This is going to be the most difficult investing environment of the last 100 years.
The system is rigged, just not in the way 99% of people think it is. And not by those they think are doing the rigging. Greed is not the reason for the rigging, nor are any of the other usual “follow the money” reasons. We cannot make a convenient demon out of Wall Street or the big banks and investment banking houses.
The real culprits are far less sinister and are actually sincere in their motives. They are not trying to defraud the middle class and strip them of their hard-earned retirement savings. No, the “bad guys” in the story are just Nobel laureates, tenured professors, and other honorable members of the economic academic establishment.
The Occupy Wall Street crowd had a right to be angry, but they should have been demonstrating in front of the economics schools at Harvard, MIT, Princeton, Yale, etc.
The economy has been rigged through a process that may have seemed innocent enough at any given point but that quickly put us on a slippery slope. A brief history will bring us up to date.
Panic Started It All
In 1913, the Federal Reserve was created by the major banks as a way to protect them from crashes. The disastrous Bankers’ Panic of 1907 was still fresh in their minds.
And there is no doubt the Fed was designed so that the big banks retained as much control as they could convince a skeptical Congress to grant them, while giving in on a few minor points.
Then in the 1930s and into the early ’40s, an intense debate ensued among economists about how to best measure the national income and gross productivity.
A government needs to have some way to measure an economy. This is especially true for a wartime government. Without such a gauge, how do you know how much you can actually tax and produce for the war effort, let alone for welfare and other services?
The debate was essentially between followers of John Maynard Keynes and more conservative economists, either the disciples of Friedrich Hayek and Ludwig von Mises or followers of the classical school of economics.
Conservative voices claimed that the government’s taxing and spending merely took money from the taxpayers and put it to work somewhere else. It’s not really contributing to the true productive economy.
Those on the other side argued that you had to know about the effects of taxes, depreciation, and the myriad forms of government spending in order to understand the economic capacity of the country.
Roosevelt Made a Fatal Mistake
But the issue really came down to politics. If you do not include government spending in the gross domestic product (GDP), the economy will appear to be shrinking in the middle of a war or in a recession, even though the government is spending money hand over fist.
So, President Roosevelt’s government ruled that federal spending would be included in GDP.
In the 1950s and ’60s, economics became more and more concerned with data and data analysis, with statistics and statistical analysis. It seemed to academic economists that with enough research, they could develop models that would tell us how the economy really works.
By the 1980s, those in charge of the central banks of the world had graduated from the same schools: the MITs, Harvards, Columbias, and Princetons of this world.
Keynesian and then neo-Keynesian economists became the driving force in academia. Politicians and bureaucrats courted them, because in essence, Keynesian economics gave them permission to spend money.
And now we get to the root of the issue.
Economics Is Divided into Religious Camps
Economics is a field every bit as divided as the Protestants and Catholics were in the 1500s or the Shia and Sunni are today.
There are those who are considered orthodox and those who are considered heretics. And there is a priesthood of the believers. When you are anointed as a high priest, you become part of the policy-making community.
In general, to be accepted as a high priest in the Keynesian economics religious community, you have to agree to a certain set of principles contained within their catechism. And one of the most important principles is that consumption is the driver of economy. A corollary is that the twin dials of money, supply and interest rates, can raise or lower consumption and thus moderate inflation and deflation.
So, the central bank, as an independent figure in the economy, must control the money supply and interest rates in the best interests of the overall economy.
And there you have it. The rigging of the economy against the interests of average citizens is not the fault of Wall Street, or even Washington, DC. Rather, it is the result of a historical process that, step by step, has elevated economics and its leading practitioners to the status of an almighty priesthood.
But Something Is Broken
Central bankers say they employ theories and models that are highly mathematical and every bit as valid as any scientific discipline.
The only problem is these models are useless. They have an unblemished record of failure in describing what is going to happen in the world.
All these models can do is apply economic theory to the data. But there are two problems with that.
First, data that do not fit into the mathematical model must be ignored. Data that are sketchy or incomplete corrupt the output from the model. And the Federal Reserve certainly does not have access to all the data that would be required to model an economy as complex as that of the United States.
