Monday, November 24, 2014

Capital Shrugged

LOS ANGELES – Capitalism’s greatest strength has been its resiliency – its ability to survive the throes and challenges of crises and business cycles to fuel innovation and economic growth. Today, however, more than four years into a credit crisis, a conspicuous enigma calls this legacy into question.

Despite recent hopes of recovery in the US, including an inventory catch-up in the fourth quarter of 2011, real US GDP growth has remained persistently below trend. Moreover, although seasonally adjusted January employment data have brought the unemployment rate down to 8.3% (while total jobs were actually lost in January), the more realistic rate of “underemployment” remains over 15% and the labor-force participation rate is at a record 30-year low. And the US is clearly not alone in its malaise, with the eurozone fighting a far more urgent sovereign-debt crisis.

So, why is this time different? The answer lies in Ayn Rand’s rhetorical invocation of despair in her 1957 epic Atlas Shrugged: “Who is John Galt?” Simply put, when the state seizes the incentives and drivers of capital investment, owners of capital go on strike.

Rand portrays innovative industrialists as akin to Atlas in Greek mythology, carrying on his back a dystopian world of growing and overbearing collectivist government. The hero, John Galt, calls for them all to shrug, to “stop the motor of the world” by withdrawing from their productive pursuits, rather than promoting a world in which, under the guise of egalitarianism, incentives have been usurped in order to protect the politically connected from economic failure.

Today, Rand’s fictional world has seemingly become a reality – endless bailouts and economic stimulus for the unproductive at the expense of the most productive, and calls for additional taxation on capital investment. The shrug of Rand’s heroic entrepreneurs is to be found today within the tangled ciphers of corporate and government balance sheets.

The US Federal Reserve has added more than $2 trillion to the base money supply since 2008 – an incredible and unprecedented number that is basically a gift to banks intended to cover their deep losses and spur lending and investment. Instead, as banks continue their enormous deleveraging, almost all of their new money remains at the Fed in the form of excess reserves.

Corporations, moreover, are holding the largest amounts of cash, relative to assets and net worth, ever recorded. And yet, despite what pundits claim about strong balance sheets, firms’ debt levels, relative to assets and net worth, also remain near record-high levels.

Hoarded cash is king. The velocity of money (the frequency at which money is spent, or GDP relative to base money) continues to plunge to historic lows. No wonder monetary policy has had so little impact. Capital, the engine of economic growth, sits idle – shrugging everywhere.

Rand, perhaps better than any economic observer, underscored the central role of incentives in driving entrepreneurial innovation and risk-taking. Whittle away at incentives – and at the market’s ability to communicate them through price signals – and you starve the growth engine of its fuel. Alas, central bankers, with their manipulation of interest rates and use of quantitative easing, patently neglect this fact.

Interest rates are more than a mere economic input that determines levels of saving and investment. Rather, as the Austrian economist Ludwig von Mises emphasized, they are a reflection of people’s aggregate time preference – or desire for present versus future satisfaction – not a determinant of it.

Interest rates thus incentivize and convey to entrepreneurs how to allocate capital through time. For example, lower interest rates and cost of capital raise the relative attractiveness of cash flows further in the future, and capital investment increases – the system’s natural homeostatic response to higher savings and lower consumption.

State manipulation of interest rates, however, does not influence time preference, even though it signals such a change. The resulting inconsistency creates distortions: as with any price control, capital receives an incentive to flow to investment that is inconsistent with actual supply and demand.

The Fed is purposefully and insidiously distorting the incentive system – specifically, signals provided by the price of money – resulting in mal-investment (and, when public debt is monetized, inflation). This can continue for a time, rewarding unproductive investments and aspiring oligarch-speculators who presume that the Fed has eliminated risk. But, as Rand reminds us, at some point the jig is up.

Today, after the largest credit expansion in history, that point has clearly been reached. Impassive capital now ignores deceptive market signals, and the liquidation of untenable mal-investment percolates through the system as immutable time preferences prevail.

The state, in the long run, simply cannot direct entrepreneurs to lend, borrow, and invest; investment capital will inevitably shrug when faced with oppressive manipulation of free markets. When that happens, we see the true result of loose monetary policy: not the creation of more economic activity, but the destruction of the natural mechanism of economic coordination and adjustment, robbing the system of its resilience. In effect, monetary policy has “stopped the motor of the world.”

At the conclusion of Atlas Shrugged, Galt aims to restore the old system anew as the collectivist regime crumbles. Will something like that, too, happen in our own dystopian world (in which all remaining Republican US presidential candidates seem to favor firing Fed Chairman Ben Bernanke)? How long must capital wait for the day when, free of distorted incentives, the engine of growth is fueled and humming again?

