Friday, February 12, 2016

China: Sleeping With the Fishes (excerpt)

Some very smart people are taking very big bets that China may be the subject of the sequel to “The Big Short,” the movie about how the subprime mortgage crisis triggered the housing and financial meltdown of 2008. That’s according to a 1/31 WSJ article titled “Currency War: U.S. Hedge Funds Mount New Attacks on China’s Yuan.” Here is an interesting item from the piece:
Kyle Bass’s Hayman Capital Management has sold off the bulk of its investments in stocks, commodities and bonds so it can focus on shorting Asian currencies, including the yuan and the Hong Kong dollar. It is the biggest concentrated wager that the Dallas-based firm has made since its profitable bet years ago against the U.S. housing market. About 85% of Hayman Capital’s portfolio is now invested in trades that are expected to pay off if the yuan and Hong Kong dollar depreciate over the next three years--a bet with billions of dollars on the line, including borrowed money. "When you talk about orders of magnitude, this is much larger than the subprime crisis," said Mr. Bass, who believes the yuan could fall as much as 40% in that period.
The Chinese government has taken note and has already sent George Soros a dead fish wrapped in newspaper. Actually, the warning to Soros and others not to start a currency “war” with China appeared in an opinion piece by a low-level government official in the 1/27 People’s Daily Online headlined “Think twice before declaring war on Chinese currency.” The official wrote: “Soros’ challenge to the RMB and Hong Kong dollar are doomed to fail, without any doubt.” We will see who wins. However, betting against China seems to be a very good bet these days. Consider the following:

(1) Depreciating currency. The yuan is already down 8.2% since it peaked on January 1, 2014. As Debbie and I have been monitoring since mid-2015, the problem is a big swing from capital inflows before last year to massive capital outflows, as shown by the 12-month sum of China’s trade surplus and the 12-month change in China’s non-gold international reserves. This proxy implied about $1.0 trillion in capital outflows last year. (See our China Capital Flows.) The author of the op-ed in China’s leading communist newspaper wrote, “But it is hard for the dollar to be strong against the RMB for the long run, since China is still maintaining an expanding trade surplus.” He didn’t mention the capital outflows.

(2) Dialing for dollars. Several factors triggered the capital flight. The Chinese government has stepped up an anti-corruption drive since it was first started during November 2012. Perhaps that caused wealthy Chinese to move funds abroad. More importantly, the tightening of US monetary policy with the termination of QE during October 2014 and the widely anticipated rate hike late last year caused Chinese companies that had borrowed in dollars to scramble to pay these loans. The resulting drop in the yuan accelerated the capital outflows. A 1/26 FT article by Gillian Tett covered this subject very well.

(3) Fewer opportunities. Of course, capital outflows may also reflect fewer profitable investment opportunities in China. Profits earned by Chinese industrial companies in November fell 1.4% y/y, marking a sixth consecutive month of decline. China’s official M-PMI dipped to 49.4 last month, the sixth consecutive reading below 50.0 and the weakest since August 2012.

On the other hand, the NM-PMI was 53.5, remaining solidly above its December 2008 low of 50.8. Still, there is no doubt that China’s economy is slowing, as evidenced by the 8.3% y/y decline in railways freight traffic through December. Last year, electricity output rose just 2.4%, the slowest pace since 2009.

The China Syndrome Again

Another movie that comes to mind, of course, is the “China Syndrome.” There is no shortage of doomsday scenarios with China as the epicenter of a global meltdown. For example, a 1/26 CNBC article is titled “A China bank contagion could blow up global markets.” While the headline is alarming, the story is actually relatively reassuring, at least relative to the headline. Here are a few of the key excerpts from this comprehensive and well done piece by Tim Mullaney:

(1) Low default risk among banks:
A measure of default risk used by Moody’s Investors Service puts the risk of any of the Big Four Chinese banks--Bank of China, the Industrial and Commercial Bank of China, China Construction Bank and Agricultural Bank of China--defaulting in the next year at no more than 1.5 percent, and for some as little as 0.5 percent.
(2) Government backed:
Even with nearly $11 trillion of assets and loans that reach into all sectors of China’s $10.3 trillion economy, for now, experts see little likelihood the banks themselves will be a problem; China’s largest banks are all controlled by a government that has the determination and resources to prop them up if necessary. And their ties to U.S. institutions are narrow enough that bond-rating agencies don’t foresee anything like the financial contagion of 2008, when liquidity problems quickly spread from bank to bank and nation to nation as the extent of the mortgage crisis became clear. …

