Howard Marks Memo: Economic Reality

Marks outlines economic principles he says elude certain presidential candidates

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May 27, 2016
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In 1977, responding to the difficult energy outlook brought on by the Arab Oil Embargo, President Jimmy Carter created the position of Secretary of Energy and chose James Schlesinger as America’s first “energy czar.” Previously Schlesinger had served as Chairman of the Atomic Energy Commission, Director of Central Intelligence, and Secretary of Defense, and in his early days he taught economics at the University of Virginia. I was tickled by a story – undoubtedly apocryphal – about his days in academia that made the rounds when Schlesinger was in his new energy post.

As the story went, Schlesinger was such a convincing evangelist for capitalism that two students in his economics class decided to go into business after graduation. Their plan was to borrow money from a bank, buy a truck, and use it to pick up firewood purchased in the Virginia countryside, which they would then sell to the grandees in Georgetown. Schlesinger wholeheartedly endorsed their entrepreneurial leanings, and they proceeded with great enthusiasm. From the start of their venture, the former students could barely keep up with the demand.

Thus it came as quite a shock when their banker called to tell them the balance in their account had reached zero and the truck was about to be repossessed. They contacted Schlesinger, and he listened attentively as they recounted their experience: they had, in fact, been able to acquire vast amounts of wood for $50 a cord, and they’d been able to sell all they had for $40 a cord. How could they be broke? Wherehad they gone wrong? Schlesinger puffed on his ever-present pipe and said: “The answer’s obvious: you need a bigger truck.”

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While it certainly wasn’t the case with Schlesinger (despite what the above tale suggests), most ordinary citizens don’t have what it takes to figure out what is and isn’t economically feasible. Since we’re in the midst of election season, with promises of cures for our economic woes being thrown around, this seems like a particularly appropriate time to explore what can and can’t be achieved within the laws of economics. Those laws might not work 100% of the time the way physical laws do, but they generally tend to define the range of outcomes. It’s my goal here to point out how some of the things that central banks and governments try to do – and election candidates promise to do – fly in the face of those laws.

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When I was in high school, one of my buddies convinced me to take a class in accounting. I found the double-entry bookkeeping we learned to be logical, symmetrical and unambiguous. After accounting I moved on to economics, and I found it equally logical. The die was cast for my career in business.

Like the lesson of the Schlesinger story, the rest of economics is also pretty straightforward, and its laws are quite reliable. If you buy for $50 and sell for $40, you won’t make money . . . period (or stay in business long). That reminds me of a joke I used in “bubble.com” in January 2000, one my father told me roughly 60 years ago:

“I lose money on everything I sell.”

“Then how do you stay in business?”

“I make it up on volume.”

For those of us in the business world, economics defines reality. (You may think you’ve heard me poke at it, but what I deride is economic forecasting, not economics. There’s a big difference.) The realities of economics are the subject of this memo. My primary methodology will be to describe ways in which people (and especially politicians) tend to propose things that conflict with economic reality, and explainwhy they’re unlikely to work.

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Let’s start with central banks’ attempts to achieve monetary stimulus. When central banks want to help economies grow, they take actions such as reducing the interest rates they charge on loans to banks or, more recently, buying assets (“quantitative easing”). In theory, both of these will add to the funds in circulation and encourage economic activity. The lower rates are, and the more money there is in circulation, the more likely people and businesses will be to borrow, spend and invest. These things will make the economy more vibrant.

But there’s a catch. Central bankers can’t create economic progress; they can only stimulate activity temporarily. GDP, or national output, can be seen roughly as the amount of labor employed times productivity, or the amount of output per unit of labor. In the long term, these things are independent of the amount of money in circulation or the rate of interest. The level of economic activity is determined by the nation’s productiveness.

Central bank actions can encourage or accelerate economic activity, but they can’t create economic activity that otherwise wouldn’t occur. Much of what central banks do consists of making things happen today that otherwise would happen sometime in the future. It’s not clear that the effects are long-lasting or anything more than an acceleration of events within the confines of a zero-sum game. What is beneficial, however, as Professor Randall Kroszner of the Chicago Booth School of Business wrote me, is the fact that:

[Central banks] can help to prevent a complete financial meltdown and the negative economy-wide externalities associated with a financial collapse. In these circumstances, and if done appropriately, their actions can do more than just move up future production to the present by helping to avoid economic activity losses due to a panic.

In the old days, when cars often failed to start, there were fluids we could squirt into the carburetor to get them going. But they weren’t fuel for long-term operation.

For example, lending people money can enable them to buy things today that they otherwise mightn’t have bought until later (if at all). If a consumer buys a boat today with money made available through a low-interest loan, that’s a boat he won’t buy next year. Lending people money doesn’t alter their lifetime incomes, meaning consumers may buy fewer boats later, when the loans have to be repaid, causing disposable income to contract.

So far, as the last seven years show, (a) central banks haven’t been able to generate the growth they hoped for and (b) the impact of each successive jolt of stimulus seems to have been less powerful.

Rather than believing central banks can make economies more productive, it’s my bottom line that there’s a naturally occurring growth rate for each economy, and that rate dictates the long-term output, not central bankers’ actions.

Continue reading the memo here.