We’ve financially engineered ourselves into a 100 year drought.Travis Duhn
When I think about finance, I tend to fixate on the financial system as a whole. I believe there is tremendous value in mapping out the forces at play in the markets, how these forces interact, and ultimately, arriving at a clear picture of why these forces behave a particular way. This post is a small piece of this puzzle, but an important one nonetheless.
My aim is to put forward an argument that explains the contemporary characteristics of the financial markets as well as an explanation for why these characteristics have come to define it. This is a question that my close friend/business partner and I have been trying to come to grips with as of late, but discussion can only take you so far. Ultimately, the best way to distill your thoughts on a particular subject is to write them out. This is our attempt at sense-making and we hope you’ll appreciate our conception of this complex system.
The Flat Economy
Contemporary financial markets are oriented towards the endless pursuit of yield for investors. This orientation has been developed and maintain via monetary policies that prevent the occurrence of a healthy deflationary period. By refusing to let the system run its natural course, we’ve nurtured a chronically ill economic environment that is increasingly characterized by the pursuit of short-term gains at the expense of long term growth.
The current monetary policy more or less relies on quantitative easing to prevent deflationary periods and adjust asset values. This creates an environment where investors rely on debt financing to offset underperforming returns, which in turn leads to a cyclical debt crisis. The endless pursuit of yield within the current structure disincentivizes long-term growth strategies and hinders innovation because the time horizon for returns has been skewed. Put another way, the financial markets have become accustomed to the quick fix.
Reduced investment into the growth sectors leaves the economy stagnant and increases the demand for riskier short-term investments because these investments are effectively more liquid. Unfortunately, this leads to greater yield repression in the long term, creating the need for greater yield in the short term. This essentially constitutes a positive feedback loop that maintains the current structure, resulting in a flat economy. The greatest concern arising from this dynamic is that bursts of volatility within the system are mistaken for instances of growth.
The Notion of Permanent Growth
The Solow-Swan model is an economic model that establishes a framework of long-term economic growth. Simply put, the model predicts that in the long run, economies eventually converge to reach equilibrium. Therefore, permanent growth is only achievable through prolonged technological progress. The way this is supposed to play out is through innovation, specifically innovation that generates an increase in per capita productivity, which in turn leads to greater returns on investment.
This typically occurs cyclically – a period of relatively high-interest rates encourages investors to save capital. Conversely, this is followed by a period of low-interest rates which incentivizes the use of leverage to deploy capital. The current system is essentially defined by a permanent (or at least seemingly permanent) low-interest-rate environment and as a result, innovation is stifled. This is effectively a system that is forced to cannibalize itself in order to generate returns. The consequence of this is that the system is only able to sustain itself at the expense of long-term growth and innovation. This results in a perverse kind of permanent growth, whereby leverage is perpetually used to extract returns in the short-term.
When you conceive of the system in these terms, it is easy to see the cause for concern. The contemporary financial system is one in which yield is artificially created through various debt instruments. This kind of financial engineering has enabled the system to arbitrage itself in the short-term to generate returns for investors, but this comes at a significant cost. Reliance upon debt to extract yield in the short-term has undermined the role of long-term investing and has therefore hindered the ability of our economy to innovate in a meaningful way.
This triggers some important questions – is our economy due for another “great recession?” What are the repercussions for delaying a recession further? And would we be better off if we experienced a correction sooner rather than later? These are topics that will continue to be explored as this blog unfolds.