On this election eve it is all too tempting to delve into policy nuances of the competing camps vying for control of the world’s largest economy. But that runs the risk of being perceived as taking a political stand, which is not the purpose of these pages. Not to mention, as many a pundit have already stated, if one is only now researching issues such as the economy, do the country a favor and don’t vote (a statement which lands me in hot water for seemingly discouraging the franchise). To play it safe, we’ll instead impartially take shots at all political sides, and for good measure, expand our assault to policy makers in other countries as well. The subject that enables us to launch such a wide-ranging critique is none other than the structure of the economy, namely the system regarded as the victor in the past century’s battle for global supremacy: free market capitalism.
Rather than attack the shortcomings of the free market, we posit that it largely does not exist, not only in mercantilist and/or authoritarian emerging countries such as China and Russia, but also in the world’s advanced economies. The readers of these pages have been exposed innumerable times to the concept of market distortions, both in the real economy and in financial markets. Some of these phenomena are the product of explicit government policy while others are the (insert our favorite phrase) unintended consequences of policy makers’ measures to combat crises and other (real and imagined) economic ills. Regardless of the origin, distortions have become so pervasive in the global economy that one could argue that possibly outside of the barter system practiced in a yet-to-be discovered aboriginal Amazonian society, the free market exists in name only.
The Efficient Beauty of Chaos
As the economic heavyweights have taught us, there is no greater incubator of innovation than an unencumbered market that enables buyers and sellers to come together to match needs with solutions and supply with demand. Hayek aptly described this amorphous meeting place as both chaotic and ingenious. When left to their own devices, the experimentation, imagination and entrepreneurialism of market participants are peerless in their ability to create products and services that enhance society’s productivity and well-being. Sometimes the market conceives of products that we were not even aware we needed, such as organic omega-3 fortified flaxseed wafers, Frappuccinos and Angry Birds. Our favorite Austrian (sorry Arnold) also explained that no centralized entity could come close to replicating the efficiency of thousands of established and potential transactions among buyers and sellers. The mechanism the market uses to prescribe value to a product or service and to channel finite resources to their most effective/profitable use is prices.
But often the pricing mechanism can render verdicts considered unfavorable to the powers-that-be, either in the name of fairness, or…more often than not….due to them controverting established policy narratives or subverting the interests of the status quo. In order to override judgments meted out by prices, authorities rely upon an arsenal of tools, some overt some subtle. Whatever the instrument, the result is the same; distorted markets are those where underlying supply, demand or costs have been altered in a manner that pricing signals are different than what would have occurred in an unfettered market.
To see evidence of the distortions impeding pricing mechanisms, one only need glance at the headlines of the financial press, cruise down a supermarket aisle, or…if wearing a sturdy raincoat…visit a photovoltaic solar farm in soggy Germany.
Oh What a Tangled Web The Fed Weaves
In the quest to uncover distortions, the most obvious place to look is the market for U.S. government debt. If the goal is to impact pricing outcomes, what better place to get more bang for your buck than tossing a wrench into the benchmark interest rate for global financial assets, which also happens to be the funding source for the world’s largest debtor. And this is precisely what has been occurring with the Fed’s unending wave of extraordinary easing measures. Interest rates theoretically should be set by the willingness of investors to hold government securities given the sovereign’s debt profile, the country’s inflation rate, growth prospects, etc. In reality, short-term interest rates are influenced by the Fed Funds rate, which as we know, has been riveted to the floor at 0.25% through mid-2015. By sucking up the (considerable) issuance of short-term Treasuries, the Fed is ensuring distorted demand for the debt of a country with 100% gross debt to GDP, a public sector on the ascendency and leadership in vapor lock as the country approaches the 2013 fiscal cliff.
In the early days of the financial crisis, when rates were initially cut to zero, the spread between 10-Year and 2-Year notes blew out to nearly 300 basis points (3%) as investors used the prices of the 10-Year to register their expectation that the low Fed Funds rate would ultimately lead to inflation. Such a relatively high yield on the benchmark 10-Year would only further constrict credit flow in an anemic economy (to those who could actually qualify for a loan). To mitigate this signal, the Fed unleashed its torrent of quantitative easing, thus impacting the prices of government paper all along the yield curve. The resulting artificial demand for Treasuries (from the marginal buyer…the Fed) not only diminishes the movements of the Treasury market as an effective gauge of economic health, it also has sent shockwaves throughout the entire financial universe.
