Field of Dreams Print E-mail







Field of Dreams

Spring has sprung here in the Colorado high country. April means heavy wet snow, warming temperatures, longer days, budding flowers and baseball. For many the start of baseball season is a boring non-event. To others it rekindles powerful memories. We recall the aromas of grass and oiled leather mitts. We can hear the chatter of boys we knew long ago speaking the language of the game and feel the sun on our faces. The crack of a wood bat, the pure colors of sunshine, green grass and chalk white lines set beneath a crystal blue sky. It is the stuff of dreams- at least for some.


In 1989 the movie Field of Dreams brought the book, Shoeless Joe Jackson Comes to Iowa to the big screen. If you are a fan you recall the storyline; Iowa farmer hears voices, plows under his corn crop in favor of a baseball diamond, sees ghosts playing ball on the field, kidnaps a famous writer and helps a country doctor time travel to realize a life long dream. You may wonder where all this is going, especially those not fans of our nation’s pastime. You may recall the words that haunted Kevin Costner in this flick, “If you build it he will come.” And if you remember the end of the movie cars are streaming to the non-descript ball field nestled in the corn. Costner’s character ditches the accepted economic wisdom of Iowa and goes “Supply Side”.


If You Build It They Will Buy


(How Supply Side Economics Contributed to the Financial Crisis)



It is no secret that I am a free market guy. I believe in Supply and Demand Curves and the concept of price equilibrium. When we mess with one variable the other two become distorted. I try to keep my politics and my economics separate. My goal is to examine the effects of policy manipulations on free markets and to look for hints of the future consequences. What I have learned of economics over 30 years is that the lag time between policy input and economic consequence is longer than most think. Consider that meaningful policy changes generally occur in response to historic events, things like wars, depressions and life altering technologies. The social structures that arise to promote such policy redirection take years to develop and implement. The distortions they bring to the free market are often not fully recognizable in the early stages and show themselves only after the rigors of several economic cycles of growth and recession. It has been my thought that the seeds of this economic quagmire were not planted in the new millennium, or the last decade, or with the dot com bubble; not with the failure of Long Term Capital Management, not even in the ‘90s. The seeds of this economic meltdown will be traced to the early 1980s. Remember my oft referenced quote attributed to Aristotle, “It is the sign of an educated mind to be able to entertain an idea without accepting it.”  All I ask is your consideration of this idea. You are not required to hear voices or see ghosts and no time travel is necessary. I will make every attempt to hack off Reagan Republicans and Clinton Democrats as near equally as possible.


Supply Side Economics gained its enduring hold on American capitalism during the Reagan administration. The Supply Side school of thought concluded that supply creates its own demand. To further develop the concept, supply-siders proposed that the key to economic growth rested in the production of goods and services and that demand was a secondary function of the prosperity created. Policy incentives targeted marginal and capital gains taxation and prompted the relaxation of regulations perceived to slow growth, investment and initiative. These ideas presented a fresh approach, trumpeted by the “Great Communicator”, one Ronald Reagan. The dark years of the seventies are best remembered for stagflation, an oil embargo, American hostages in Iran and a soft spoken President in a cardigan telling Americans to tone down their expectations and turn down their thermostats. The sting of a lost war was all too fresh.


The energy and optimism of the Reagan Revolution breathed new life into America and Americans. While many of the tax code modifications favored capital over labor Americans were prepared to believe that “a rising tide lifts all boats”, that tax cuts would produce increased revenue and that wealth creation for capital would make its way to labor and thus consumers. Among the most consequential shifts in policy was the promotion of open international trade that laid the groundwork of today’s globalization.  The long bull market in stocks from 1982 through the dot com craze of 2000 is a testament to the power of financial incentives, optimism and a very market friendly Federal Reserve.


Econ 101



The relationship between supply, demand and price is an expression of one of the most fundamental and yet important of capitalism’s economic laws. Notice I used the word laws, not theory, not hypothesis, but laws. A law is an immutable standard of truth. As with any law we may try to bend it to our will or break it if we wish to tempt fate and consequences. When we have a balance between the supply of a good and the demand for that good we achieve what econ texts refer to as price equilibrium. When supply outstrips demand equilibrium is lost and prices fall, reflecting the glut. This in a nutshell is the weakness inherent in supply side economic theory.


