CHAPTER 7

Zombification of the Economy ... Let’s Repeat

“Maybe it’s all part of a plan, I’ll just keep on making the same mistakes hoping that you’ll understand”

—Ed Sheeran

The vast majority of monetary policy mistakes come from denying structural issues or trying to solve those without addressing them.

Imagine a plumber that tries to fix a leak by painting the walls and trimming the garden. The house looks nice; the leak is still there.

Another of the monetary policy mistakes is to assume that recessions are caused by lack of liquidity and credit, and not by the excess of the past.

Imagine an alcoholic that goes to the doctor and says how terribly he feels sobering, and the doctor prescribes a dose of vodka and a few beers.

But it is not a joke.

The mantras repeated by consensus simply do not work.

“Devaluation boosts competitiveness and exports.”

With more than 20 central banks conducting beggar-thy-neighbor policies—trying to devalue their currencies to export more—global trade has stalled.

In the eurozone, exports stalled after rising when the euro was “too expensive,” as we show on Figure 7.1, just as devaluation policies were implemented.

It is clearly a global issue, driven by the increase in protectionist measures since 2008, led by antitrade policies of the United States, Russia, and China, among others, according to 2016 data from GIS. Stagnation in global trade, however, has stronger ramifications.

Figure 7.1 Euro area international trade before and since QE

Source: Eurostat.

Part of the increase in protectionist measures comes precisely from the mutual accusations of currency manipulation.

Even between countries that did not increase barriers to trade, exports did not improve due to weakening of the currency.

No country’s economy has ever collapsed due to a strong currency. Many have due to a weakening one.

Currency Wars. No One Wins

“Devaluation rarely helps the economy, but it can help investors”

—Matt Lynn

A currency war happens when the explicit policy of a country’s central bank is to devalue at any cost and its competitor nations follow the same strategy.

Devaluation. Looks like a great idea. Competitiveness “improves,” debt “disappears” as the currency in which it is denominated loses value, and everything starts again. Well, no.

Because the fundamentals of the economy do not change, and credibility of governments and the financial system collapses, destroying the economy. This pyramid scheme does not work without confidence.

Since 2010, most Asian and OECD central banks have engaged in some form of aggressive currency manipulation scheme: increasing money supply, selling currency, lowering interest rates, hoarding gold or U.S. dollars, and so forth.

In this race to zero, once you pop, there is no stop. It is estimated that since 2013 central banks have expanded their balance by 15 percent per annum.

Consequences of a currency war:

One effect of this currency war is the investors’ pursuit of yield at any cost to compensate for the fear of the loss of value of money. That is, less interest accepted for higher risk.

Unemployment does not improve, and work conditions worsen. It still amazes me to read that some people think that monetizing debt creates jobs.

Unemployment is reduced when economic activity recovers, when we see real productive private investment. When we create a monetary bubble, the effect is counterproductive, because money is invested in short-term financial assets and real investment falls.

Central banks will penalize investors for being conservative. But these, in turn, do not put money to work for 15 years, and less so in real assets, until they see a secure environment and growth opportunities. Money goes to the place that central banks are going to support until their final defeat: financial risky assets.

In the meantime, labor conditions weaken and real wages stall, sending the troubling signal of a level of unemployment that might appear low but where citizens struggle increasingly to make ends meet. The destruction of the middle class.¹

As there is less job security because businesses are unable to find a stable long-term environment, disposable income falls, because real salaries do not increase but taxes do.

“Currency devaluation is merely a transfer of wealth from all of a nation’s citizens to politically favored industries, usually export industries. It is no different from giving a subsidy to any domestic producer. The subsidy is paid by all the citizens of the subsidizing country, not by the foreigners who buy the subsidized good. They get a bargain.

Furthermore, devaluation does not make a nation more competitive. It does nothing to spur increased domestic saving or external capital investment, which lead to the increased application of capital per capita, the only sources of increased worker productivity and the only sources of increased real wages. Devaluation does not reveal the onerous, wealth-destroying effect of economic regulation, not does it reveal the true costs of the welfare state, which relies on high taxes to fund present consumption at the expense of future prosperity. What the state spends cannot be saved and invested, no matter how cheap the currency.”

—Patrick Barron

The main risk of widespread devaluation is global stagnation caused by the fall of productive investment and real disposable income.

