What do quantum mechanics and the theory of relativity have to do with global central bank policy? Years of aggressive central bank policies haven’t resulted in the type of accelerated global growth one might expect, so Brooks Ritchey, Senior Managing Director at K2 Advisors, Franklin Templeton Solutions, wonders if there is an alternate universe where that is in fact the case. He breaks down the role of monetary and fiscal policy in generating growth, and what investors need to think about when such policies aren’t delivering it.
J. Brooks Ritchey
Senior Managing Director at K2 Advisors, Franklin Templeton Solutions
The current and prevalent view among some modern theoretical physicists is that our universe is not the only universe, but rather there are many parallel or multi-verses that likely exist alongside or in tandem to ours. In the book The Hidden Reality: Parallel Universes and the Deep Laws of the Cosmos, author and physicist Brian Greene makes a compelling case for this remarkable possibility. Greene describes that “the mathematics underlying quantum mechanics … suggests that all possible outcomes happen, each inhabiting its own separate universe. If a quantum calculation predicts that a particle might be here, or it might be there, then in one universe it is here and in another it is there. And in each such universe, there’s a copy of you witnessing one or the other outcome, thinking—incorrectly—that your reality is the only reality. When you realize that quantum mechanics underlies all physical processes, from the fusing of atoms in the sun to the neural firings that constitute the stuff of thought, the far-reaching implications of the proposal become apparent. It says that there’s no such thing as a road untraveled.”
Bizarre. Greene goes on to describe that in addition to quantum theory, cosmological theory supports this freaky notion as well.
So what purpose the Cliff Notes lesson in theoretical quantum physics? It suggests that there could be a universe, maybe multiple among the multi-verses, where the outcome to all of the central banks’ quantitative easing efforts post-2008 has been sustained growth. One where the Federal Reserve’s (Fed’s) Keynesian plan has worked accordingly, GDP growth is firmly and organically established, and everyone is living happily ever after. Just next to that universe there may be another in which quantitative easing (QE) also worked to jump start the economy, but then an asteroid smashed into the northern plains of North America and all of humanity was destroyed—truly unsettling. Fortunately for us there has been no asteroid, however growth has not yet taken hold either—and that is decidedly unfortunate.
The Universe of Economic Growth—or Lack Thereof
According to statistics from the International Monetary Fund, the G20 in aggregate appeared to be growing at a respectable 3% in 2013, but when examining the developed world’s portion of that data, the “reality” that emerges is much less optimistic.1 The European Union (EU) grew 0.1% in 2013 and looks to be on a similar trajectory this year. The United Kingdom and United States saw growth of 1.7% and 2.2% respectively in 2013. Growth in France was near 0% and this year France, along with Japan and Germany, could be flirting with possible recessions.
Putting these statistics into perspective, despite the developed world having engaged in what is likely the most comprehensive monetary stimulation effort of the last 200 years, growth can best be described as middling. Without the fortunate shale revolution in the Northern Plains of the United States (and thankfully not the asteroid) growth there likely would be much lower, probably not much ahead of Europe today.
The good news about the universe in which we find ourselves, at least according to Modern Portfolio Theory, is that a truly diversified portfolio of uncorrelated and negatively correlated strategies/assets is still of value, in our view.2 Unsustainable fiscal and monetary imbalances often leave in their wake alpha capture potential—alpha being a measure of performance on a risk-adjusted basis—so we’ve got that going for us. The bad news is that there is no easy solution to the many problems and structural headwinds the developed economies of the world face, and without change I think our global economy could likely remain stuck in a long gray plod of disappointing economic growth for who knows how long … infinity???
Two Schools of Thought
Before we imagine a universe that provides a path out of this economic quagmire, let’s take a closer look at what got us here in the first place.
The arguments for QE and against QE can for the most part be distilled down to two very distinct schools of economic thought; schools that have served as the framework for the majority of modern economic and market theory taught in academia today. On one side we have Keynesian economics, theory based on the ideas of British economist John Maynard Keynes. On the other we have Austrian economics, based on the ideas of a collection of academics—some of whom were originally citizens of Austria-Hungary (no surprise). At the risk of over-simplifying what are without doubt two extremely deep and detailed theories, to help structure our discussion I thought I would attempt to summarize each:
In the simplest of terms (and we do mean simple), Keynesians argue that private sector business decisions may sometimes lead to inefficient outcomes, and therefore government intervention is occasionally needed to step in with active monetary policy actions. These actions may be coordinated by a central bank. Generally, the Keynesian view believes that spending is what drives economic growth, and that deficit spending in a recession can be offset via fiscal surpluses in an expansion (and therein lay the rub).