China’s banks also benefit from the explicit backing of the government there, in contrast to the U.S., where bank bailouts remain controversial seven years after the crisis. China’s central bank also has much more room to lower interest rates than does the U.S. Federal Reserve, which has set the target range for its key policy rate at 0.25 percent. The current Chinese base interest rate is 4.35 percent.
(3) Credit growing:
To date, China’s banks have not experienced anything like the cataclysms that rumbled through U.S. and European institutions between 2007 and 2009. Neither have their problems resulted in any significant shortages of credit: Retail sales in China rose 11 percent in December 2015, and housing sales have begun to rebound from an earlier dip. …

China’s banks are mostly funded by deposits rather than the capital markets, said Grace Wu, an analyst for Hong Kong-based Fitch Ratings. That makes them less vulnerable to short-term twists in the mood of markets, she said. They also have loan-loss reserves, collectively, that are nearly twice as big as the amount of loans that are 90 or more days past due, according to Moody’s Investors Service.
(4) Some cracks:
That said, China’s banks are in worse shape than a year ago, by many measures. Reported loan delinquencies have risen to 1.59 percent of loans as of Sept. 30, up from 0.95 percent at the end of 2012, Moody’s Investor Service says. And critics have seized on banks’ decisions to classify fewer loans whose borrowers are more than 90 days late on their payments as non-performing, saying banks and the government are trying to paper over the extent of a fast-growing problem.

Moody’s Investor Service cut its outlook for China’s bank sector to negative from stable, on Dec. 11. It pointed to the loan-loss problems, as well as an increase in overall borrowing to 209 percent of gross domestic product, from 193 percent a year ago, that it says raises systemic risk.

But all four of China’s largest commercial banks, each majority-owned by the government, are still rated A1/Stable--six notches above speculative grade and higher than all six of the top U.S. banks, which are rated A2 or A3. Bigger problems lurk in smaller Chinese banks that are less systemically important, the ratings agency said.”
(5) Conclusion: I know what you are thinking: Didn’t the rating agencies completely miss seeing the subprime mortgage disaster? We all know that they were actually part of the problem because they failed to rate junk credit as junk. Instead, they rated most of the junk that was sliced and diced into credit derivatives as investment grade, even AAA. It’s all in the movie.

The author of the CNBC article acknowledges the worries about a repeat of 2008. He notes:
The problems China’s banks have are focused in manufacturing and wholesaling--and an increasing number of those borrowers are relatively small businesses, Moody’s said. That raises the risk that their problems are not well understood or that they could worsen.
However, it is true that China’s bank loans are funded entirely by deposits. The ratio of M2 to bank loans was 1.48 during December and has exceeded 1.28 since the start of the data in December 1999. Then again, in yuan terms, bank loans are up a whopping 210% since December 2008. In dollar terms, they are up $10.2 trillion, from $4.4 trillion during December 2008 to $14.6 trillion during December 2015. Yet despite all that credit, the economy has slowed significantly.

Something is fishy in the state of China.
(Based on an excerpt from YRI Morning Briefing)

Friday, January 29, 2016

Blaming the Fed (excerpt)

How did we get into this mess? Despite all the easy money provided by the Fed and the other major central banks, global economic growth is subpar. Indeed, it may be heading into a recession. Inflation remains below the 2% target of the major central banks. Commodity prices are crashing, and stock prices have been weak since the start of the year. Consider the following:

(1) High price of easy money. Today’s problems may be traced to the termination of the Fed’s QE program on October 29, 2014 and the subsequent anticipation of a mere 25bps hike in the federal funds rate, which finally happened on December 16, 2015.

The Fed’s easy monetary policies at the beginning of the previous decade certainly contributed to the subprime mortgage mess. This time, the Fed’s easy money in recent years encouraged borrowers in emerging markets (EMs) to borrow lots of money from banks and in the bond markets to expand commodity production. A significant amount of that debt was in dollars. The prospect of the tightening of US monetary policy after so many years of near-zero interest rates caused EM borrowers to scramble to sell their own local currencies to buy dollars to pay off their dollar-denominated debts.

