimization, but that buying in was their idea in the first place. This is tyranny updated for the 21st century. Much cleaner than putting people up against a wall. Once you start looking for it, you see it everywhere.

So, what’s a reformed optimizer to do?

Personally, I’ve gone back to the Lessons of History, and the collective experience of human civilization. I’ve abandoned the view we should try to engineer “optimal” outcomes for individuals or society. I’ve come to believe that rather than engineer Answers, we should focus on the maintaining and improving the integrity of our Processes: the approximate equality of justice and educational opportunity.

I’ve also abandoned the idea that human civilization progresses on a linear trajectory, or, more precisely, that human civilization can progress along a linear upward trajectory. In reality, things move in cycles and mini-cycles. These cycles are driven not only by changes in the natural world, but also the constant friction generated by individuals and states in competition for power and resources.

Put another way: we oscillate between freedom and tyranny, and between varying levels of equality and inequality over time. This is natural and inevitable (which is not to say it’s “pleasant” or “ideal”). We’ve been fortunate that the general trend over time has been upward. That doesn’t mean we’ll never experience another period of dramatic upheaval and regression a la the Dark Ages.

I believe we should be much more concerned with managing the risks inherent in sudden paradigm shifts such as the French Revolution, Russian Revolution, and the spike in aggressive, authoritarian nationalism that occurred in the 1930s.

In finance nerd terms: mind the tails.

We’re not doing a very good job minding the tails right now. In optimizing for short-term economic growth, our default fiscal policy of every-increasing borrowing and default monetary policy of “plunge protection” (a.k.a The Greenspan/Bernanke/Yellen/Powell/Draghi/Kuroda Put) have provided economic and financial market stability at the expense of political and social stability. One of the most powerful voices in our political discourse today is a freshman rep who is an avowed democratic socialist (whatever that’s supposed to mean). If you can’t see how this relates to the legacy of the financial crisis; the legacy of quantitative easing; the deflationary impact of globalization and technological innovation–well, if you can’t see how all this interrelates, I’m not quite sure what to tell you.

You can’t destroy risk. You can only transform it.

That insight is in short supply among technocratic optimizers.

Unhelpful, Misguided, Amateurish

A reader responds to my MMT post:

[t]he above is a terrible unhelpful, misguided and amateurish review of MMT. Your understanding of the role of inflation and the actual operational positions espoused by its proponents is useless. Perhaps it’s driven by politics or some ideology but you could probably learn a bit by spending a bit more time on it all.

Fair enough.

Look. I’m not an economist. I write as a practitioner in financial markets. As such, I’m mainly concerned with incentive systems and how they impact strategic decision making by individuals and institutions.

Politicians are always and everywhere incentivized to run deficits and print money. Hand politicians a license to run deficits of arbitrary size and they will print and print and print. This isn’t left versus right political thing. This is a human nature thing.

Under MMT, it would be up to self-interested politicians and their appointed bureaucrats to ensure we don’t end up with hyperinflation. Self-interested politicians and appointed bureaucrats hardly have an unblemished track record when it comes to economic management.

Now, I should be clear here that my commenter is correct. My opposition to MMT is absolutely ideological. Specifically:

  • I don’t believe bureaucrats are capable of pulling off the operational balancing act MMT requires.
  • More importantly, I don’t believe bureaucrats ought to be empowered to try and pull off the operational balancing act MMT requires in the first place.

In my estimation, the downside risks are catastrophic. We could end up on The Road To Serfdom. We could end up with hyperinflation. Anyone regularly involved in decision making under uncertainty knows that the way you manage the risk of ruin is either to hedge it or to avoid taking it in the first place.

That’s not to say MMT can’t work. The theoretical viability of MMT is something for economists to argue over.

My argument is much, much simpler. Given what we know about human nature and fallibility, and given the historical track record of economic planners and administrators, the potential negative outcomes from a real-world implementation of MMT (you know, total economic collapse) far outweigh the potential benefits.

As a wiser man than me once said: “you were so preoccupied with whether you could, you didn’t stop to think whether you should.”