How do investors profit from currency wars? Through energy commodities, physical gold, Bitcoin, and inflation-linked asset-backed securities. It is called the inflation hedge. Anything whose market value increases due to the weakening of the currency.

Cheap Money Calls for Cheap Debt

We have already seen that massive stimulus and low rates have not reduced debt. Total gross debt has continued to rise at a dangerous pace.

Because, when talking about debt, we must also analyze the quality of that debt.

There is nothing negative if a business or a country adds some leverage to conduct an investment that will generate a real economic return in the future. As some of those investments might fail due to unforeseen elements, the amount of debt taken must take into account the ability to repay it today, as well as the risks that the forecasted future revenues might be smaller.

The quality of debt is very important. Incurring into massive deficits to pay for current unproductive expenses means a higher burden in the future.

In my book, Life In The Financial Markets,² I mention the following items to understand the current danger:

The overindulgence of debt accumulation: The saturation threshold, destructive debt, and volatile cost of debt.

• The Threshold of Debt Saturation is the point at which an additional unit of debt does not generate economic growth, but simply causes further stagnation of the economy. This threshold was surpassed in the OECD, between 2005 and 2007.

• Destructive debt is the one generated by unproductive expenditure, which produces no positive effect on growth and perpetuates a system that confiscates and engulfs the real economy through taxes, detracting investment and annihilating consumption.

• Volatile cost of debt: As yields cannot be kept artificially low forever, we face the risk of debt shocks, because the outstanding debt increases while low yields are unsustainable.

“Cheap” debt tends to attract capital to low-productivity and short-term investments and leads to poor capital allocation.

If an investment is sound and in high-productivity sectors with strong value added, it will be profitable at a rate of 5 percent or 1 percent. Businesses that require high leverage and cheap rates tend to be extremely poor and risky. Furthermore, the constant push to “lend” because rates are low also leads to poor decision making. It is not a coincidence that the investments that thrive in credit booms are construction, real estate, ultra-leveraged bets, and short-term liquid financial assets. It is because they are the easiest sectors to deploy large sums of capital for a short-term profit.

The reality of the current environment is that, as the world has been approaching the limits of debt saturation, two things have happened.

First, recoveries are weaker (see Figure 7.2).

Second, overcapacity is perpetuated, as shown in Figure 7.3.

Without the cleansing factor of creative destruction in the excesses created in the economy, the burden of overcapacity takes hold of the economy and creates slack and lower growth. Even more importantly, overcapacity makes real productive investment stall, and the impact is felt in many areas of the economy.

For example, it is no coincidence that nonperforming loans have risen in European countries and Japan at the same time as liquidity and low interest rates took hold. Banks were unwilling to let companies go bankrupt and would help refinance any project they could in order to make it survive, thinking that maybe things would improve in a couple of years, or that lower interest rates would make the projects viable. None of the two things happened. But the other thing that did not happen was to let high-productivity sectors thrive.

Figure 7.2 The pace of recoveries since 1975

Source: The Wall Street Journal; OECD.

Figure 7.3 Capacity utilization in key economies

Source: World Bank; BIS.

The reality is that stimulus and government industrial plans are always directed at low-productivity, highly capital-intensive projects whose need is more than questionable. But these projects create “cheap and quick GDP” and give the impression of supporting jobs. Cheap debt multiplies that effect and at the same time erodes potential GDP.

Technology Does Not Kill Jobs

Meanwhile, mainstream media promotes the idea that technology kills jobs and that old economy industrial plans are what is needed, even though empirical evidence shows the contrary.

If technology destroyed jobs, there would be no jobs today, after the most dramatic evolution in technology seen at exponential pace in the past decades.

The evidence of more than 140 years shows that technology has created more jobs than it has destroyed. Study of census results in England and Wales since 1871 finds rise of machines has created jobs rather than making working humans obsolete.³

Technology helps create high-value-added jobs and at the same time destroys those that we do not want in the first place.⁴

Tax Burden Rises

But the mainstream message is oriented toward making us think that unemployment is due to globalization, world trade, technology, or any other force except the obvious: misallocation of capital into low-growth, poor return sectors and massive increase in taxation.