(2) Scrambling for dollars. Fed officials have been either blithely oblivious or negligently unconcerned about how the “reach for yield” by investors in the US might have facilitated the capital flows into EMs, which now have been reversing, as evidenced by the 15.6% drop in the Emerging Markets MSCI currency index since July 9, 2014.

The EMs have had to intervene in the forex markets to slow the descent of their currencies. Their non-gold international reserves have declined $838 billion to $7.4 trillion from July 2014 through October of last year. Of course, some of that decline is exaggerated by the depreciation of reserves held in euros and in yen, though that also has depressed the dollar value of reserves.

From this perspective, the 23% increase in the trade-weighted dollar since July 1, 2014 is to a large extent a massive short-covering rally by EMs. The soaring dollar increased the local currency prices of commodities priced globally in dollars. It’s likely that the plunge in commodity prices might have been triggered by the short-covering dollar rally combined with the tightening of credit for EMs. Of course, the supply-led glut of commodities only made things worse.

(3) End the Fed. Fed officials don’t spend much time analyzing credit market developments and flows of funds, especially on a global basis. The Fed does have an excellent flow-of-funds database for the US. However, it lacks any data on credit derivatives, which might explain why Fed officials were blindsided by the subprime mortgage disaster. The Fed’s research staff conducted no significant research on mortgage credit derivatives prior to the previous financial crisis.

Similarly, this time around, the Fed mostly has ignored the impact of ultra-easy monetary policy on global credit flows, particularly to EMs. That analysis was left mostly up to the Bank for International Settlements (BIS). Just as bad, Fed officials show virtually no interest in the dollar. They take no responsibility for its movements; nor do they try to understand the implications of these movements.

(4) Are EMs subprime? The fear is that all this is leading to another emerging markets crisis that could set off a global financial contagion similar to what happened in 2008. It’s actually surprising that nothing big has blown up so far. There could shortly be a Venezuela debt crisis, according to the financial press. My relatively optimistic spin has been that the dollar borrowing by EMs has been largely financed in the capital markets, which are better able to absorb shocks and losses than banking systems. Loans to EMs haven’t been sliced and diced into different tranches of credit derivatives as were subprime mortgages.

Of course, there are many high-yield bonds that were priced too cheaply and have seen their yields soar since mid-2014. However, they were never rated as anything other than junk. EMs and junk bonds have been great shorts recently, but I doubt there will be a sequel to “The Big Short” based on them.

Tuesday, December 29, 2015

The Great Disruption: From Brawn to Brain (excerpt)

During 2016 and beyond, I will continue to investigate a new long-term theme: “The Great Disruption.” It is increasingly obvious that technology is disrupting business models. That’s what it has always done. It just seems to be doing it faster and in more industries than ever before. For example, previously I discussed how technological innovations are increasingly disrupting the energy and finance industries.

In the past, technology disrupted animal and manual labor. It speeded up activities that were too slow when done by horses, like pulling a plow or a stagecoach. It automated activities that required lots of workers. Assembly lines required fewer workers, and increased their productivity. The focus was on brawn. The Great Disruption is increasingly about technology doing what the brain can do. Today, I extend the analysis of The Great Disruption to the implications of the rise and proliferation of smart machines.

Smart Machines I: LOL or COL? Robots with artificial intelligence are coming. Should we laugh out loud--happy that they will do lots of our dirty work? Or should we cry out loud--fearing that they will take away all of our jobs? Perhaps the most significant disruptive force at the forefront of technological innovation is the meeting of machines and hyper-connected systems, according to a March Wired article. “Smart machines” are the birth child of this powerful combination. There isn’t a single agreed-upon definition for them yet. That’s probably because they are undergoing major development for a multitude of applications. In essence, smart machines are computing systems that are capable of making autonomous decisions, like robots and self-driving cars.

