Jamie Clark

Growing money trees

Jamie Clark

In the first of two long-read articles, Jamie Clark explores the switch in focus from monetary to fiscal policy and how this will be implemented. In the second article, Jamie explains how the team has positioned the Liontrust Macro Equity Income Fund to benefit from this development.

With apologies to sinologists and horticulturalists, the popular understanding of “money tree” originates from UK party politics. In fact, we can credit our present use of the phrase to Theresa May and her appearance on a Question Time election special of 2017. When pushed by a nurse to justify the government’s public sector pay cap, May replied “there is no magic money tree”. By which, of course, it was meant that government has no untapped, or consequence-free source of cash for public spending.

 

But attitudes are changing. Whilst few accept the existence of any magic reservoir of public funds, there is a growing appetite for the state to play a more active economic role. To adapt the metaphor, we’ll term this simply the money tree.

 

We believe this signals an important shift in the economic consensus. We are passing from an era where central banks and interest rates held sway, to another where politicians are rediscovering fiscal expenditure and will repurpose it to meet present needs.

 

This change will exert a powerful bearing on economies and a parallel influence on the style of company that investors choose. There will also be more specific opportunities, as political agendas favour particular industries. Our portfolio is positioned to capture such outcomes.

 

To appreciate the importance of this change, why its happening and its durability, some history is needed.

 

The turning policy cycle: money trees to monetarism

By weight of influence, any talk of money trees, or fiscal expenditure, must begin with John Maynard Keynes.

 

Written in the midst of the Great Depression, Keynes’ General Theory of Employment Interest and Money (1936) marked a break from classical economics. Before Keynes, it was accepted that markets were self-correcting; any imbalance between supply and demand automatically adjusting to set a new and optimal equilibrium. This is what Adam Smith meant when he wrote of the “invisible hand”.

 

Keynes differed in arguing that an economy could suffer habitual demand shortfalls, where supply doesn’t clear and a market operates beneath full capacity. What we produce might not be bought, the unemployed could remain so and entrepreneurs can’t be induced to borrow and invest.

 

Keynes’ greatest insight lies in his analysis of the underlying cause [1]. Because we have limited visibility of the future, our capacity to forecast an investment’s “yield ten years hence” is “often negligible”. This means our investment choices are beset by inescapable uncertainty, to which mathematical analysis has few answers. Instead, Keynes believed that entrepreneurial activity was dependent on “animal spirits”, or a “spontaneous urge to action”. By consequence, if our “animal spirits are dimmed” and we are left with “nothing but mathematical expectation”, economic activity may “fade and die”. The upshot was that “slumps and depressions” may be more “exaggerated" than warranted [2].

 

The prescription was for the state to use fiscal policy to provide certainty. This would require that government take an “ever greater responsibility for directly organising investment” for “the general social advantage” [3]. Explicitly, government would need to “incur debt during the slump” in order to “press on with capital expenditure”, or cut taxes to “increase the purchasing power” of consumers. Equally, government “should incline to the opposite policy” when conditions improved [4].

 

This kind of demand management defined UK economic policy after the second world war. Its success was evident in low inflation and unemployment, along with high economic growth – a point highlighted by comparison with the meagre record of the 2009-2019 period, as presented in the below chart. Little wonder that 1945-1970 is often known as “the Golden Age of Capitalism”.

 

UK GDP growth


But this was fleeting. From the mid-1950s, the monetarist economist Milton Friedman set about repudiating Keynesianism [5]. Friedman rejected Keynes’ diagnosis of uncertainty, on grounds that repeat fiscal stimulus must eventually influence worker expectations, triggering increased wage demands that simply produced higher inflation.

 

This was prophetic. By the early 1970s the UK was suffering growing inflationary pressures. But these were merely foreshocks to the seismic inflationary impact of the 1973 oil crisis, wherein crude oil prices rose fourfold. As measured by the Retail Price Index, UK inflation spiked from 2% in Autumn 1967 to a breathtaking 27% in August 1975; the below chart illustrates how extraordinary this was, as judged by the 3.9% average of the precedingGolden Age.

 

UK Inflation


Higher oil prices cut real incomes in oil importing, advanced economies. This caused a deep recession, which, in combination with steep inflation, gave rise to the ugly phenomenon of stagflation. Faced with the choice of stimulating the economy to cut unemployment, or curbing it to reduce inflation, Keynesianism had no answer.

 

The policy cycle turned from Keynesian demand management to Friedman’s monetarism. Controlling inflation, rather than smoothing the economic cycle, was the priority. Given Friedman’s dictum that “inflation is always and everywhere a monetary phenomenon”, fiscal policy was swapped for the central banker’s toolkit of interest rates and monetary aggregates. The model was the Bundesbank, whose independence and control of the money supply meant German inflation peaked at only 8% in 1974 [6]. The protagonist was Paul Volcker, Federal Reserve chair, whose aggressive use of rates reduced US Consumer Price Index inflation from 14.8% to 2.5% between 1980 and 1982.

 

US Inflation and interest rates


The success of monetary policy in arresting inflation encouraged the impression of the central banker as superman. This reputation was burnished over the succeeding two decades, a period known as the Great Moderation, as monetary policy was credited with creating the kind of stable growth absent from the inflationary 1970s [7]. Thanks to the Lawson Boom of the late 1980s and the UK’s 1992 departure from the Exchange Rate Mechanism, the UK’s Great Moderation began later. Nevertheless, the effect is clear from the contrast between UK inflation (RPI) in this time and the 1970s.