Economists know that incentives distort human behavior as we act in our own self interest. They also know that the introduction of policy incentives does not circumvent the laws of economics. When supply side incentives are introduced that lead to increased production there must be a corresponding increase in demand or prices will decline, taking profits lower. This relationship helps free market capitalism guard against the emergence of destructive and potentially deflationary “over production and over capacity”. Capitalism has wonderful self correcting mechanisms that maintain homeostasis when left undisturbed.


Supply side economic theory appeared a staggering success at the outset only to succumb to an ugly and prolonged relapse. The relapse presented as the “double dip” recessions of 1980 and 1981-1982. Paul Volker, the man credited with breaking the back of inflation in the ‘70s and early ‘80s with 20% Fed Funds rates was replaced by Alan Greenspan just in time for the big stock market crash of 1987. Following the cigar chomping legend was not an easy task. Many market participants were skeptical of Mr. Greenspan’s credentials. The new Chairman was most reluctant to begin his term with an intractable market crisis. Mr. Greenspan recognized the stock market collapse as an opportunity to make an historic policy shift of his own and stealthily introduced the “Greenspan put”. Massive liquidity and immediate interest rate cuts restored stock market wealth and masked emerging structural problems. To a nation that had become accustomed to crushing recessions and double digit unemployment, Mr. Greenspan’s policies were a welcome change from Mr. Volker’s tough love. Stocks rose 563% from their December 4, 1987 low through January 14, 2000. Unemployment would not exceed 7.8% during the new Chairman’s reign. The economy prospered, slowdowns were mild and corporate profits soared. Supply side economics had a staunch ally at the Federal Reserve.



Altering the Supply and Demand Curve



To continue to bend the laws of supply and demand in favor of price stability and profit it became necessary to manipulate one of the variables, to rig the game. From 1979 through 2001 monetary policy engaged in a general easing that took borrowing costs from over 20% to about 5%. This policy propped up prices and earnings in two ways. Producer’s borrowing costs fell, reducing input costs lowering profit thresholds. Second, the reduced borrowing costs allowed consumers to leverage their incomes, boosting demand while pushing prices higher. Thus the process began that would soften recessions, lower the bar for business “success”, help support prices/profits and largely contribute to overproduction and overcapacity. The seeds of the current crisis hit the dirt. Globalization, securitization and leverage would distort the relationships between supply, demand and asset prices in ways few envisioned or understood.




Bubbles in Supply, Demand and Asset Values



Supply side economic theory assumed that as production grew sufficient demand would follow to soak up supply. But as we have come to realize the American business model became far too dependent upon buying today and paying tomorrow. Stagnant income could not support the level of consumption needed to feed the ramped up supply. Corporations and consumers accumulated long term liabilities with a bet on continuing employment, stable income and a never ending supply of revolving credit. We “cash flowed” our lifestyles, giving into the consumer culture. Living beyond our means became part of the American dream.


Corporate and consumer credit became imbedded in American capitalism. When coupled with accommodative monetary and fiscal policy burgeoning credit helped propel consumption. This perpetuated the supply side model despite the inherent and worsening structural imbalances. It became clear in the 1990s that additional stimulation and input price controls would be needed to maintain the artificial price equilibrium.


The open trade policy that was secondary to tax incentives in supply side theory moved front and center. The techno-global revolution introduced digitized standardization. International modes of production became the rage. The relationship between labor and capital was irrevocably altered. Labor became a fungible and price sensitive commodity moving easily from the American rust belt to booming new factories in Asia and South America . When one remembers that labor accounts for about 70% of production costs outsourcing was a powerful tool of cost control. The techno-global revolution would prove to be a great leveler of wages that depressed the purchasing power of domestic consumers. In the international labor markets the laws of supply and demand held true. Digitization and millions upon millions of new workers hammered wages and job security here in the US . Meanwhile national companies became international and nation state economies became part of the global economy. Globalization helped move the means of production to the lowest cost provider and began a process that would undermine the purchasing power of America .


Input prices dropped with outsourcing. For international companies the input price component was improved, but at the expense of US purchasing power. To remedy this potentially limiting development the demand side of the equation needed another shot of adrenalin. Securitization of consumer debt provided a new multiplier for lenders. It also assured a new pool of credit to keep consumers buying up new supply from China, Brazil and India . Securitization turned lenders into servicing agents operating a new fangled money turnstile fueled not by banking deposits but by Wall Street. With the Shadow Banking system moving credit outside the domain of banking and the jurisdiction of federal regulations an explosion of credit and consumption powered supply side economics to even greater heights. Overproduction shifted off shore. Securitization and globalization combined to enhance the potential for a world wide catastrophe. Despite the growing signs of imbalance risks were minimized by markets, regulators, ratings companies and most importantly the Chairman of the Federal Reserve. Banks moved into the securitization game after fighting for and winning greater relaxation of Depression era regulations.      