Like smartphones, smart machines are about to penetrate the world in a major way. In 2014, industrial robot sales increased by 29% to the highest level recorded for one year, according to the International Federation of Robotics. We humans can laugh about it or cry about it. Either way, the robot revolution is going to disrupt the way we work. Here are a few compelling reasons why the coming of robots is so important:

(1) Cost of a bot. At least two different types of manufacturing robots can currently be purchased for the cost of about a low-salaried employee. Baxter, the world’s first dual-arm collaborative robot for manufacturing, has a current base price of just $25,000, as listed on the Rethink Robotics website. Foxbots, also used to perform routine manufacturing jobs, cost about $20,000 per year, according to the December 2014 Harvard Business Review (HBR). Still, the fully loaded cost of purchasing and operating a robot varies widely across applications.

Several industries are on the verge of reaching, or have already reached, the point where it’s cheaper to employ robots than humans, according to a BCG note. For example: “A human welder today earns around $25 per hour (including benefits), while the equivalent operating cost per hour for a robot is around $8 when installation, maintenance, and the operating costs of all hardware, software, and peripherals are amortized over a five-year depreciation period. In 15 years, that gap will widen even more dramatically,” the analysts calculate.

(2) Ideal vs. idle workers. “Automation is inevitable. It’s a tool to produce abundance for little effort. We need to start thinking now about what to do when large sections of the population are unemployable through no fault of their own. What to do in a future where, for most jobs, humans need not apply,” said a C.G.P. Grey YouTube video as quoted in a 9/5 Barron’s thought piece. In the same regard, HBR warned that “we will soon be looking at hordes of citizens of zero economic value. Figuring out how to deal with the impacts of this development will be the greatest challenge facing free market economies in this century.”

Robots ultimately may make better employees than humans in a lot of ways. They don’t need to take bio breaks, eat lunch, go home to see their families, or sleep. And you won’t find them making trips to the water cooler, getting involved in office politics, or otherwise losing focus from assigned tasks. They can work anywhere and won’t hesitate to relocate. They can operate in dangerous environments without requiring employers to worry about lawsuits. They won’t care, complain, or get frustrated unless they’re programmed to do so--or learn to on their own.

Seriously, though, companies are sure to reap productivity boosts and labor cost savings from the use of robots and other smart machines, especially as they become smarter and more affordable. On its Q3 earnings call, Amazon executives touted the benefits of using robots over the cost: “[The] capital intensity [of our fulfillment centers using robots] is offset by their density and throughput. So it’s a bit of an investment that has implications for a lot of elements to your cost structure, but … pairing our associates with … robots to do some of the hauling of products within the warehouse has been a great innovation for us. We think it makes the warehouse jobs better and … our warehouses more productive.”

It’s not easy to estimate just how many human jobs will be replaced by robots. A 2014 Gartner presentation indicated that one in three jobs will be taken by smart machines by 2025. According to a lengthy 2013 Oxford paper, around 47% of total US employment is at high risk of automation over the next decade or two. Two high-tech industry pundits writing in HBR recently forecasted that nearly 30% of today’s workforce will be of no economic value by 2025. Forrester’s less extreme projection is that “16% of jobs will disappear due to automation technologies between now and 2025, but … jobs equivalent to 9% of today’s jobs will be created.”

Net, net, lots of jobs will be automated, but new kinds of jobs will be created too. Indeed, an engineering degree may be required for humans to remain competitive in the workforce. Of course, humans are still required to create and enhance robots as well as attend to their ongoing maintenance. Further, creative humans with soft skills unlikely to be matched in the robot world will certainly be more likely to be employable than low-skilled laborers. Before we know it, most humans at least will be required to work alongside robots.

Smart Machines II: They’re Here! As smart machine technology becomes more affordable and more widely adapted, it’s unlikely that any industry or occupation will remain untouched by its transformation. Robot labor has already had a transformational impact on goods-producing industries. More slowly adapting to the use of robot workers are service-related industries. However, many service-oriented fields are on the cusp of rapid transformation based on recent advances in robotic engineering. Let’s take a look at some examples by field.

(1) Manufacturing. Foxconn, the world’s largest contract manufacturer, initially installed 10,000 robots in 2011 and is now doing so at a pace of 30,000 per year. The robots are used to perform routine manufacturing tasks including spraying, welding, and assembly. During the summer of 2013, Foxconn’s CEO said at the company’s annual meeting: “We have over one million [human] workers. In the future we will add one million robotic workers.” (For more on this, see the prior-mentioned HBR article.)