Our World In Meta-Games

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Source: Brandt Luke Zorn via Wikipedia

The world is a complicated place. A good way of attacking that complexity is to view the world as a nested series of games and meta-games.

Ben Hunt at Epsilon Theory wrote an excellent post about meta-games in financial markets a while back, specifically in the context of financial innovation. While I’m going to take a slightly different angle here, his illustration of how a meta-game works is useful as a jumping off point.

It involves the coyotes that “skirmish” with the residents of his town:

What’s the meta-game? It’s the game of games. It’s the larger social game where this little game of aggression and dominance with my wife played out. The meta-game for coyotes is how to stay alive in pockets of dense woods while surrounded by increasingly domesticated humans who are increasingly fearful of anything and everything that is actually untamed and natural. A strategy of Skirmish and scheming feints and counter-feints is something that coyotes are really good at. They will “win” every time they play this individual mini-game with domesticated dogs and domesticated humans shaking coffee cans half-filled with coins. But it is a suicidal strategy for the meta-game. As in literally suicidal. As in you will be killed by the animal control officer who HATES the idea of taking you out but is REQUIRED to do it because there’s an angry posse of families who just moved into town from the city and are AGHAST at the notion that they share these woods with creatures that actually have fangs and claws.

For simplicity’s sake, I’m going to write about four interrelated layers of “games” that influence financial markets. Imagine we are looking at a set of Russian nesting dolls, like the ones in the image at top, and we are working from the innermost layer out. Each successive layer is more expansive and subsumes all the preceding layers.

The layers/ games are:

1. The Security Selection Game

2. The Asset Allocation Game

3. The Economic Policy Game

4. The Socio-Political Power Game

Each of these games is connected to the others through various linkages and feedback loops.

Security Selection

This is the most straightforward, and, in many ways, the most banal of the games we play involving financial markets. It’s the game stock pickers play, and really the game anyone who is buying and selling assets based on price fluctuations or deviations from estimates of intrinsic value is playing. This is ultimately just an exercise in buying low and selling high, though you can dress it up any way you like.

While it often looks a lot like speculation and gambling, there is a real purpose to all this: price discovery and liquidity provision. The Security Selection Game greases the wheels of the market machine. However, it’s the least consequential of the games we will discuss in this post.

Asset Allocation

Asset Allocation is the game individuals, institutions and their financial advisors play as they endeavor to preserve and grow wealth over time. People often confuse the Security Selection Game with the Asset Allocation Game. Index funds and ETFs haven’t helped this confusion, since they are more or less securitizations of broad asset classes.

At its core, the Asset Allocation Game is about matching assets and liabilities. This is true whether you are an individual investor or a pension plan or an endowment. Personally, I think individual investors would be better served if they were taught to understand how saving and investing converts their human capital to financial capital, and how financial capital is then allocated to fund future liabilities (retirement, charitable bequests, etc). Unfortunately, no one has the patience for this.

The Asset Allocation Game is incredibly influential because it drives relative valuations across asset classes. As in Ben Hunt’s coyote example, you can simultaneously win at Security Selection and lose at Asset Allocation. For example, you can be overly concentrated in the “best” stock in a sector that crashes, blowing up the asset side of your balance sheet and leaving you with a large underfunded liability.

I sometimes meet people who claim they don’t think about asset allocation at all. They just pick stocks or invest in a couple of private businesses or rental properties or whatever. To which I say: show me a portfolio, or a breakout of your net worth, and I’ll show you an asset allocation.

Like it or not, we’re all playing the Asset Allocation Game.

Economic Policy

The Economic Policy Game is played by politicians, bureaucrats, business leaders and anyone else with sociopolitical power. The goal of the Economic Policy Game is to engineer what they deem to be favorable economic outcomes. Importantly, these may or may not be “optimal” outcomes for a society as a whole.