Another nifty tool in warping sovereign debt markets is the regulatory preferences for putatively risk-free assets on a bank’s balance sheet. As stated in our recent discussion on Financial Repression, there is a glaring conflict of interest when regulators cajole banks into holding government debt in the name of (hah!) safety. This practice is a component of the international Basil III banking capital requirements and is displayed most egregiously in Europe’s financial calamity. Who in their right mind would load up their balance sheet with debt of teetering countries like Greece, Spain and Portugal? Greek, Spanish and Portuguese banks, that’s who. As foreign investors have (rightly) fled this garbage, local banks have stepped in to fill the vacuum, thus helping governments avoid….for now….default. Banks are not doing this out of magnanimity or national pride, but because the European Central Bank (ECB) has shredded its rules and agreed to take junk government paper as collateral thus providing life-saving liquidity to these banks (see the June posting on Europe for further analysis of the toxic relationship between governments and banks).
Currency War, Anyone?
Another market obviously affected by central bank machinations is the currency market. Even on its best days, foreign exchange markets fall short of “unfettered” status. Rather than currency values being set by the demand for a country’s underlying goods, its growth prospects, inflation outlook and interest rate differentials, FX prices are instead guided by a cartel of central bankers and other authorities, using a range of tools. In addition to policies such as the Fed’s previously described extraordinary efforts to keep interest rates low, policy makers can effect exchange rates by imposing trading ranges, limiting international purchases of domestic financial instruments or directly intervening into markets by purchasing foreign currency (paid for with the local flavor) in order to lower the value of the domestic currency. Such initiatives are great for exports, but lousy for consumers as they are pummeled with imported inflation, namely via commodities in the case of American businesses and households.
As the pace of global growth subsides and the competition among nations for export advantages heats up, accusations of currency manipulation begin to fly. Claimants have plenty of evidence to point to: China continues to keep the Renminbi’s trading range tight. Brazil has implemented capital controls, and the United States continues to preach the advantages of a strong dollar whose price is set by the market while it does everything in its power to manipulate the hell of that process.
Bubbles Bubbles Everywhere
Price levels in other financial markets are influenced not only by current central bank policy, but also by other, often well-established, actions. The Fed has been explicit in its desire to force yield-starved investors further out along the risk spectrum in search of satisfactory returns. In normal times, if we can remember them, equity markets are said to be driven by the three “E”s: earnings, economics and emotions. To that we can now add a fourth: easing. The influence of policy is evidenced by investors paying ever more attention to anticipating the government’s next big market-moving initiative, rather than concentrating on fundamental investment drivers. This reaction is also a component in increasing correlations among risky assets, the so-called risk-on / risk-off trade.
During the commodities bull market of the past decade, this asset class attracted investors not only as a component of portfolio diversification and an inflation hedge, but also due to the impressive yield several sectors were delivering. It should be no surprise then that investors again sought to dial up their allocation to commodities as the Fed ramped up its smorgasbord of easing. The proposition becomes all the more enticing as low rates makes financing speculative positions with buckets of borrowed money all the more affordable. In the long run, supply and demand may indeed have the final say, but until then, artificially goosed demand for an array of industrial inputs will put pressure on commuters’ wallets and the income statements of businesses purchasing raw materials for fabrication and energy for running factories and transporting wares.
Power Corrupts; Absolute Power Corrupts Absolutely
Rather than reserve all our ire for the Fed and ECB, other financial markets are rife with distortions as well. China….being China….has historically limited domestic retail investors stock holdings to mainland-listed shares, while curtailing international players. This winnowing of participants results in price distortions as investors desiring equities exposure have no choice but to invest domestically. And they have good reason to seek yield as the government sets deposit rates so low….to benefit state-favored industrial borrowers in an example of another distorted market, this time for credit….that in order to keep up with inflation, local investors must seek exposure to risky assets. This is the same reason the nation’s property market has experienced a bubble. Guess they have not heeded the American lesson that real estate prices don’t only go up up up.