Clinton’s Failure


(Supply Side Philosophy Invades Banking)



The repeal of the Glass-Steagall Act occurred on Bill’s watch. There was no gun to his head as apologists suggest. He was mostly a willing participant in the engineered prosperity of his time. Signing the Gramm-Leach-Bliley Act into law in 1999 contributed mightily to the demise of the American banking system. Bill opened the door for “too big to fail” financial institutions all too often funded with public deposits. Giant unmanageable institutions emerged with tentacles that reached into insurance, securities underwriting and off balance sheet investment vehicles that harbored enough risk to sink a nation and push the world to the brink of financial chaos.


The new global financial order with the Fed, regulators and ratings companies in tow took to the supply side model like penguins to water. Nation after nation followed America ’s lead. The trading imbalances brought about by levered American consumption of Asian produced goods created a massive transfer of wealth. US dollars piled up in current accounts in China, Japan and oil producing countries. These funds contributed to a downdraft on interest rates and helped shrink the perception of risk. In this environment American dollars were recycled back into the production/consumption machine in the form of asset backed securities. The producers engaged in vendor financing, betting along with American consumers that jobs would remain plentiful, purchasing power stable and the credit markets would continue to fuel this doomed business model. With Wall Street at the switch the money machine churned on and the securitization market took over. Banking’s futile attempt to stay in the game led to increasing risk taking off balance sheet. With the insulation of Glass-Steagall stripped away it was a mater of time before the wires of fractional reserve banking and leverage crossed to produce ruinous sudden combustion. 


Housing, the Final Straw



It is clear that supply side economic models overestimated the correlation between production and subsequent demand. To support the highly incented growth rate of supply it clearly became necessary to stimulate demand beyond sustainable levels. The straw that broke the consumer’s back arrived when homes became collateral for consumer lending and the catalyst for the last gasp of supply side economics. When domestic spending power had evaporated in a cloud of negative savings the next step in the death march took consumers to their own front doors.


The legacy of Chairman Greenspan will forever be diminished by his advocacy for exotic mortgages and derivatives. His devotion to unregulated markets and the wizardry of Wall Street quants will haunt him and those who survive him for many years. But the Chairman is far from alone in fomenting the housing disaster. Misguided and long standing policies that promoted home ownership as an entitlement combined with cheap money and securitized lending to destroy free market discipline. These policies worked to opposite ends.  If we assume that home prices are in part determined by the cost and availability of money and the income of prospective buyers it becomes clear how political motivations and monetary policy combined to both inflate and undermine this vital asset. Let’s look at the ill-advised political policy first. There was a desire to increase home ownership among those unable to attain it at market cost. While a kind gesture this policy was destined to disrupt the housing market. It introduced a segment of buyers whose income was well below the average of existing home owners. These buyers were stretching to jump into the appreciating market and therefore represented a population more likely to default. Next we must consider how cheap money and exotic mortgages including teaser ARMs ramped up demand in the ultimate of liquidity driven markets. We added less qualified and lower income buyers to the market while fueling higher prices. The answer among the supply side lenders was to offer more speculative forms of debt. The lessons of Minsky should hang on the wall of every financier. Lenders filled the gap between buyer qualifications and an inflating market with ever riskier mortgage products and slack credit analysis. The ultimate Ponzi scheme occurred at a mortgage lender near you.


Keynes To The Rescue?