If you are lucky, the people in power will do their best to think about optimal outcomes for society as a whole. Plenty of people would disagree with me, but I think generally the United States has been run this way. If you are unlucky, however, you’ll get people in power who are preoccupied with unproductive (yet lucrative) pursuits like looting the economy (see China, Russia, Venezuela).

The Economic Policy Game shapes the starting conditions for the Asset Allocation Game. For example, if central banks hold short-term interest rates near or below zero, that impacts everyone’s risk preferences. What we saw all over the world post-financial crisis was a “reach for yield.” Everyone with liabilities to fund had to invest in progressively riskier assets to earn any kind of return. Cash moved to corporate bonds; corporate bonds moved to high yield; high yield moved to public equity; public equity moved to private equity and venture capital. Turtles all the way down.

A more extreme example would be a country like Zimbabwe. Under Robert Mugabe the folks playing the Economic Policy Game triggered hyperinflation. In a highly inflationary environment, Asset Allocators favor real assets (preferably ones difficult for the state to confiscate). Think gold, Bitcoins and hard commodities.

This is no different than Darwin’s finches evolving in response to their environment.

Do you suppose massive, cash-incinerating companies like Uber and Tesla can somehow exist independent of their environment? No. In fact, they are products of their environment. Where would Tesla and Uber be without all kinds of long duration capital sloshing around in the retirement accounts and pension funds and sovereign wealth funds and Softbank Vision Funds of the world, desperate to eke out a couple hundred basis points of alpha?

Insolvent is where Uber and Tesla would be.

In general, western Economic Policy players want to promote asset price inflation while limiting other forms of inflation. There are both good and selfish reasons for this. The best and simultaneously most selfish reason is that, to a point, these conditions support social, political and economic stability.

However, the compound interest math also means this strategy favors capital over labor. This can create friction in society over real or perceived inequality (it doesn’t really matter which–perception is reality in the end). We’re seeing this now with the rise of populism in the developed world.

The Sociopolitical Power Game

Only the winners of the Sociopolitical Power Game get to play the Economic Policy Game. In that sense it is the most important game of all. If you are American, and naïve, you might think this is about winning elections. Sure, that is part of the game. But it’s only the tip of the proverbial iceberg.

This game really hinges on creating and controlling the narratives that shape individuals’ opinions and identities. If you are lucky as a society, the winners will create narratives that resemble empirical reality, which will lead to “progress.” But narratives aren’t required to even faintly resemble reality to be effective (it took me a long time to understand and come to grips with this).

You could not find a more perfect example of this than President Donald Trump. People who insist on “fact checking” him entirely miss the point. Donald Trump and his political base are impervious to facts, precisely because Trump is a master of creating and controlling narratives.

Ben Hunt, who writes extensively about narrative on Epsilon Theory, calls this “controlling his cartoon.” As long as there are people who find Trump’s narratives attractive, he will have their support. Facts are irrelevant. They bought the cartoon. (“I just like him,” people say)

It’s the same with Anti-Vaxxers. Scientific evidence doesn’t mean a thing to Anti-Vaxxers. If they cared even the slightest bit about scientific evidence, they wouldn’t exist in the first place!

I’m picking on Trump here because he is a particularly prominent example. The same can be said of any politician or influential figure. Barack Obama. Angela Merkel. JFK. MLK. I think MLK in particular is one of the more underrated strategists of the modern era.

Here is Sean McElwee, creator of #AbolishICE, commenting to the FT on effectively crafting and propagating narratives:

“You make maximalist demands that are rooted in a clear moral vision and you continue to make those demands until those demands are met,” said Mr McElwee. “This is an issue where activists have done a very good job of moving the discussion of what has to be done on immigration to the left very quickly.”

If you want to get very good at the Sociopolitical Power Game, you have to be willing to manipulate others at the expense of the Truth. It comes with the territory. Very often the Truth is not politically expedient, because our world is full of unpleasant tradeoffs, and people would prefer not to think about them.

