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Populism defined: “the people versus the elite” or “political ideas and activities intended to get the support of ordinary people by giving them what they want.”
Before jumping in I must acknowledge a newsletter I read this month written by Neils C. Jensen of Absolute Return Partners. The article was focused on Europe but triggered me going down a rabbit hole on a similar topic specific to the US.
Populism is not just a recent US phenomenon, we don’t have a monopoly on it, and we aren’t even on the leading edge of its impact on government or society. Several places in Europe are far ahead (behind?) of us in this regard, but it’s here; and it’s something we will have to deal with none the less.
The term “populous” president was occasionally thrown around regarding President Obama, but the current president has turned it into a real thing, embracing such a label. Looking at the cadre of Democratic hopefuls and persons of influence within the Democratic party, it is obvious that the president is not the only one going down this path. While the policies may be different, many within the political spectrum are blatantly trying to represent that they can give the populous the most benefit. Trump is doing it through training wrath on the political elite, immigration, and evil trade partners. Democratic hopefuls are focused on the business elite, forgiving student debt, nationalized health care, and even Modern Monetary Policy.
As discussed in previous Insights, most recessions are caused by a debt cycle that implodes due to a misallocation of capital. Appropriately allocated capital produces returns, and hence economic growth. The current recovery is closing in on the longest in US history; but is also the flattest. I see three specific causes of this flat recovery, the same causes of which are likely leading us into the next recession. Populism is one, and a growing one, of those causes; all of which are inter-related.
- Low interest rates: The Federal Reserve, cheered on by Wall Street and the Federal Government, pushed rates to the zero bound and kept them there; “lower for longer”. Additionally, massive amounts of liquidity were inserted into the national and global economy through quantitative easing. People/companies invest when they believe they can obtain a return on their investment. Usually this is as a function of the cost of debt; interest rates. If I can’t borrow money and obtain a higher return than I will be paying in interest, why make the investment? Lower interest rates lower the bar for required returns needed for investments to be made. Tons of liquidity also means there is often more money than truly good investments. This is when investment dollars are spent on economically nonproductive items, like stock buy backs, which have occurred at a historically unprecedented rate over the last several years. According to David Rosenberg, chief economist of Gluskin Sheff, total private enterprise profit growth in the US over the past several years has been zero. This means that taken in sum, stock price increases are a result of share buy backs and expanding PE ratios, and not growing performance. New corporate debt offerings and stock buybacks are close to perfectly correlated. This results at share counts being a two-decade low, which is amazing when we consider how much larger the economy is than two decades ago. Share buybacks only make sense for a subject company when they can’t invest in their business and obtain a return worthy of the investment. This in and of itself indicates malinvestment.Economist Knut Wicksell developed a way to measure the amount of misallocated capital within an economy. This formula is known as the Wicksellian Spread. The first step in the formula is calculated by subtracting the nominal GDP growth rate from BAA rated corporate bond yields. History has shown around a 2% spread is where an economy is in balance. The spread generally grows heading into a recession, having moved all the way to 10% heading into the Great Recession. The good news is we are currently nowhere near those kinds of spreads. The bad news comes in step number two.
The second step is to use the spread to calculate the total amount of misallocated capital across the economy. I will spare you the math, but the resulting misallocated capital is equivalent to more than 20% of the US GDP (and moving higher). This compares to 15% at the height of Great Recession.