(2) Apparel. Another production example, SoftWear Automation, an Atlanta-based start-up, is changing the way apparel is produced, as discussed in an 11/23 WSJ article. So far, SoftWear’s SewBots can do basic sewing tasks with a few human workers attending to them. Their engineers are working on getting the bots by next year to produce garments from start to finish.

(3) Logistics. In March 2012, Amazon announced its acquisition of Kiva Systems for $775 million. “Amazon has long used automation in its fulfillment centers, and Kiva’s technology is another way to improve productivity by bringing the products directly to employees to pick, pack and stow,” according to the press release. Fast-forward to the online retailer’s Q3 earnings call, when Amazon executives said that 30,000 bots were being used in 13 fulfillment centers. That’s double the 15,000 they had in 10 warehouses at the end of 2014. And their intent is to use robots more widely.

(4) Transportation. Previously, we discussed the proliferation of self-driving cars in detail. Recently hitting the roadways of Germany was a test of a semi-autonomous truck. Oh, and, let’s not forget the drones! We have heard a lot about Amazon’s testing of drones for end-to-end product delivery. (By the way, drones have many other applications outside of logistics. See Internet analyst and venture capitalist Mary Meeker’s slide #81-86 and 187-190 for more.)

(5) Restaurants. In a video of a recent Tokyo expo showcase, robots can be seen chopping carrots, mixing ingredients, icing a cake, and wrapping sushi rolls. The clip is titled: “Japan’s chef of the future is a robot.” In the US, the CEO of Panera Bread, a casual dining chain, said on the company’s Q3 earnings call: “Labor is going to go down … as digital utilization goes up, and--like the sun comes up in the morning--it is going to continue to go up … much as you are seeing it happen in Panera today.”

(6) Medicine. The Da Vinci robot is just what the doctor ordered. The four-armed surgeon-operated robot has already transformed the way patients are operated on in a UK hospital, as described in a 5/8 Guardian article. “You can rotate the instruments 360 degrees, so they are more dexterous than the human hand,” said the hospital’s robot coordinator. “We are going into places now that we couldn’t get into before.”

(7) Entertainment. The 12/14 Bloomberg showed a picture of a very creepy-looking robotic baccarat dealer named “Min” at a demonstration in the headquarters of a Chinese entertainment company. Currently, Min can only deal cards, but she’s in the shop to be programmed for interacting with customers. In the near future, robots like Min are expected to be introduced in US casinos.

Smart Machines III: Your New BFF. Indeed, there are certainly many other examples where robots can and will be utilized in the near future. Additionally, lots of new technologies that don’t require physical bots per se are automating jobs in service-related fields like journalism and finance. The point is: The robot revolution isn’t coming, it’s already here--and it’s everywhere! Today’s most impressive humanoid robots possess a variety of soft skills that can be leveraged in a multitude of ways across industries. Here are a few intriguing examples:

(1) Best frenemy. Japan’s Softbank’s cute-young-boy-like robot named “Pepper” demonstrated the ability to identify human emotions on stage at the WSJDLive 2015 conference. Like many of today’s smart machines, Pepper is also able to integrate various developers’ software applications to enhance “his” growing list of useful skills, like taking a selfie, as seen in a 2/15 Japan Times YouTube video.

Not all robots are cute, though. “Russia and China are building highly autonomous killer robots” was the title of a 12/15 Business Insider article. While a robot army may sound like a concept in your favorite science fiction movie, it may soon become a reality. A Russian defense contractor has said it will show prototypes of combat robots within two years, noted the article.

(2) Back to pre-school. Machines are learning the way toddlers do at Berkeley’s technology research hall. There, robots can be found playing with Legos, wooden spoons, model planes, and a set of square and round pegs, recounted Bloomberg in a 9/2 special feature. BRETT, a child-like robot, even takes pauses to think as he discovers the world!

(3) Winning games. Google’s DeepMind AI team has invented a computer that can learn to play and beat humans at video games, as they presented in a 2/26 Nature science journal letter. So robots now are capable of engaging in reinforcement learning, i.e., using cognitive functions to determine how to act in specific environments. In other words, they can program and train themselves.