I have been picking on the left a lot lately so I’ll pick on free market fundamentalists here instead. In general it is not a good idea to highlight certain features of the capitalist system to the voting public. Creative destruction, for example. In Truth, creative destruction is vital to economic growth. It ensures capital and labor are reallocated from dying enterprises to flourishing enterprises. Creative destruction performs the same function wildfires perform in nature. Good luck explaining that to the voters whose changing industries and obsolete jobs have been destroyed.

Because of all this, many people who are very good at the Sociopolitical Power Game are not actually “the face” of political movements. These are political operatives like Roger Stone and Lee Atwater, and they are more influential than you might think.

The Most Important Thing

There is a popular movement these days to get back to Enlightenment principles and the pursuit of philosophical Truth. I’m sympathetic to that movement. But I’m not sure it really helps you understand the world as it is.

In the world as it is, people don’t make decisions based on Truth with a capital T. In general, people make decisions based on: 1) how they self-identify; and 2) what will benefit them personally. Rationalization takes care of the rest.

When have you heard an unemployed manufacturing worker say, “yeah, it’s a bummer to be out of a job but in the long run the aggregate gains from trade will outweigh losses like my job”?

In the world as it is, people operate much more like players on competing “teams.” They want their team (a.k.a tribe) to win. They are not particularly concerned with reaching stable equilibria across a number of games.

And that tribal competition game is probably the most important meta-game of all.

Monopoly Money

I predict we are going to hear a lot more about Modern Monetary Theory (MMT) in the next few years. I am not particularly happy about it, but I think it is the way the cookie will crumble.

To the extent the hard left wing of the American political spectrum has coherent economic principles they are grounded in MMT. And it is the hard left and right wings of the political spectrum that have the momentum these days.

Here’s the gist of MMT:

Governments that issue their own currencies are not budget constrained. In other words, government spending is not constrained by tax revenues. As long as a government issues its own currency, it can run perpetual budget deficits of any size. A sovereign currency issuer can’t go bankrupt. The MMT people are actually right about this, and in my view this is what lends MMT a superficial degree of credibility. Because the MMT people can point to deficit hawks and say, “The Rich are lying to you!” which is a message that sells.

Since they are not budget constrained, governments can spend whatever is necessary to ensure maximum employment and an arbitrarily high standard of living for the population. To the extent tax revenues fall short of the required spending, the government will simply run a deficit. Under MMT, you really can have your cake and eat it. The government need only decide everyone is entitled to as many cakes as he wants. In fact, the only reason we don’t have MMT today is nasty, greedy Elites perpetuate the myth of balanced budgets the keep the huddled mass of The 99% in check. That’s the MMT view, anyway.

Sure, you can get down into the weeds on any number of operational details. But the above is all you really need to know to get to grips with MMT.

Why MMT Is A Bad Idea

The MMT people are absolutely correct that a sovereign government that issues its own currency cannot go bankrupt. That doesn’t mean MMT “works,” or is a particularly good idea.

Two reasons spring readily to mind:

Even with fiat money, inflation remains a constraint on government spending. A government can spend as much as it wants, as long as someone is willing to hold its liabilities (a government liability is always an asset to someone else). Yes, in theory this amount is still unlimited. The Bank of Japan, for example, has printed an extraordinary amount of money with hardly a whiff of inflation. Ultimately, the amount of money a government can print is limited by its credibility. Fiat money is a faith-based system.

When people lose faith in government liabilities (a.k.a money), they abandon them for stores of value like land, gold, bitcoin, whatever. Hyperinflation results as people try to unload their monopoly money as quickly as possible while it still has some purchasing power. I remember reading stories about Zimbabwe’s hyperinflation in the mid-2000s. Prices would rise so fast people would take the bus to work in the morning but wouldn’t be able to afford a ticket on the way home.

Now, the MMT people will argue the government can use taxation to “mop up” excess liquidity and maintain price stability. Maybe it can. Maybe it can’t. Personally I am skeptical. Regardless…

…MMT would require a massive government apparatus to administer. Let’s call this apparatus Gosplan. Under MMT, Gosplan does the following:

  • Decides on the appropriate standard of living for all citizens
  • Calibrates government spending and money creation to meet that standard of living
  • Allocates labor between the private and public sectors via a job guarantee program
  • Sets tax policy in such a way as to maintain price stability without upsetting the rest of the apple cart

Simple, right? What could possibly go wrong?