Read more from our "Central Banks in the Firing Line" Focal Point.

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    1. Commentedparthasarathy Shakkottai

      Economic ignorance has become universal in the USA and all politicians, congress and economists talk in terms of household budgets and austerity. MMT is unknown. Paul Myers is right and until USA makes an investment in infrastructure spending, the ridiculous ideology will prevail.

    2. CommentedProcyon Mukherjee

      “Oppressive manipulation of the free markets”, if it is meant for those segments where capital finds a profitable deployment in spite of absence of demand, then it is a pointer that low interest rates coupled with liquidity preference influences this spurt in demand of financial products that were non-existent even a few years’ back. This is sad that capital stock could be locked in unproductive assets that reduces the velocity of money, which otherwise could have goaded effective demand in productive areas of the economy.

      Procyon Mukherjee

    3. CommentedPaul A. Myers

      The difficulties in the United States have nothing to do with the resiliency of capital, or capital being on strike (what a nonsensical assertion) and everything to do with poor public policy created by common sense being on strike in the Republican party.

      The United States is way underinvested in public assets, principally infrastructure. If the United States embarked on a multi-trillion dollar, multi-year program of public infrastructure investment, such a program would lower system-wide costs and create fertile grounds for new private sector investment. Funds flowing into the real economy would provide an ongoing increase in the overall level of demand.

      When one understands that profitable private investment stands on the broad shoulders of public investment, then one can see the road forward to a full-employment economy growing at maximum feasible speed.

    4. CommentedZsolt Hermann

      This article offers an interesting view but it still only scratches the surface as most other assessments because we are still afraid to admit that we are in a system failure.

      Superficial tinkering with regulations, or trying austerirty and then stimulus again like in Europe, asking for more or less government control will make no difference at all because the whole system is rotten.

      And it was rotten from the beginning since the modern constant growth, expansive, excessive production and consumption, increasing credit based system started.

      But up to this point there was still some "looseness" in the system allowing the expansion, and the public was dumb enough to take the constant brainwashing and thus keep buying and taking credit.

      And the same happened with nations as well, in Europe for example the "smaller weaker" nations took the bait and swallowed all the products and credit until now their situation, eonomy and credit debt has become unmanagable.

      All of us are in the same plight now, sitting in bubbles, full of fake capital without any proper foundation, we are running out of resources and we have become completely intermingled and interdependent in the global system.

      Whatever we do this system is going to collapse, and actually this is a good thing.

      We are all slaves right now. The tycoons are slaves to their zeros on their useless bank account and more they get the unhappier they are. The costumers are slaves to the brainwashing media and the banks lending them credits, and now they are losing their jobs, homes, health insurence, and most factory workers especially in the emerging market countries are slaves even in the classical meaning of the word.

      Thus we cannot even imagine the freedom we will get when this is over, what we need to make sure is how to make the transition swift and relaitively orderly, and then what structure we build after.

      For that we already have vast amount of information on the interconnected and interdependent nature of the world today, on the state of the natural resources, and our opposition to our environment.

      Thus the new system needs to be necessity and resource based, with equal distribution, with a mutually responsible, considerate global public driven, single word wide governing system.

      With all the talent and adaptability Humans have if we get it right our potential is unlimited.

    5. CommentedWilliam Wallace

      As a businessman and entrepreneur in the real world, I can tell you flat out what determines investment: expectations of increases in demand. If expected ROI exceeds the interest rate, debt capital makes sense for the investment, otherwise it's cash on hand, stock and equivalents. End of story.

      Gimme demand and I'll invest. The problem today is lack of aggregate demand, and the lack of resources to effectively combat the situation. Monies so poorly spent, and other monies so dearly given away, over King George II's reign in DC, with his "deficits don't matter" court jester laughing in the corner throughout, left the government with so dire a structural deficit that sound stimulus spending has not been available.

      This article perpetuates the myth that most employment and innovation comes from large corporations. It does not; it comes from SMEs. Most new products and services in IT today, for example, result from larger players buying out the innovators, not from in-house R&D. And to further argue that even moderately taxing those who have great wealth would halt innovation and investment is a willful misdirect.

      Didn't expect to find this sort of objectivist drivel on Project Syndicate. Shrug.

    6. CommentedJake Lopata

      It's easy to see how someone, such as a hedge fund manager, can easily become shrouded in a single sector of the economy; but there is much more going on.

      Simply put, employment is very low (especially the labor participation rate), as a result, wages are down. This reduces disposable income; money used to save, pay bills, and consume.

      So why would businesses borrow if there is no demand? Why should firms lend if the economic outlook is bad and inflation expectations are high?

      I understand that there is a belief that market signals are distorted, but how are you arriving at the conclusion that it is due to monetary policy?