- What does this have to do with populism? The benefits of investments into productivity are felt throughout the wealth spectrum as the rising sea raises everyone’s boats. Finacialization, as we have seen with the share buybacks, benefits those in the Capital classes. It’s not that Labor hasn’t also benefited from the recovery since 2009, it has; it’s just that the wealth and income gap is growing rapidly and as a result those not in the Capital classes are feeling poorer by comparison. When individuals feel that others are getting something they aren’t, and there is no way for them to obtain what others are obtaining, they start to feel the cards are stacked against them and “it’s not fair”. “It’s not fair” leads to looking for scapegoats. As voters become more and more focused on their own situation it leads to entrenchment in their political positions and turns into votes for laws or politicians that will give them what they want. Law end up being passed that not only hinder economic growth but are outright contrary to the outcomes that are said to be desired. Anyone dealing with housing issues in California or homeless issues in several coastal states knows exactly I am talking about.Populism, through the election of populist representatives, leads to either increased or redirected government spending in an effort to give the populace what they want, regardless of economic justification (or lack thereof). In theory, it could be as simple as government spending being redirected from areas of economic usefulness (education, infrastructure, etc.) and shifted towards transfer payments (welfare, farm subsidies, etc.). In reality, the result is massive increases to the deficit. President Obama created a new normal with the level of peacetime deficit spending. Trump came into office and promptly made Obama look like an amateur. This spending has to be funded from somewhere. This circles us back to the first point made in this article. Federal Reserve policies have created massive amounts of misallocated capital. The funding of deficit spending to pay for transfer payment programs to appease the populace is misallocated capital.
- Businesses crave consistency. Risk is quantifiable, unknowns are not. While it can seem like a long time and a different world ago now, there was huge discontent within the business community during the Obama administration because the rules of the game kept changing. And even when they didn’t change there was always the threat that they might. Despite cheap financing and a growing economy, capital spending was very low during the Obama years because of this. When Trump came into the presidency capital spending ticked up noticeably because businesses assumed they would no longer be under attack. The Democrats winning the House last year seemed to ensure gridlock. With this gridlock there would normally be consistency, and at least two years of an unchanging playing field (really three by the time either a new president or controlling majority got in place). But between tweets, threats, and vacillations, business now have no idea what is coming next. Moving operations from China to Mexico because of the expectation of a protracted trade/IP war? Not a bad idea, until suddenly there is a huge threat of tariffs against Mexico for something that has nothing to do with trade. Hit the brakes! Let’s look at India instead. Wait, now tariffs against Mexico are off and India might lose favored trade nation status…and so on. In this environment of uncertainty a stock buy-back suddenly becomes a much more attractive option in comparison to a productivity investment that could be rendered worthless with a single edict.
Trump’s presidency was made possible by the rise of populism. This presidency, magnifying the uncertainty of the last presidency, encourages investment into non-productive avenues. This includes government debt to fund populist policies, which then increases the incentives for politicians to tack more and more populist. This increases spending into non-productive areas. An unvirtuous cycle.
The good news is that while this combination of Federal Reserve policy and growth of populism has resulted in a massive amount of misallocated capital in the United States, the US is once again the cleanest shirt in the dirty cloths bin. Many of the world’s largest economies, specifically Germany and China (no surprise here), have far greater levels of misallocated capital relative to the sizes of their respective economies. Additionally, at least according to Niels Jensen, a large proportion of the current misallocated capital comes from private sources and not banks. When the inevitable reversion to (and past) the mean occurs, it shouldn’t have as much of an impact on banks as it would if the misallocated capital came directly from banks, as was the case in 2008.
But I think we also need to recognize that populism is not just a political fad. And by this I mean it is neither a fad, nor is it just political. It is highly likely we will have a populist president from 2020 – 2024, whether it be Trump or one of the many populists within the Democrat ranks. Who knows what elections in 2024 could look like, but if history is any indication we will be talking about the same thing as we approach that election. Whether it is six or ten more years (or more), populism in politics is a reality, and it will continue to impact economics. Uncertainty will continue to lead to non-productivity enhancing investments by businesses. Voter pandering will continue take resources from productive uses and move them into unproductive uses. And in near certainty, taxes will be increased as politicians pretend to pay for it all. Do you have a plan?
About the Author: Forrest Jinks is CEO of Altus Equity Group Inc and a licensed real estate broker. Forrest has decades of experience as principal in a variety of alternative investment segments including real estate (residential rehab, in-fill development, multi-family, office and retail), debt, and small business start-up (online marketing and site retail). He can be reached at firstname.lastname@example.org.