I suspect things would ultimately go about as well as they have with every other centrally planned economy in history. (spoiler: not very well)

The Enduring Appeal Of MMT

Sadly, I fear MMT will continue to get traction. It is an easy sell. Under MMT, there needn’t be any scarcity. Gosplan will ensure full employment, price stability and a fantastic standard of living. If you dare to dream, you can make it real. It’s the perfect economic platform for the populist left. If I were a hard left politician, I would be out flogging MMT at every opportunity. “Cake for everyone!” I would tell the euphoric crowds. “One for having and one for eating!”

Like socialism more broadly, MMT appears to offer a convenient “out” from some of the nastiness and brutishness of the human condition. As Will and Ariel Durant wrote in The Lessons of History:

[T]he first biological lesson of history is that life is competition. Competition is not only the life of trade, it is the trade of life–peaceful when food abounds, violent when the mouths outrun the food. Animals eat one another without qualm; civilized men consume one another by due process of law.

In theory, MMT is attractive because it eliminates certain economic risks that individuals face, allowing them to live more dignified lives. That’s an admirable goal. But here’s the thing. Risk can never be destroyed. The best you can do is lay it off on someone else. And that’s exactly what MMT would do.

Sure, MMT might nominally eliminate unpleasantness like unemployment and poverty. But the underlying risk of economic imbalances wouldn’t be reduced. Imbalances would just shift around. Most likely they would reappear in the form of supply/demand mismatches, like shortages and surpluses of certain goods, and, eventually, serious inflationary pressure.

Update (09/13/18): In response to some responses I received on this post, and as a reflection of related conversations, I wrote a brief follow-up post. The follow-up makes it clearer my views of MMT have more to do with human behavior, incentives and risk management. This portion is particularly relevant:

Politicians are always and everywhere incentivized to run deficits and print money. Hand politicians a license to run deficits of arbitrary size and they will print and print and print. This isn’t left versus right political thing. This is a human nature thing.

Under MMT, it would be up to self-interested politicians and their appointed bureaucrats to ensure we don’t end up with hyperinflation. Self-interested politicians and appointed bureaucrats hardly have an unblemished track record when it comes to economic management.

Macroeconomics For Lazy Pragmatists

A friend asks:

I’m interested in your thoughts on how you would look at [macroeconomic] fundamentals [for international investing]. Presumably that would involve (among other things) looking at the top industries that drive the national economies?

This question inspired me. Now, I am not a “macro guy” and I am definitely not an academic. I am mostly concerned with understanding the handful of key drivers that might impact a given investment. So if you are a pedant you can quit reading now. You’re not going to find anything to like about this.

Have all the pedants left now?

Great. Before we get in to economic fundamentals it’s worth specifying the high level variables that shape every investment environment:

  • Economic growth prospects & fundamentals
  • Rule of law / protection of property rights
  • Asset valuations

The ideal investing environment is one with strong economic fundamentals; where the rule of law is upheld; and where cheap valuations are cheap. The stars will almost never align in this way, if for no other reason that if the first two variables are looking good, you are going to have to pay up for assets. But that’s the dream, anyway.

This post will focus on the first bullet: economic growth prospects and fundamentals.

The Most Important Things

Before we go any further, I need to emphasize that investing is not as simple as saying: “oh GDP growth looks good so it’s a good time to invest.” In fact, there is essentially zero correlation between GDP growth and stock market performance. What macro analysis helps you do is assess the drivers and risks associated with an economy. When you consider those drivers and risks in relation to valuations, you can use them to help formulate and/or evaluate various investment cases.

Seth Klarman said it best: every asset is a buy at one price, a hold at another price, and a sell at another.