But even more important, the models themselves are created from assumptions that are just plain wrong. The theory itself is broken.
Any business that operated according to models so demonstrably bad would soon be bankrupt, and those who created them would be fired. Yet central banks continue to crank out models that don’t work and then endlessly tweak them. But they never think about their core assumptions.
It Hasn’t Worked Yet, so Why Keep It Up?
One of those wrong assumptions is that lowering interest rates spurs the economy. But rates are already down nearly to zero. There seems nowhere to go.
Central bankers, though, have an answer. Those who met at the 2016 Economic Symposium at Jackson Hole, WY, support negative interest rates.
Of course, not all of the high priests agree with a move to negative rates. There are actually some notable economists, including Nobel laureates, who think negative rates are a very bad idea. But in general, what we heard out of Jackson Hole is that they are quite an acceptable idea.
Throw the Savers under the Bus
Their proposing negative interest rates proves the Fed does not care about helping savers. The Fed thinks decent equity prices are wonderful. They think lower interest rates are good for investors. They are willing to trade your returns on fixed income for a rising stock market.
The fact that some have to make “sacrifices” is part of the process. This is the burden of a high priest. Someone has to make the difficult choices.
But it is not even true that ultra-low or negative interest rates are better for the overall economy than rates that more accurately reflect free-market dynamics.
By lowering rates to the zero bound, Fed policy has favored a relatively small number of people who own the vast majority of stocks. In so doing, it has slowed down the growth of the economy. This also makes for persistent unemployment and underemployment of working-class citizens.
And savers are thrown under the bus.
But the focus should be on Main Street and the average guy out in the real world, not the stock market.
It’s Too Late Now
By keeping interest rates low, the Fed and other major central banks have now unbalanced the financial system so badly that the markets very likely will crash when rates start to rise.
And that means your bond funds will get killed, as well as your equity funds.
That is precisely why the Yellen Fed is having trouble coming to the point of normalizing interest rates. They know the reaction from the stock market is going to be really, truly, unbelievably ugly. And because they have been the pushers of the heroin of ultra-low rates, they are going to be blamed for the withdrawal.
Analysts point out that as a rule, the Fed reduces interest rates by about 550 basis points (5.5 percentage points) in a recession. If a recession kicked in tomorrow, it would plunge us to the breathtaking interest rate of -5%. But Janet Yellen approves of rates as low as -6% or -9% during the next recession.
If at First You Don’t Succeed, Try, Try Again
Ben Bernanke cut interest rates from 5% to near-zero in 2007–2008. Moving rates up and down was all the Fed knew to do. It had always worked before. If it wasn’t working this time, they had just not gone far enough. More of the same should do the trick.
Well, more hasn’t done the trick. Not even over the longer term. It might have worked for a year or two, but after that, the Bernanke-led Fed feared a negative stock market reaction. So, they kept rates artificially low for eight years and decimated fixed-rate income returns of pension funds and retirement plans for the middle class.
Central banks all over the world did the same, and more.
Would the markets have screamed bloody murder if the Fed had raised rates back to 3% in, say, 2010 or 2011? For sure, but the members of the Fed board are the high priests who have taken it upon themselves to make such weighty decisions. They are not there to be popular. And whether they know it or not, they are not there to worry about the level of asset prices.
And Credit for the Recovery Goes to…
The Fed will argue that the low rates did work. The economy emerged from recession. Unemployment drifted back down, however slowly. “Yay for us,” said the Fed.
Don’t buy that statistical economic garbage. The economy recovered in spite of Fed policy, not because of it.
The economy recovered because business owners, entrepreneurs, and workers rolled up their sleeves and made things happen. It involved a lot of pain: layoffs, asset sales, lost customers, and more. But the hard-working citizens of this country slowly and painfully pulled themselves out of the nosedive.
Those are the people who deserve the credit.
Of course, the economic high priests and the politicians take credit for the recovery. But to borrow a phrase, “You did not build that.”