Ben Bernanke has replaced Mr. Greenspan at the helm of the Federal Reserve. All that he promised in past speeches about how he would attack a 1930s style downturn is being delivered. He has dropped interest rates near zero and produced on quantitative easing, putting the Fed balance sheet to work in the credit markets. The fed has played most of the cards in its hand. After monetary policy and quantitative easing have been enacted the burden of rescue shifts to the policy makers and fiscal stimulus programs. The role of the stimulus program is to replace consumer and corporate demand. On the all important consumer side of the equation demand has fallen off due to jobs losses, tighter credit and higher savings. Consumers are suffering a hangover born of a decade or more of levering up to spend beyond their means. Balance sheet repair will mean spending less, saving more and paying down debt.  Keynes’ “paradox of thrift” speaks directly to this point. While reduced spending and increased savings may be beneficial to the individual balance sheet it is deleterious to the general population and to the supply side model. All signs point to more savings creating a bigger hole for fiscal stimulus to fill. Factory use rates are at 67%, levels last seen in the 1982 recession. This decline provides testament to the impact of the $1 trillion decline in output or supply. The economy is a freight train going in reverse. It must be slowed, stopped and redirected. The forces of economic inertia will take years to redirect. While Keynesian programs will offer short term help and soften the blow of recession only entrepreneurship and time will heal the gash in the fabric of the global economy. The $778 billion stimulus package is a Band-Aid. Pronouncements coming from the G-20 are much the same.


Purist or Pragmatist



A fly fishing buddy of mine once asked me on a day the fish weren’t biting,” Are you a purist or pragmatist?” The fish weren’t hitting our flies so the conversation turned to worms. In these economic times does a free market guy say its time for a little creative destruction or does he advocate pouring buckets of money into our floundering economy? In both fishing and economics pragmatism wins out. The world looks to America in a time of economic free fall for a game plan for recovery. The global consequence of a failure of leadership in a crisis of this magnitude is too grim to test. In deference to Mother Nature and the nature of capitalism sometimes you have to put a worm on the hook. It beats going hungry.


The bank bailout programs present similar choices but on a different stream. The toxic assets we hear so much about are pretty simple to understand. They are the product of over-supply. The creation of too much liquidity and too many exotic mortgages bound into too many derivatives revved up with too much leverage produced investments as near worthless as the empty houses that stand behind them. The Public Private Investment Plan designed to move this waste from bank balance sheets reveals the market weakness of these assets. When the government must offer 6:1 leverage in non-recourse loans with the taxpayer on the hook for most of the downside and private  investors looking at huge upside potential one must remember “the bigger the dowry the more homely the bride.” Finally the relaxation of “mark to market” takes us back in time to the days when these nasty assets sat in Special Investment Vehicles off bank balance sheets. There and then they could be marked at any level the bank wished to hang on them. Relaxing mark to market requirements changes nothing. In summary if I move a cow pie from one pasture to another it remains a cow pie.


Where Is the Investment World Headed?



There is no one on the planet who knows the precise answer to this question. Let’s look to the horizon for clues. Here are a few pointed out by Bill Gross of PIMCO. The world must de-leverage. Protectionism and mistrust will put globalization in neutral if not quite reverse. Transparency in markets, corporate books, banking and investments must occur to restore confidence and liquidity. Stricter regulation is coming.


Good rules define competition and make for fair play. Bad rules disrupt play and ruin any game. Congress will be making the rules. This certainly dampens my optimism. Slow growth, some commodity inflation and higher borrowing costs appear to be in our future.


Treasury markets are clearly a bubble waiting to pop. The Fed will reverse liquidity assistance and allow rates to rise as soon as a recovery takes firm hold. A second potential needle targeting the Treasury bubble is the dollar. If it declines significantly investors funding our stimulation will demand greater compensation for the risk. It is likely that too much has been made of the Chinese threats to sell Treasury and Agency securities. The same is true of their calls for an alternative to the buck as the world’s reserve currency. Certainly some diversification lies ahead for the world’s creditor nations. To be clear the Chinese own too many Treasury securities to abandon the market or to sell dollars. Both actions would harm their US holdings. As my late mom used to say,” Don’t cut off your nose to spite your face.” The Chinese would do well to heed that bit of advice. Not only do they need to protect their investment they need sound US dollars to help pay down the cost of their blunder into supply side economics. Someone has to buy all the cheap goods made in all those gleaming new factories by a few billion new capitalists. The political risk of social unrest is enormous for the Chinese government after the relocation of so many from farm to factory.   


For Love of the Game



At some point we may stop trying to manipulate the system for greater profit or smoother business cycles or greater home ownership or whatever the cause du jour.  We must expand our field of vision to include decades rather than years when evaluating the efficacy of policy. We must disconnect politics from economics. My love of country and capitalism breeds a strong reverence and accounts for my bullheaded determination as an entrepreneur. I ask no quarter and seek no bailout. I will survive on guts and brains if the Lord and markets deem it so. This is as it should be. I love this game.


  And for you baseball fans, Costner’s performance in For Love of the Game might just top his work in Bull Durham and Field of Dreams