Simplifying even further, let’s consider Keynesian to be “the school of short-term economic planning.”
Austrian theory on the other hand argues for very limited government intervention in the economy, particularly in the area of money production. Indeed, the Austrian school believes that central bank manipulation of economic cycles with artificial stimulus does more long-term harm than good, ultimately creating bubbles and recessions that are far worse than would be experienced in a natural economic cycle. This then would be “the longer-term school.”
To summarize, the Austrian school suggests that markets are self-correcting mechanisms that follow fairly smooth cycles, and that it is better to let nature run its long-term course (so to speak) as opposed to intervening when things may be less than optimal (i.e., recession). Keynesians on the other hand believe economic cycles can be smoothed with tactical short-term government monetary intervention, and that fiscal policy may be modified occasionally to better guide market cycles. So which view is correct? Is it better to ease aggressively—and then ease some more when things are still not improved, or should the Fed simply remain on the sidelines and let the markets sort themselves out on their own? As they say, there are two sides to every story—and then there is the truth. Put differently, we do not live in an “ either-or” world (or should not anyway), and the optimal application of economic theory—in my humble opinion of course—probably lies somewhere in the middle of these two diametrically opposed views. Perhaps in some universe out there this utopian equilibrium has been established, but clearly not in ours—at least not yet.
In practice, Keynesian thinking has generally guided most of the Fed’s policy decisions post-World War II, and has certainly been front and center in the aftermath of the 2008 Lehman Brothers bankruptcy. Most would agree that the exceptional measures introduced by central banks around the world at that time―most decidedly Keynesian in nature―could be deemed appropriate in that they succeeded in restoring financial stability, while also preventing a full-blown global depression.
Subsequently, as the financial system stabilized, the justification for further QE became more rooted in the belief that such policies were again required to restore aggregate demand, particularly after the sharp economic downturn in 2009.
With each successive round of easing, however, the effectiveness of such policies in stimulating sustained growth is increasingly questioned, while the potential for longer-term negative consequences increases. Murmurs from the Austrian table in the back of the room begin to resonate.
So here we are with a global economics engine that has never really fully kicked back in, despite QE’s one through three, and now the policies of Japan’s Shinzō Abe and the ECB’s Mario Draghi dubbed “Abenomics” and “Draghinomics.” Where does it all end?
I do not presume to know more than those running the Fed in terms of economic policy making, however this of course does not preclude me from offering opinions on the matter.
While monetary weapons can be a good first step to remedying an economic crisis, they are clearly not enough on a standalone basis to return an economy to stability and growth. Monetary medicine cannot heal fiscal ailments in the areas of budgeting, regulation, taxation and related policies. To return any economy to stable and organic growth the aforementioned fiscal roadblocks need to be addressed—sounds Austrian I know (more likely I’m somewhere in the middle).
My concern is that there has been an almost total academic capture of the mechanism of the Fed and other central banks around the world by neo-Keynesian thinking and hence policymaking, while the executive and legislative branches of the government have turned a blind eye to the necessary reforms.
So while the plan has thus far worked brilliantly for Wall Street, what central bankers have succeeded in doing is preventing, or at least postponing, the hard choices and legislative actions necessary by our politicians to fully implement a sustainable and prosperous future for our children—and theirs.
When I allow my thoughts to run in these directions it can naturally be distressing at times. I remind myself then that I can only focus on the variables in my life that I can control, and among those are investment portfolio positioning. I often use a vehicle metaphor when discussing markets with friends and colleagues. When things are r“isk-on” it is okay to take the red convertible sports car for a lively jaunt. When things are “risk-off” perhaps the solid sedan is a better option.
Today I view the world as “risk-uncertain,” and in these instances I recommend the armored vehicle. That is a suitably diversified portfolio of alternative strategies, one that is focused on capital preservation and non-directionally driven market gains through strategic and tactical strategy allocations.
Alternative investments cover a varied set of asset classes and strategies that go beyond traditional stocks and bonds. Alternative investment asset classes include real estate, real assets (e.g., commodities, infrastructure) and private equity, while alternative strategies primarily consist of hedge strategies, including use of derivatives. Hedge strategies typically have the ability to utilize short positions (i.e., seeking to profit on a decline in value of an individual security or index) in contrast to traditional mutual fund strategies which typically permit only long positions.
I believe the prudence of such an approach to investment management is underscored given the current environment. That is unless you find a way into another universe.
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