(4) Walk in the woods. Google’s Boston Dynamics has a robot named “Atlas” that’s mastered the balance and other abilities required to take a stroll through the woods. Though not perfectly nimble yet, Atlas is undergoing training similar to military boot camp. “Researchers kick the robot, throw weights at it or make it walk over rock beds to observe how well it adapts to challenges,” reported the 8/18 NYT.

(5) Hazardous work. The earlier-mentioned Baxter robot has undergone testing in a simulation as lab assistant for Ebola workers, thereby reducing the risk of contagion. PackBots were utilized to search for victims in places where humans couldn’t go at the 9/11 disaster zone. Just last week, the WSJ reported that new robots have been deployed at the scene of Japan’s Fukushima nuclear meltdown to aid in the decontamination process.

Saturday, November 14, 2015

Global Economy: At Your Service (excerpt)

The evolution of national economies tends to follow a well established pattern. They all start out as mostly agricultural economies. They evolve into manufacturing economies. In the next stage of development, services increasingly predominate. In the final stage, economies become knowledge-based. Most emerging economies are currently based on labor-intensive agricultural and manufacturing businesses, but moving towards more services. On balance, most developed nations around the world are in the third stage, with services outpacing manufacturing.

While the recent batch of weak industrial production indexes for Germany (down 1.1% in September), the US (-0.2), the UK (-0.2), Brazil (-1.3), Taiwan, and Singapore (both little changed after big declines) suggests that a global manufacturing downturn may be underway, the increasingly services-led global economy isn’t falling into a recession. Indeed, it seems that services industries are creating enough jobs to boost some of the demand for what factories make, especially autos. Let’s have a closer look:

(1) Global perspective. All this is increasingly evident in the JP Morgan Global PMIs for manufacturing (M-PMI) and non-manufacturing (NM-PMI). The available data we have since 2010 show that the global NM-PMI has generally exceeded the global M-PMI. The spread between the two has actually widened since early 2014. During October, the NM-PMI was 53.7, while the M-PMI was 51.4.

(2) Country perspective. Not surprisingly, these trends--which admittedly are still relatively new and therefore open to debate--can be seen in most of the major economies of the world, since they must add up to the totals compiled by JP Morgan. During October, the spread between the NM-PMI and M-PMI in the US was 9.0ppts, the most since February 2001, and the fourth highest in the history of the series going back to July 1997.

In the Eurozone, the two were nearly identical from 2010 through 2013; but since then, the region’s NM-PMI has been consistently higher than the M-PMI. In China, the NM-PMI has exceeded the M-PMI every month since the start of 2010, with an average spread of 4.4ppts. Interestingly, over the past two years since October 2013, NM-PMIs among emerging market economies have averaged 51.3, while the comparable measure for developed countries has averaged 54.7.

(3) Third-stage economies. Of course, this is all circumstantial evidence of a global transformation from manufacturing to services. However, there is plenty of evidence showing that the major “industrial” economies--including the US, the UK, Canada, Australia, Japan, and the Eurozone countries--have evolved into “services” economies. That’s easiest to see by comparing employment in the services-producing and goods-producing sectors of these economies. The former has been outpacing the latter for at least three decades. A similar conclusion can be deduced by comparing real GDP of goods versus services.

So, for example, in the US, payroll employment in goods-producing industries accounts for only 14% of total payroll employment, down from 44% during 1943. During Q3, services accounted for $9.9 trillion (saar) of real GDP, while goods accounted for $5.3 trillion of real GDP. Since services-producing businesses tend to be less cyclical than goods-producing ones, this transformation should moderate the business cycle.

(4) Know-it-alls. On the other hand, the transformation of the US economy from services-producing industries to knowledge-producing ones may increase the problem of structural unemployment for some workers. That’s because knowledge workers spend their entire workday trying to figure out how to put the rest of us out of work.

They’ve already figured out how to replace factory workers with robots. Indeed, robots are even starting to displace workers in China’s factories. Last year, China was the single largest market for industrial robot sales, according to the International Federation of Robotics (IFR), and within two years there will be more industrial robots in Chinese factories than in either the European Union or the United States.

This is just the start. There are only 30 robots for every 10,000 manufacturing workers in China, compared with 323 per 10,000 in Japan and 437 per 10,000 in South Korea, IFR data show. Automation is also coming to the services sector. San Francisco start-up company Momentum Machines, Inc. has set out to fully automate the production of gourmet-quality hamburgers. McDonald’s is well on the way to offering self-serve kiosks at a majority of their stores instead of paying employees to ask, “Do you want fries with that?”