Even while talking up the need for economic growth and for businesses to thrive, the Fed disdains the actual workings of the free market. They do not give credit to the free market, when it, not monetary policy, is actually the driver of the economy.
Fed Economists Make a Mistake
The Fed points to the data. Or their interpretation of it. They are correct that they lowered interest rates and kept them low overlong and that the economy has kind of, sort of, modestly recovered.
Yes, both of those things happened at the same time. There is undoubtedly correlation, but the high priests see causation. They think that the one thing (low rates) led to the other thing (recovery).
They are simply mistaken.
The fact is there is no evidence, other than correlation, to demonstrate that low rates were actually the cause of lower unemployment and recovery. But this does not slow them down one bit. If any science student resorted to the same fusion of statistical correlation and causation, his paper would be thrown out and he would fail the course.
An economist “sees what he wants to see and disregards the rest,” to paraphrase an old song.
Yes, It’s Rigged
So coming back around to my original point: Yes, the economy is rigged. But it is rigged by an economic priesthood that is in the seat of power at central banks around the world and particularly at the Fed. Wall Street and admittedly small-scale stock market investors are simply the beneficiaries of the policy.
In a Place with No Good Choices
So, what should we do? There are not many options. Maybe someday, we’ll elect a president who will replace Federal Reserve governors with those who favor allowing the market to set interest rates.
Or maybe we could get Congress to remove the Federal Reserve’s mandate to achieve full employment. Congress could take that responsibility for themselves, rather than trying to blame the Fed for employment numbers.
And in the absence of those unlikely events, perhaps we can rally some members of Congress to really put the heat to the Federal Reserve about negative interest rates.
If we were to allow the markets to set interest rates, there would be serious volatility and problematic markets for more than a few months. It would likely trigger a serious recession as markets adjusted.
There is no magic wand to get us to normal. If there were, I’m pretty sure the Federal Reserve would wave it at once. I think everybody realizes that rates should already have been normalized—and that to do so now is going to be problematic.
We really have come to a place where there are no good choices.
Here Come the Negatives
Here is the most likely scenario I think we are facing. We are going to go into the next recession with interest rates still stuck in the sub-1% range. This gives the Fed very little room to work.
For sure, the Federal Reserve will not sit on its hands and do nothing. Though it has been proven that quantitative easing (QE) did not work, we will get QE on a scale that is currently unimaginable, blowing out the Fed’s balance sheet to a level that is unrecognizable.
And unless there is considerable pushback from Congress—and I do mean considerable, not just the usual suspects on the far right of the Republican Party grousing about an out-of-control Fed—we are going to see negative rates in the world’s reserve currency.
Then there will be a snowstorm of papers from the high priests. They will conclusively demonstrate that negative rates will have all kinds of positive effects on the economy and employment. And none of those papers will be worth the electrons used to publish them. Their conclusions are just theoretical blather, based on outmoded assumptions about the way the world works.
The central bankers of Europe who are experimenting so exuberantly with negative rates came to Jackson Hole and told everyone that the rates are working wonderfully.
This Is Out of Control
But due to the rates in Europe, the hoarding of cash in Switzerland is at astronomical levels. It’s a fascinating arbitrage. Bank rates are -75 basis points, and you can insure your cash in a safe deposit box for about 10 basis points. And in Switzerland you can find a bill worth $1,000. It makes total sense.
Negative rates will drive consumer spending down, not up. They will result in less income in retirees’ pockets, forcing them to save more, work longer, and spend less.
The next 10 years will see an explosion of government debt and an implosion of the ability of governments to fulfill their promises.
Any economic or investment model based on past performance under previous economic conditions will be worthless. As in, just as worthless as the Federal Reserve’s present models.
We Must Change Our Trading Strategies
We are truly going to have to go outside the box if we are going to figure out how to get our portfolios from where we are today to the other side of the coming crisis. There is truly no way to predict what our investment portfolios might look like six months or one year or six years from now.
You cannot assume that your investment returns are going to look anything like the average for the last 20, 30, or 40 years. I know there are those out there who will tell you that is exactly what is going to happen.
