The Shifted Path of Capital Principle- by NEIL SISKIND

I’ve developed “The Shifted Path of Capital Principle” to explain that, in the modern U.S. economy, capital often flows from the Fed, to banks, and then directly into assets- as opposed to moving from the Fed, to banks, and into the broader economy through investments by businesses in their respective operations and through income growth, as in prior U.S. economies and ages- which leads to potentially-dangerous asset inflation, without more general economy-wide inflationary pressures, and even with economy-wide deflation.

In the old economy (or, the Industrial Age), assets such as homes and stock prices were beneficiaries of industry and inventiveness, hard labor, and prosperity. These factors, or characteristics, led to earnings growth for companies, and wage growth and income growth for employees and executives, and, in turn, led to higher stock prices for companies and rising home demand from, and rising home prices for, employees and consumers. This path of capital, from business investment and growth outward to the larger economy, also led to higher product prices, as demand grew, and as U.S. labor was finite. Eventually, inflation set-in, interest rates increased, and the economy slowed. Stock prices would reflect earnings declines (or earnings growth, if company pricing-power permitted for price increases to outpace inflation), and home prices would level-off or decline as interest rates rose and as demand slowed. Eventually, as interest rates declined, a new up-cycle in the economy would begin.

In the modern economy (or, the digital economy), dollars flow more directly from the Fed into assets. Dollars flow directly from the Fed to banks, and then into homes which are used as generators of income and profit, rather than as places to live as the result of employment, income growth, and economic prosperity, as has, historically, been the norm. Houses and apartments become trading vehicles and short-term income generators. On the equities side, dollar denominated debt is incurred by companies to buy their own company stock to push up the price and their EPS. This flow of debt capital directly into stocks- instead of into companies’ operations, where it leads to earnings growth through productivity, ingenuity, and capex, resulting in sales, pricing power, and stock price growth- works to “directly” (rather than through a more indirect “trickle through”) and, some might say, “artificially”, cause stock prices to rise, irrespective of any growth in earnings, or even in revenues.

At the same time as inexpensive debt capital is being used by businesses and investors to inflate assets, it’s also being used by businesses to deflate prices and wages.

The combination of cheap debt and a higher stock price is used by companies to increase “scale” through heightened marketing and acquisitions. The scale allows for lower input costs, and, thus, lower consumer prices, and lower wages as competition declines. The scale provides for higher profits, due to a greater industry presence and more revenues driven by size and low prices, and fewer competitors. Big companies grow bigger, and small competitors have lesser and lesser abilities to compete because technology causes consumers to care less about location, convenience, and relationship than about price, alone.

All of the above, taken together, means that the path of capital leads to less price and wage inflation, but more investment-oriented, or even risk-oriented uses of capital, as capital flows directly from the Fed to banks, and from banks to assets- instead of into capex, innovation, productivity, and wage growth.

In the modern economy, a mature economic cycle means less price and wage pressures, and more asset bubbles and financial imbalances from misallocations of cheap credit. As the Fed looks at accepted economic indicators to evaluate inflationary pressures, it misreads signals to indicate low risk (because of low price inflation), and then keeps rates too low for too long, as asset imbalance grow- until it’s too late to ease out of the situation or achieve a soft landing.

Flat and inverted yield curves are misread to only reflect low inflation expectations (including misreading flat and inverted curves to reflect low term premiums due solely to low inflation expectations) rather than portending asset crashes, and investors’ expectations of eventual slower or negative growth.

When the Fed does decide to act because it sees credit and asset bubble risks, this divergence in how debt capital has affected prices (to cause product and wage de-flation vs. asset in-flation) puts the Fed into no-win scenarios. By raising interest rates where economic growth and inflation are muted, but where assets grow pricey, causes public and political outrage because the Fed is deflating assets that have been the engine of the economy (such as real estate) while pushing already low growth and low inflation even lower. The Fed’s attempts to limit systemic risk from asset risk, where the Fed has let asset bubbles fester, is difficult where growth and inflation are muted.

Business cycles don’t die of old age. The Fed often kills them. In the modern economy, if the Fed fails to raise interest rates (by choice or by external pressures), a business cycle will still come to an end, only in a different manner- despite investors’ preferring not to recognize this. If growth and inflation are low and the Fed maintains low interest rates to extend a business cycle, asset prices and debt will become inflated, and, instead of an economic slowdown, we have asset crashes and a financial crisis, which can be triggered by any variety of events.

One way or another, sooner or later, a business cycle ends.

Recommendations for achieving maximum financial stability-

Because of the shifted path of capital, the Fed’s assumptions about, and regular and standard measurements of financial risks to the general public and to the financial system, should also shift:

The shifted path of capital in the modern economy must be understood, embraced, and recognized at earlier stages of an economic cycle so that assets, and entire economies and financial systems, don’t have to be compromised by interest rate hikes to control asset prices (in economies which do not, otherwise, call for rate hikes due to low growth and/or low inflation), resulting in significant asset price crashes, following significant asset price inflation and misuses of debt capital that were permitted to occur for too long.

Because of the shifted path of capital, legislators should better understand the path of capital once it leaves the Treasury, and the reason for the path, and create laws and policies that better protect the public and the financial system in this new economic paradigm, or else take necessary legislative measures to reverse the trajectory of this modern paradigm:

Mere awareness of and de-risking from the shift in the path of capital through the economy earlier-on in cycles (through the Fed’s early identification of pockets of instability and then raising of interest rates in response) is not enough, especially since it’s unrealistic to expect the Fed to be able to time monetary policy precisely enough, and since such a policy, alone, would significantly shorten business cycles. Legislators and policy makers must understand the underlying reasons for the shift, where liquidity provided by the Fed, now, very often bypasses what is believed to be supply side stimuli- businesses, and, in particular, businesses’ investments in their operations (as opposed to in their stocks)- and goes directly into assets and asset growth activities, allowing for stock prices to rise, even when earnings don’t, and allowing deflation to take hold where only the largest companies that scale the fastest and the largest by acquiring other smaller assets in their respective industries, and, then, achieving the lowest prices and downward wage pressures from less competition, can survive, and, on the consumer side, allowing for (or causing) the cost of shelter to detach from incomes. With that understanding, legislators must create new federal legislation to maximize more long-term sustainable growth without the constant risk of asset bubbles followed by asset crashes from the Fed tightening on monetary policy to control asset and credit bubbles, while, otherwise, preferring to keep rates low to encourage economic expansion. New legislation should include changes to the Fed’s mandates, and changes to the Fed’s policies, tools, and the Fed’s standards of measurements of economic risks from low interest rates and liquidity (such as wage inflation, which may be slow to come, if ever, even as assets grow out of control), and changes to bank regulations; or else we have to understand the underlying economic reasons for the shift, and, if the shift is deemed to be a net-negative evolution of our economy, attempt to use legislation and regulations to have the root causes of the shift minimized or reversed by creating changes to investor, borrower, and bank incentives, and to make structural changes to the economy.



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