Country1	Total Tax wedge 2015	Annual change 2015/10 (in percentage points)2
		Tax wedge	Income tax	Employee SSC	Employer SSC3
	(1)	(2)	(3)	(4)	(5)
Belgium	55.3	–0.62	–0.47	0.02	–0.18
Austria	49.5	1.34	1.44	0.02	–0.12
Germany	49.4	0.39	0.39	0.00	0.00
Hungary	49.0	2.42	1.25	1.17	0.00
Italy	49.0	1.79	1.79	0.00	0.00
France	48.5	–1.44	0.86	0.79	–3.09
Finland	43.9	1.59	0.17	0.91	0.50
Czech Republic	42.8	0.62	0.62	0.00	0.00
Sweden	42.7	–0.05	–0.05	0.00	0.00
Slovenia	42.6	0.04	0.04	0.00	0.00
Portugal	42.1	4.93	4.93	0.00	0.00
Slovak Republic	41.3	3.43	0.81	–0.40	3.02
Spain	39.6	–0.19	–0.19	0.00	0.00
Greece	39.3	–0.81	1.44	–0.05	–2.19
Estonia	39.0	–1.06	0.16	–0.89	–0.33
Turkey	38.3	1.33	0.71	–0.11	0.73
Luxembourg	38.3	3.95	2.89	0.46	0.60
Norway	36.6	–0.65	–1.15	0.34	0.16
Denmark	36.4	0.04	–0.17	0.00	0.10
Netherlands	36.2	–1.91	0.52	–1.94	–0.49
Poland	34.7	1.78	0.55	–0.27	1.49
Iceland	34.0	0.66	1.78	–0.12	–0.99
Japan	32.2	1.99	0.00	1.01	0.99
United States	31.7	0.91	0.96	0.00	–0.04
Canada	31.6	1.21	0.49	0.29	0.44
United Kingdom	30.8	–1.76	–1.91	0.13	0.02
Australia	28.4	1.52	1.74	0.00	–0.22
Ireland	27.5	1.65	0.91	0.74	0.00
Switzerland	22.2	0.12	–0.23	0.18	0.18
Korea	21.9	1.75	0.83	0.51	0.41
Israel	21.6	0.84	0.30	–0.12	0.66
Mexico	19.7	3.74	3.75	0.00	0.00
New Zealand	17.6	0.57	0.57	0.00	0.00
Chile	7.0	0.00	0.00	0.00	0.00
OECD	35.9	0.89	0.76	0.08	0.05

Source: OECD Note: Single individual without children at the income level of the average worker.

¹ Countries ranked by decreasing total tax wedge.

² Due to rounding, the changes in tax wedge in column (2) may differ by one tenth of percentage point from the sum of columns (3)–(5). For Denmark, the Green Check (cash benefit) contributes to the difference as it is not included in columns (3)–(5).

³ Includes payroll taxes where applicable.

⁴ The statistical data for Israel are supplied by and under the responsibility of the relevant Israeli authorities. The use of such data by the OECD is without prejudice to the status of the Golan Heights, East Jerusalem, and Israeli settlements in the West Bank under the terms of international law.

This change in the tax burden is essential to understand microeconomic effects and why the models that assume increases in consumption from lower rates and higher liquidity have been so wrong.

Cost of Capital Rises

We have mentioned in chapter 1, and throughout the book, that overcapacity and uncertainty reduce the desire of companies to invest despite massive liquidity and low rates.

And we mentioned that cost of capital does not fall. We need to understand this.

A company decides to invest in a project when the expected return on invested capital (ROIC) is higher than the weighted average cost of capital (WACC). This means that the company is making an economic real return over its cost of running the business.

This WACC is the weighted average of the cost of debt—which falls with low rates and high liquidity—and the cost of equity. What is this cost of equity? A firm’s cost of equity represents the compensation the market demands in exchange for owning the asset and bearing the risk of ownership.⁵

Figure 7.4 Equity risk premia 1990–2016

Source: Citi; FactSet.

One of the things that has happened in this period of massive financial repression, and is a driving factor behind the decision of companies to invest less despite low interest rates, is that the cost of equity has soared driven by the Equity Risk Premium. See Figure 7.4.

What does this mean? That although debt is cheap, equity is at 50-year highs in risk. It is more expensive, and therefore, the weighted cost of capital has not fallen, it has risen.