Thursday, November 5, 2015

The Grand Delusion (excerpt)

Is it possible that monetary policy can’t fix all of our economic problems? That was one of my main discussion points with our accounts in Boston last week. In recent years, the major central banks have been taken over by macroeconomists who believe that they have the power to tame the business cycle. Since the financial crisis of 2008, they’ve led us to believe that they can revive self-sustaining economic growth and stabilize inflation around 2%. That’s because they strongly believe in their powers--even though they’ve been providing abnormally easy monetary policy since the crisis yet economic growth remains subpar with inflation below 2%.

I believe that the macroeconomists at the central banks (a.k.a. central monetary planners) have failed to achieve their goals because they are blindly fighting very powerful economic forces that are microeconomic in origin. They are also fighting the forces of technology and demography. Technological innovation, one of the primary drivers of “creative destruction,” disrupts and displaces the old ways of doing things with better goods and services at lower prices (BGSALP). Demographic trends are disruptive too, as people are living longer while baby creation is tanking, as evidenced by plunging fertility rates around the world, with deflationary consequences.

By ignoring these forces, the macroeconomists are unknowingly disrupting the microeconomic adjustment mechanisms that automatically eliminate economic and financial excesses on a regular basis. In other words, their obsession with moderating the business cycle is actually contributing to the problems they are trying to fix, because they won’t let Mother Nature--who is a microeconomist--manage the business cycle. Consider the following:

(1) Tolstoy. Last Thursday, we learned that real GDP rose just 1.5% (saar) during Q3. That was widely reported. Not as widely reported was that the GDP deflator rose just 0.9% y/y. Excluding food and energy, it was up just 1.1% y/y, the lowest since Q1-2010. The deflator for personal consumption expenditures excluding food and energy rose only 1.3% y/y, with the comparable market-based core inflation rate at just 1.1%.

Why has the Fed’s ultra-easy monetary policy failed to boost inflation? The answer may be in Leo Tolstoy’s War and Peace. A chart of the US CPI since 1800 shows very clearly that inflationary periods have been associated with wartime conditions during the War of 1812, the Civil War, World War I, and World War II through the Cold War. The restoration of peace is associated with outright deflation, i.e., falling prices after each one of these wars with only one exception. There has been no deflation since the end of the Cold War, though the CPI inflation rate has declined from 4.7% y/y during November 1989, when the Berlin Wall was toppled, to zero today.

During wartime, government takes command of the economy since all resources must be mobilized to win the war. Global trade is disrupted since there can be no trade among combatants, and it can be hard to trade with allies. In other words, wars are trade barriers. During peacetime, globalization occurs. There is more free trade even among former adversaries, and markets become freer from government controls and also more competitive.

The end of the Cold War in 1989 was the end of biggest trade barrier of all time. It led to China joining the World Trade Organization during December 2001. So far, it has been different this time because there has been no deflation. That’s because so far the central banks have succeeded in averting it with ultra-easy monetary policy. But that doesn’t mean that there won’t be adverse consequences.

Macroeconomists don’t spend much time thinking about markets, especially competitive ones. These markets tend to be very deflationary because having fewer barriers to entry during peacetime means that established, profitable producers are constantly under attack from startups hoping to take some if not all of their profits by providing BGSALP. It’s one of Mother Nature’s great wonders because it greatly benefits the one and only economic class that should matter--that is, the Consuming Class!

Competition exists in nature for only one reason, which is to improve the standard of living of consumers. It is not designed to enrich companies, shareholders, trade unions, or workers. The protagonist in this natural narrative is the entrepreneurial capitalist. (Along the way, those who succeed among them have a tendency to turn into crony capitalists, but that’s a subject for a book that I will write someday.)

(2) Turing. These days, the hero of entrepreneurial capitalists is Alan Turing, the British mathematician who is widely credited with having invented the computer. As a result of the IT revolution, entrepreneurs are able to disrupt business models in every industry with innovations that provide consumers with BGSALP. Steve Jobs, who was a big fan of Turing, was the entrepreneurial capitalist who started the personal computing revolution by inventing operating systems that could run PCs, laptops, smartphones, and iPads. All these devices have become increasingly affordable, compact, portable, and powerful thanks to the Cloud and other innovations.