Note that all of this is addressed toward folks who are thinking of investing with a fundamental view over a multi-year time horizon. If you are trying to swing trade currencies you will need to look at the world very differently. (And good luck with that, by the way)

Some of you might say, “well I will be a contrarian and just push money into bombed out economies where stocks trade on single-digit PEs and mean reversion will do the heavy lifting.” That’s all well and good. But if you really think this way I would expect to see a not-insignificant exposure to places like Russia, Brazil and Turkey in your portfolio today.

Otherwise quit kidding yourself. You are a phony.

Why Macro Matters

I talk to a lot of investors who say “we’re bottom-up stock pickers” as if the macroeconomic environment somehow has no impact on their portfolios. I am not sure if these people are genuinely delusional or if this is just something they are used to putting in their pitch decks and have come to recite by rote without thinking.

If you genuinely believe this I think you are reckless at best and a complete idiot at worst. Of course the macroeconomic environment matters. At the very least it shapes the opportunity set.

We also do people a huge disservice by teaching them economics as if it’s physics. Not only is it obnoxiously intimidating but it lends economics a false sense of precision. I believe we should really teach economics using an ecological framework. Macro fundamentals define our economic habitat. There is often a feedback loop between macro fundamentals and investor behavior. If you can develop actionable insights into that feedback loop, you can make a lot of money.

So what we’re really doing with macro analysis is trying to understand our habitat. Thinking about it this way de-emphasizes making point estimates of future economic growth, which are notoriously inaccurate.

What Does a Healthy Habitat Look Like?

In the natural world, we can evaluate the health of an ecosystem based on its values. Here are some ecosystem values courtesy of the EPA:

Ecosystem_Values
Source: EPA.gov

Economies can be evaluated along similar lines:

  • “Biotic Resources” (Demographics)
    • Is the labor force growing?
    • Is the labor force becoming more or less productive?
    • How educated and innovative is the labor force?
  • “Biodiversity” (How Diversified Is The Economy?)
    • Is economic activity highly concentrated in particular industries? If so, what are their characteristics?
    • Is there a diverse array of financial market participants providing ample liquidity? Or are markets fragmented and illiquid?
  • “Energy & Nutrients” (How Is The Economy Financed?)
    • What does national income look like?
    • Is there a current account deficit? If so, is the country heavily dependent on external debt?
    • Where is the economy in the credit cycle?

More Energy & Nutrients

I want to spend a little more time on “Energy & Nutrients” as this is where many of the traditional textbook macro concepts come into play. More importantly, when this area of the ecosystem gets squirrelly, really nasty outcomes tend to result. Financial crises and deep depressions and hyperinflations and such.

Let’s start with the classic GDP identity:

GDP = Government Spending + Consumer Spending + Investments + (Exports – Imports)

More commonly written as:

GDP (or Y) = G + C + I + (X-M) 

Most of this is pretty self-explanatory, but the X – M term bears further scrutiny. This term is also called the “current account.” If it is positive you are net exporter (trade surplus) and if it is negative you are a net importer (trade deficit). Negative current account balances must be financed somehow. Countries do this either by selling claims on their assets to foreigners or by drawing down foreign currency reserves.

You can decompose and rearrange this identity in various ways. I’m not going to spend a bunch of time doing that here. You can find plenty of resources online. For now just trust me when I say the current account is equal to the difference between investment and domestic savings.

This is a critical concept because there are three and exactly three ways to finance private investment (a.k.a economic growth): 1) out of consumer savings, 2) with a current account (trade) surplus, 3) debt and equity issuance.

There is a school of thought among certain individuals that trade deficits are always and everywhere evil. That issue lies well beyond the scope of this post. What’s more relevant is the potential for dangerous imbalances to build up inside economies dependent on external financing. Dangerous imbalances are the stuff of financial crises, political revolutions and sovereign defaults.

The Example of Egypt

The Egyptian economy is a disaster.

For much of the recent past Egypt was dependent on direct foreign investment and tourism for foreign currency to fund its current account deficit (Egypt imports significant quantities of food and fuel). These sources of financing dried up following the country’s 2010 revolution and ensuing political turmoil, draining foreign currency reserves, driving up government debt levels and ultimately forcing a devaluation of the Egyptian pound (which is pegged to the dollar in a futile valiant effort to maintain price stability).