How can the cost of equity rise with massive liquidity? Because investors globally understand that the company’s decision to invest one dollar of its cash in business growth is not attractive enough. Maybe the market does not understand overcapacity and tax burden, but understands that the likelihood of getting a positive return on new investments is poor, and that the risk is rising.

The reader might think this is simply a speculator’s measure and that historically investors always prefer companies to stay put than to invest and expand. But that is incorrect. Investors had historically rewarded sound expansion plans and ambitious growth projects. It is only since debt saturation was evident and becoming increasingly clear and stimulus plan after plan did not generate the expected growth that the market started to increase equity risk premia.

The reader might also think that this does not bother governments, who do not need to explain to investors in a General Shareholders’ Meeting if investments have generated profits. But governments have a similar risk, and it is embedded in their relative cost of debt compared to the lowest-risk asset. Bond yield premiums and access to markets. Even if the entire debt was monetized, currency devaluation and mass inflation are the “cost of equity” of poor capital allocation of governments. The difference is that in the case of countries, it is the citizens that pay for their leaders’ reckless actions.

Productive investment is not low relative to the solvent capital demand, but with respect to estimates of what is considered “normal” by mainstream economists and governments, which use as reference a bubble period.

The investment-to-savings ratio used by some central banks is fallacious because it ignores overcapacity, the level of indebtedness of the real economy, and technology, and above all because the “reference” was an abnormal period of excess.

Zombification of the economy. A weakening growth environment with a rising debt. The result: a massive amount of debt-financed, no-return spending that burdens and suffocates any productivity improvement.

Real negative rates destroy long-term investment and credit to the real economy, because they incentivize bubble-type short-term investment and investment in financial risky assets. Also the problems in the financial system rise as lending happens with rates disconnected with reality and real risk. Ken Garbade and Jamie McAndrews already alerted in 2012 of the negative effects of interest rates below zero.⁶

Low level of investment is not an anomaly; it is an evident and growing sign that overcapacity and excess debt are a global problem and that the real growth generated is very poor. Also, that “investment” without real economic profitability translates into white elephants (plans to build things simply for the sake of building), more taxes, and more debt. And the velocity of money collapses. The economy is zombified.

Governments do not have better information or better skills than the private sector to identify attractive investments. But they do have the incentive of spending without worrying about the consequences and receiving no real penalty for it.

It is one thing to use leverage to grow and another to add debt to maintain GDP artificially.

The multiplier effect of public spending is inexistent in open and indebted economies.⁷ Nobel laureate Angus Deaton names what is called the “Deaton paradox” which explains that the increase in public spending often generates the opposite effect. “Income shocks”—spending more—does not generate the desired “consumption shocks.” Because the tax increases and the uncertainty created by the funnel effect in the real economy attack the marginal propensity to consume.

If governments carry out a number of investments without real economic return using surplus resources, it would not be a serious problem, but the mainstream Keynesian economists who seem only to follow Lord Maynard Keynes when thinking of spending and never to save and lower taxes, should have tattooed the words “to finance with deficits only investments with real economic returns.”⁸

The world needs to recover supply-side policies, allow families and businesses to breathe, reduce taxes, and encourage productive investment by removing barriers to value-added sectors and eliminating subsidies to obsolete ones. But that does not provide photo opportunities or invitations to inaugurate bridges and airports.

Zombification. The engine of stagnation is to encourage wasteful spending and low-productivity investment in the hope that in the long run it will disguise itself. It confuses getting fat—sustaining GDP artificially—with getting stronger.

Repeating the same mistakes expecting different outcomes will not change this.

¹ 30 Facts That Prove The American Middle-Class Is Being Destroyed, Tyler Durden, Aug 21, 2014.

² Life In The Financial Markets. Daniel Lacalle, Wiley, 2014.

³ Deloitte, 2016. Stewart, Debapratim De, and Alex Cole.

⁴ www.theguardian.com/business/2015/aug/17/technology-created-more-jobs-than-destroyed-140-years-data-census

⁵ Investopedia.

⁶ If Interest Rates Go Negative ... Or, Be Careful What You Wish For, 2012.

⁷ Corsetti, Meier, and Müller, 2012, “Fiscal multipliers are negative in times of weakness in public finances.”

⁸ Collier and Brown “What Keynes Really Said About Deficit Spending.”