In the GDP accounts, the price deflator for IT capital equipment spending has declined 79% since 1977 when Apple introduced the Apple II, a color computer with expansion slots and floppy drive support. Capital spending, in current dollars, on IT equipment, software, and R&D now accounts for over 40% of the total of such spending, up from just 23% during 1977.

(3) Bismarck. The welfare state originated in Germany during 19th century with the policies implemented by German Chancellor Otto von Bismarck. The welfare system in the United States began in the 1930s, during the Great Depression. After the Great Society legislation of the 1960s, for the first time a person who was not elderly or disabled could receive need-based aid from the federal government. The notion that government has an obligation to provide a social welfare safety net is now widely accepted in all developed nations.

The good news is that people are living longer and more comfortably in their old age. The problem is that government deficits have swelled to finance entitlement spending rather than public investments in infrastructure. It’s conceivable that the plunge in fertility rates might be partly attributable to the perception that raising children is expensive and not a good investment if the government will support us in our old age, obviating the need for adult children to do that.

The result is that the number of social welfare beneficiaries are increasing faster than workers who can support them. In the US, the ratio of 65-year-olds who are not in the labor force rose to a record 24% of the civilian labor force during September, up from 20% only 10 years ago.

In any event, these demographic trends are likely to be deflationary, since older people tend to consume less than younger people with children. This might explain the strong secular correlation between the inflation rate in the US and the Age Wave, which is the percent of the labor force that is 16 to 34 years old. The Age Wave has dropped from a record 51.2% during January 1981 to only 35.4% currently. Over that same period, the CPI inflation rate has plunged from over 10% to under 2%.

Last week, the Chinese government abandoned its one-child policy, which over the past 35 years has led to a myriad of social and economic ills in China. All Chinese couples will be allowed to have two children. The move is most likely too little too late, as China already faces a declining, graying population without the workers it needs for its vast economy.

(4) Bernanke. The macroeconomists who are running the major central banks seem oblivious to these secular forces of deflation. Nonetheless, they can be credited with successfully countering the natural forces of deflation, so far, with ultra-easy monetary policy. Perhaps they eventually will be proven right in their belief that if they persist, then self-sustaining growth will make a comeback and inflation will stabilize around 2%.

More likely, in my view, is that easy money has lost its effectiveness and won’t boost demand as still widely expected by the demand-side macroeconomists who steer the central banks. Meanwhile, on the supply side, easy money has disrupted the economic laws of nature by propping up ““zombie” producers, who would have been buried for good, and for the good of the economy, in a competitive market. The living-dead companies exacerbate deflation with their excess capacity and weaken profits for healthy companies, thus depressing the overall economy.

As I’ve often noted, no one has been as committed to moderating the business cycle with monetary policy as former Fed Chairman Ben Bernanke. He reiterated this view in a 10/4 WSJ op-ed titled “How the Fed Saved the Economy,” timed to coincide with the release of his new book, The Courage to Act: A Memoir of a Crisis and Its Aftermath:

“What the Fed can do is two things: First, by mitigating recessions, monetary policy can try to ensure that the economy makes full use of its resources, especially the workforce. High unemployment is a tragedy for the jobless, but it is also costly for taxpayers, investors and anyone interested in the health of the economy. Second, by keeping inflation low and stable, the Fed can help the market-based system function better and make it easier for people to plan for the future. Considering the economic risks posed by deflation, as well as the probability that interest rates will approach zero when inflation is very low, the Fed sets an inflation target of 2%, similar to that of most other central banks around the world.”

In his memoir, Bernanke does acknowledge that the “experience of the Great Moderation had led both banks and regulators to underestimate the probabilities of a large economic or financial shock.” In my opinion, attempts by the central banks to moderate the business cycle make the economy more vulnerable to financial instability and deeper recessions. Consider this: After so many years of attempting to revive economic growth and stabilize the financial system, Fed officials have hesitated to hike the federal funds rate by a measly 25bps, fearing the consequences. By the way, I looked in the index of Bernanke’s book for the word “capitalism.” It isn’t there.