While Brazil is a free-market bastion compared to China, it too is unafraid in providing a guiding hand in certain sectors of the economy. One of which is the allocation of credit by the government-linked Brazilian Development Bank. Gone are the days of rampant Latin-American protectionism, expropriation (except in Venezuela and Argentina), and industrial policy. But this entity still provides support to inefficient enterprises that likely could neither attract private capital nor compete on the global stage with leaner foreign competitors.
The Real Economy
The extensions of credit highlighted above illustrate that the real economy is not immune to market distortions. The most obvious example of this is the U.S. housing market, both in the run-up to, and in the aftermath of, the crisis. Lame-brained policies created to bump up home ownership, along with the acquiescence of the securitization market (the shadow banking system) as it churned out Frankenstein-bonds, artificially increased the demand for housing, especially among market segments that had previously been denied access to credit…as it turns out, many for good reason. After the market’s monumental collapse, the federal government unleashed a barrage of programs to suppress the price discovery mechanism needed to clear markets of excess inventory and ultimately find equilibrium. Programs such as the first time home buyers tax credit only pushed purchases forward by the few souls who could still qualify for a mortgage. Loan modification programs and threats to sue banks back to the stone-age should they dial up foreclosures only further cloud market function. Cash for clunkers was a similar deal. It pushed forward sales that would have occurred anyway, but did nothing to alter the long-term viability of the auto market (which finally now is recovering…..thanks to time).
On everyone mind’s these days…especially in context of tomorrow’s election…is the U.S. healthcare system. Yet even before the Affordable Care Act was dreamed up, the market for health services in America was far from free. The source of one of the main distortions is the large share of services paid by third parties, mainly thanks to the tax preference given to employer provided insurance. Any time there is little or no direct cost to a product’s consumer, demand will inevitably spike and lead to a strain on the system. This in turn has led to payers of health care…government and insurance companies… to micromanage the system, which has blown everything up. Perhaps more than in any other segment of the economy, the failures of U.S. healthcare have been due to a lack of free market pricing mechanisms, not because of the supposed iciness of the market. This issue is all the more relevant as the U.S. is on the path to move towards a system, which if not a single-payer, at least will have dramatically fewer providers than at present. So much for thousands of transactions being the source of innovation.
The Green Dream
Perhaps the best way to provide cover for manipulating a market is to proclaim a public good comes from doing so. Until 2011 farm belt politicians threw their collective weight around to ensure gasoline refiners blended corn-based ethanol into the end product. While claiming the benefit of a green source of energy, they ensured foreign sources of similar world-saving products, namely Brazilian cane-based ethanol, got slapped with a nasty tariff. Artificial demand for their product and unintended consequences in the form of a third of the nation’s corn crop being diverted to ethanol plants rather than into animal feed, cereal boxes and Aunt Mable’s cornbread. In the end, consumers paid the price. Other segments of the alternative energy universe also provide fertile ground for authorities to stoke demand for a product that otherwise would not be commercially viable. This explains why countries with such notoriously drab weather such as Germany and Japan are leaders in solar energy capacity.
Can We Practice What We Preach?
Price signals are supposed to empower market participants with the information necessary to make informed decisions. That process becomes more difficult when one cannot trust the validity of the information presented. What’s worse, if the market is being overtly twisted by a force such as policy makers, one cannot guarantee that the measure applied will be reversed (or increased) thus potentially rendering recently made transactions unprofitable. Who would want to commit capital in such an environment? Given the above examples of financial market shenanigans, imagine being a portfolio manager and having account not only for the intrinsic value of various instruments, but also factor in how the whims of policy makers may cause gritty fundamental analysis to be all for naught. Clearly in some circumstances market intervention may be necessary, but even in these cases policy makers must measure the costs and benefits, including the nebulous unintended consequences. As many have said, the free market may certainly have its flaws, but it has proven far more effective in meeting society’s needs….when actually allowed to be free….than the competing systems championed in years past.