This is going to be the most difficult investing environment of the last 100 years.
We are still going to need to diversify, but I think we have to diversify among trading strategies that diversify among asset classes. Being long or short anything these days on a buy-and-hold basis is just plain dangerous.
Here Is My Heresy
The following are a few paragraphs on what the country should do. This summary is chock full of economic “heresy.”
- We should radically alter our tax policies. Drop the corporate income tax to no higher than 15% and preferably 10% on total global income. But no deductions for anything. None. That would make us competitive with the world. If we made that corporate tax work like a business value-added tax, our corporations could deduct the tax for their products manufactured in the United States when they sent them overseas. This would give us a huge manufacturing advantage, along the lines of what Europe already has.
- To get really creative, increase that business consumption tax to the point where we can get rid of the Social Security tax for both employees and employers. Employees get an increase in pay, especially those at the lower end, reducing income inequality. The measure is relatively neutral for businesses. Deductible at the borders for exporters. That would go a long way toward helping the income inequality situation while still providing a safety net.
- And that would allow us to radically reduce the income tax, which is the most destructive of all taxes in terms of incentive. Properly constructed, we could actually not even charge income tax for incomes below $100,000. And make it 20% above that level. No deductions for anything. Period. We can quibble about the numbers, but you get the idea.
- Completely replace the Food and Drug Administration and other destructive bureaucracies that function as prison guards of the past. It’s the 21st century, and we should begin to act like it. I am not saying that we don’t need regulatory oversight of drug and food, financial and banking, environmental, etc. However, oversight has become overkill. The bureaucracies have become an innovation-killing force unto themselves, forever expanding their own fiefdoms. Pare them back. Force them to eliminate 5% to 10% of their rules every year for four years until they get down to the essentials.
- Finally, the true heresy: If we change the policies currently driving the Federal Reserve, it is highly likely the economy will fall into a recession sooner rather than later. If we do nothing, it is also likely we will fall into a recession. I know recessions are part of the normal business cycle, but it is difficult to watch large numbers of people go unemployed. No president wants a recession on his or her watch.
It Certainly Won’t Be Easy
So, the only thing you can do is to hit the fiscal spending button. But in a recession, we are already running up massive debt. Where to get the money without creating even more of a burden for taxpayers?
The president sits down with the Federal Reserve and the senior lawmakers in Congress and says, “I want you to authorize a bill allowing the Federal Reserve to issue US government-guaranteed, 1%, 40-year infrastructure bonds to any self-funding city, county, or state project approved by a bipartisan commission with no politicians on it.”
There must be serious guidelines for getting access to this inexpensive funding. No one gets to build a bridge to nowhere in their district. We know that we need more than $3 trillion of infrastructure building just to bring our water systems, ports, electric grid, roads and bridges, transportation systems, etc., up to snuff.
The money for infrastructure rehab is going to have to be spent sooner or later anyway. So, let’s do it now in one massive 5- to 10-year program. That would put three million people to work in good-paying jobs.
Yes, I know that some of the projects will be boondoggles. There are no perfect solutions, but we must rebuild if we want to see the future more evenly distributed and our children’s infrastructure taken care of.
It will take a while to ramp up these projects. But within two years, the infrastructure construction business could be booming.
Congress will have to authorize that. The president will have to beat Congress over the head during his or her first 90 days in office to force this through.
Congressmen of both parties will want to attach all sorts of bullshit riders to the bill. The Speaker and the majority leader must not allow that to happen.
The Prospect Truly Saddens Me
Short of this massive infusion of fiscal spending, we are going to go into an even deeper recession than we did last time. And it is going to take longer to recover.
If you think your portfolio was slow to recover last time, don’t hold your breath this time.
Do you want to wait another eight or nine years to get back to where you are right now? How does that play into your retirement plans?
I sigh as I write this, knowing that the bulk of the American populace—and its leadership—are going to sit and do absolutely nothing.
And I do not know what to do to change that. The prospect truly saddens me.