Trust & Growth

I read John Mauldin’s newsletters.  In the most recent one, he published what Dylan Grice said about trust in economics.  It reflects my own views, so I want to quote the the piece a little bit, and add my own thoughts.

Of the many elemental flaws in macroeconomic practice is the true observation that the economic variables in which we might be most interested happen to be those which lend themselves least to measurement. Thus, the statistics which we take for granted and band around freely with each other measuring such ostensibly simple concepts as inflation, wealth, capital and debt, in fact involve all sorts of hidden assumptions, short-cuts and qualifications. So many, indeed, as to render reliance on them without respect for their limitations a very dangerous thing to do. As an example, consider the damage caused by banks to themselves and others by mistaking price volatility (measurable) with risk (unmeasurable). Yet faith in false precision seems to us to be one of the many imperfections our species is cursed with.

 One such ‘unmeasurable’ increasingly occupying us here at Edelweiss is that upon which all economic activity is based: trust. Trust between individuals, between strangers, between organizations… trust in what people read, and even people’s trust in themselves. Let’s spend a few moments elaborating on this.
First, we must understand the profound importance of exchange. To do this, simply look around you. You might see a computer monitor, a coffee mug, a telephone, a radio, an iPad, a magazine, whatever it is.  Now ask yourself how much of that stuff you’d be able to make for yourself. The answer is almost certainly none. So where did it all come from? Strangers, basically. You don’t know them and they don’t know you. In fact virtually none of us know each other. Nevertheless, strangers somehow pooled their skills, their experience and their expertise so as to conceive, design, manufacture and distribute whatever you are looking at right now so that it could be right there right now. And what makes it possible for you to have it? Exchange. To be able to consume the skills of these strangers, you must sell yours.  Everyone enters into the same bargain on some level and in fact, the whole economy is nothing more than an anonymous labor exchange. Beholding the rich tapestry this exchange weaves and its bounty of accumulated capital, prosperity and civilization is a marvelous thing.
Trust is core to all economic activity.  You only want to act if you think you will not be cheated.  Poor societies are often characterized by a lack of trust, which hampers exchange, and hampers credit as well.  To the degree that you doubt that you will be rewarded for the fruits of your labor, you will face frictional costs in doing business, and you might reduce your business in areas that don’t seem to be worth the risk.
Lying & cheating raises the costs for businessmen, which leads them to reduce activity by spending effort on fraud prevention, or raise prices to cover costs from fraud.  That reduces total economic activity — as prices rise, quantity falls.
But there is another more pervasive way to reduce trust.  It is to move the economic goalposts by changing the value of money.  Why does the Fed think it is doing something good by manipulating interest rates?  First, most central bank governors have not done it well.  They ease far too much, and tighten far too little.  They don’t take away the punchbowl when needed, or to the degree needed when the party gets hopping.
The result is too much debt, and an eventual liquidity trap which we are now in, and which the present Fed intensifies.  From Grice:
So now we know we have a slightly better understanding of who pays: whoever is furthest away from the newly created money. And we have a better understanding of how they pay: through a reduction in their own spending power. The problem is that while they will be acutely aware of the reduction in their own spending power, they will be less aware of why their spending power has declined. So if they find groceries becoming more expensive they blame the retailers for raising prices; if they find petrol unaffordable, they blame the oil companies; if they find rents too expensive they blame landlords, and soon. So now we see the mechanism by which debasing money debases trust. The unaware victims of this accidental redistribution don’t know who the enemy is, so they create an enemy.
The actions of the Fed are not costless, they take purchasing power away from others.  Further, the Fed will find it exceptionally difficult to remove policy accommodation when the time comes to do so.  Why?
It is a constant that the more the Fed eases, the worse the adjustment is when the tightening comes.  This one will be a Lollapalooza.  I have often said that Fed tightening cycles end when something blows up.  But what happens if something significant blows up early in their tightening cycle, and inflation is still running hot?  Or that interest rates have risen enough that there is no way that the US Government can ever repay their debts?
This is the second aspect of trust.  What is my money worth?  Why do we have these worthless bureaucrats with bad economic theories trying to manipulate our actions, when they lead us into overindebtedness?  Yes, in the short-run it looked good, BUT WHO IS LOOKING OUT FOR THE LONG RUN! Where, pray tell, are the statesmen looking out for our long-term well-being?  Ron Paul has retired.  Tom Coburn acts in the shadows.  Rand Paul is new… is there anyone else thinking long-term?  I see little of it in DC, in either party.
Few want to take the political & economic pain necessary to reduce debts and liabilities that we will not be able to pay.  And as such, businessmen limit their activities, because they don’t see benefits to taking risk in an abnormal environment., and growth reduces.
As I said to a friend today:

We live in unusual times.  Long-term valuation measures are flashing red.  Some short-term measures are flashing green.  Marginal productivity of capital is declining, and so firms use excess cash and borrowing capacity to pay dividends and buy back stock, because profitable organic growth opportunities are few.  That is not a great environment to be long stock. 

Further harming the environment is the tight coupling of government policies on monetary policy and the deficit.  Thus, even with bonds, I’m playing it relatively safe.  To me, this is mostly a time to preserve capital.

Economic growth requires trust in society.  Without trust, there is no growth.  That means policies and laws have to be long-term & dependable.  When things change too much, economic actors slow down, because it takes time to work through change.  (And that’s another reason why the PPACA will be a job-killer, and slow down the economy.  It is too big, too complex, too burdensome — it was not designed to extend healthcare, but to destroy the relatively good pre-existing private system.)

I am not surprised that growth has slowed; I am surprised that markets are as high as they are.  When the Fed finally overreaches their abilities, we will painfully learn the governments and central banks are not omnipotent, and that they more often hinder our prosperity than not.