 

The Great Moderation


This is not to say that central bankers were completely responsible. Rather, they were assisted by the powerful disinflationary combination of demographic ageing, excess global savings (i.e. deficient economic demand), technology and the entry of Chinese and eastern European workers into the global economy.

 

Although beyond our present scope, these forces were also important contributors to the global financial crisis, ensuring that interest rates remained low and that a debt bubble could inflate [8].

 

The policy cycle turns again: and back to money trees

 

What is within remit is the monetary response to the financial crisis, its disappointments and why this implies a coming turn in the policy cycle and the embrace of money trees.

 

With the exception of Obama’s Keynesian American Recovery and Reinvestment Act (ARRA), the job of managing  financial crisis fell to central banks. As is known, interest rates were cut to near-zero on the assumption that a “wealth effect” would raise the value of real assets and encourage spending as extra money was created. This effect was amplified by quantitative easing, or bond purchase programmes; the incredible scale is clear from the US$3.3trn expansion of the Fed’s balance sheet.

 

Federal Reserve total balance sheet assets


There were successes. A second Great Depression was averted and labour markets, notably in the US and UK, have been strong; the UK’s 3.8% unemployment rate, sits 4.6 percentage points beneath financial crisis highs and at levels unseen since the mid-1970’s.

But there have also been disappointments. As per the below, UK GDP remains short of the levels implied by the record of the Great Moderation.

UK GDP 1993 2019

Alarmingly, given its bearing on future prosperity, productivity growth has been especially muted in the UK. Having averaged 2.3% in the decade preceding the financial crisis, labour productivity has slumped to an average of only 0.3% since its onset.

UK labour productivity

Which brings us to why monetary policy has underwhelmed, or the reason why the policy cycle is about to turn again. Simply put, monetary policy is more effective at curbing inflation than it is at stimulating growth. This asymmetry is the difference between Paul Volcker pulling on a string and curbing inflation, and later central bankers pushing on a string to stimulate growth in the teeth of the financial crisis. One works, the other doesn’t.

In contrast, Keynes teaches that fiscal stimulus can create demand sufficient to excite the animal spirits of entrepreneurs and provoke them to action. No doubt, the lack of such measures in the last decade has weighed heavily. How else to explain the UK’s weak investment and productivity record at a time of near-zero interest rates?

Even central bankers – those most vested in the merits of monetary policy – have conceded the limits of their abilities and the value of fiscal alternatives. Its seems certain that the policy cycle is about to turn when even the Bank for International Settlements, the central bankers’ club, warns that persistent low rates tend to financial busts that damage the real economy and produce ever lower rates [9]. The message is similarly clear when the Bank of England tells us that near-zero rates have limited stimulative power and offer little protection from the next downturn [10]. But the real tell must be near plaintive tone of figures like IMF Director Krisitlina Georgieva, in appealing for “fiscal policy to play a more central role” [11].

We believe there are two key ways of benefiting from the rediscovery of the money tree: one is stylistic and the other concentrates on sectors that should benefit from greater fiscal spending. Read the second of our long-read articles to find out more.


[1] See Robert Skidelsky, Keynes: The Return of the Master (2009) and George A. Akerlof and Robert J. Shiller, Animal Spirits (2009).

[2] J.M. Keynes, The General Theory of Employment, Interest and Money (1936), C.12: The State of Long-Term Expectation;

[3] Ibid;

[4] J.M Keynes, How to Avoid a Slump (1937);

[5] See: Friedman, Studies in the Theory of Money (1956); Friedman and Schwartz, A Monetary History of the United States (1963); and The Role of Monetary Policy (1968);

[6] Otmar Issing, Why Did the Great Inflation Not Happen in Germany?, St.Louis Fed Review, March/April 2005;

[7] Peter M. Summer, What Caused the Great Moderation? Some Cross-Country Evidence, Kansas City Fed, Q3 2005;

[8] See Ramskogler, Tracing the origins of the financial crisis, OECD (2015); Merrouche and Nier, What Caused the Global Financial Crisis?, IMF (2010);

[9] Borio et al, Monetary Policy Hysteresis and the Financial Cycle, BIS (2019);

[10] Vleighe, Monetary Policy: Adapting to a Changed World, Bank of England (2019);

[11] Georgieva, Transcript of IMF Managing Director Kristalina Georgieva’s Opening Press Conference, IMF (2019);

For a comprehensive list of common financial words and terms, see our glossary here.

 

Key Risks

Past performance is not a guide to future performance. Do remember that the value of an investment and the income generated from them can fall as well as rise and is not guaranteed, therefore, you may not get back the amount originally invested and potentially risk total loss of capital. Investment in Funds managed by the Macro Thematic team involves foreign currencies and may be subject to fluctuations in value due to movements in exchange rates. The Fund’s expenses are charged to capital. This has the effect of increasing dividends while constraining capital appreciation. The performance of the Liontrust GF Macro Equity Income Fund may differ from the performance of the Liontrust Macro Equity Income Fund and is likely to be lower than its corresponding Master Fund due to additional fees and expenses.

Disclaimer

The information and opinions provided should not be construed as advice for investment in any product or security mentioned, an offer to buy or sell units/shares of Funds mentioned, or a solicitation to purchase securities in any company or investment product. Always research your own investments and (if you are not a professional or a financial adviser) consult suitability with a regulated financial adviser before investing.

Friday, February 28, 2020, 12:35 PM