Egypt_Current_Account
Source: Trading Economics
Egypt_FX_Reserves_USD
Source: Trading Economics
Egypt_Govt_Debt_GDP
Source: Trading Economics

Essentially, the Egyptian government printed money to finance economic activity. Naturally, this resulted in a dramatic spike in inflation.

Egypt_Inflation
Source: Trading Economics

Needless to say this is a fragile ecosystem (spoiler: most developing economies are). That doesn’t mean all Egyptian securities are automatically bad investments. However, it has direct implications for the kind of margin of safety you should demand when considering an investment.

You will notice I haven’t said anything about the domestic credit cycle. That’s because I’m not going to bang on about the credit cycle here when I can just have you watch Ray Dalio explain it in a slick YouTube video.

To Conclude: A Brief Note On Currencies

I picked the Egypt example above because of the currency component. Currency is an important wrinkle in international investing. There are lots of different approaches to currency valuation but longer term investors should mostly be focus on the idea of purchasing power parity. All else equal, a basket of goods in Country A should cost the same as an identical basket of goods in Country B.

In the real world all else is not equal. Namely: inflation. So if inflation is 2% in Country A and 10% in Country B, we would expect Country B’s currency to depreciate by 8% relative to Country A.

Purchasing power parity tends to hold up pretty well over long time horizons. In the short term, however, divergences can be significant. For our purposes the important thing to recognize is that a country’s national income and balance of payments have a direct impact on the inflation rate. Inflation differentials are important variables to consider when making international investments, because they influence the currency component of the investment return, which can be significant.

A Comment on Cuba’s Biotech Sector

I was fascinated by this naked capitalism post on Cuba’s biotechnology sector: https://www.nakedcapitalism.com/2018/03/cuba-became-biopharma-juggernaut.html

This is not something we hear about in the US (you could probably write a whole book about that–may I suggest the title Ad Hominem: A Fallacy of Irrelevance?). I do not know very much about Cuba, and I know virtually nothing about the Cuban healthcare system. I do, however, have a close friend who has:

(1) worked as a practicing surgeon

(2) worked in healthcare policy here in the US

(3) visited Cuba and observed the Cuban healthcare system in action (though not the biotech sector)

I reached out to him for an opinion, and he replied with the following:

Cuba has an inexpensive system that delivers reasonably good outcomes. I thought the article was a little light on examples for exactly how the government’s control of pharmaceutical R&D delivers better outcomes. Costs are lower, in part, because they have a more favorable regulatory environment. They are also lower because the government probably maintains a single, narrow drug formulary for the entire country. With one formulary, they are able to regulate the number of drugs in each class. After all, do we really need 9 options for a medicine that gives old guys an erection? Less choice, but lower costs. You see examples of this here with Medicare Part D formularies preferred drugs.

The other question is whether they incentivize and reimburse drugs based on value. Many economists here have called for a more explicit determination of value when determining drug prices. Pharma companies can charge whatever they want for a medicine that may be no better or more effective than one that already exists, but may be within a lucrative class of medicines. Certain really important drug classes, like antibiotics, are underdeveloped in the U.S. because they are not likely to make much money, even during their exclusive patent rights period. If Cuba funded drug classes based on need and anticipated value, that would be quite smart. Some left-leaning folks have called for government to take this role here. Unclear how that would work in practice.

I am not trying to put a stake in the ground here. However, I was intrigued by both the original article and the comment and thought others might feel the same.

A Tangent

Just because some aspect(s) of the Cuban healthcare system may work well or promote decent outcomes does not imply:

  • Communism or socialism are superior economic systems to capitalist, market-based systems
  • The Cuban economy as a whole functions efficiently (or even “decently well”)
  • The economic deprivation and restricted personal freedoms of the Cuban system are acceptable tradeoffs for a healthcare system that produces some decent outcomes

(you get the idea)