Agcapita Update

May 2011
Agcapita Update

“Everyone wants to live at the expense of the state. They

forget that the state lives at the expense of everyone”
- Frederic Bastiat
 
By virtue of more than a decade of low and often
negative real interest rates, rapid monetary growth
and emerging market currency pegs, the economies
of the developed world have been skewed towards
consumption rather than production. Unfortunately,
consumption is the destruction of capital - by definition
it represents the diversion of resources from productive
purposes. Both the private and public sectors have been
indulging in this protracted debt fuelled consumption
spree. Savings rates have plunged and fiscal deficits
have expanded.
 
To the increasing bafflement of the Keynesians, it has
been requiring a larger and larger amount of debt to
create each additional unit of GDP - on the order of $4
of incremental debt to less than $1 of incremental GDP.
Why? Because on average, we are incurring debts that
do not create offsetting cash generating assets. At some
point this type of trend must result in default - whether
outright or via the printing press.  
 
Surprisingly or perhaps not surprisingly, the governments
and central banks of the developed world (let’s continue
to call them non-profit maximizers or NPMs) seem intent
on continuing this trend as they desperately force feed
the markets consumption-oriented programs in place
of stagnating private sector demand. An interesting fact
is that for the last decade in the US, private sector job
growth effectively has been absent and virtually all net
job growth has been in government or state dependent
sectors. We are facing political as well as monetary
inflation.
 

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Agcapita Update (continued)
There are many (invariably of the Keynesian stripe)
who observe that money must be lent into existence
and due to deleveraging in the private sector we face
a deflationary environment.  Of course that ignores
that money can be simply spent into existence by
the state - a powerful inflationary mechanism when
the state represents well over 30% of the western
economies and central banks have thrown off the
last few vestiges of restraint and are willing to directly
monetize fiscal deficits.
 
In our current world I would argue it’s a relatively
trivial matter to bypass private sector borrowers
altogether and have government spending inject
newly printed money into the economy. The presence
of heavily leveraged and highly impaired asset classes
- commercial and residential real estate and many
banks to name a few - don’t act as an offsetting
deflationary force as Keynesians would have us
believe.  Inflation is not an aggregate phenomenon.  To reiterate, what western economies need is more
After being released into the economy by the state,
the newly created funds are simply avoiding past
“bubble” sectors and flowing into new and less
levered areas as is their wont.   Banks may not be
lending to homeowners but the state is spending
and this money is most certainly turning up in the
economy - commodities are just the most recent
manifestation of that process and will not be the last.
 
The problem arises that all state spending requires
that capital is first taken out of the hands of the
private sector via taxes, borrowing or inflation, then
deployed in typically loss-making (capital destroying)
activities. The net result is that while government
spending may appear to increase nominal GDP, this
spending and the attendant deficits are setting the
stage for much greater problems in the future.   By
preventing private sector savings from replenishing
the pool of capital our governments are going further
into debt to finance policies that at best can only
serve to pull future consumption into the present -
once again more consumption is not what the west
requires at this moment.
 
So what of the seemingly relentless rally in the equity
markets? Rather than indicating sound fundamentals
a nascent recovery in the western economies, I
believe we are simply witnessing the re-ignition of
bank intermediated speculative finance funded by
a wealth redistribution from savers to the financial
sector.   Of course the financial sector is a vocal
proponent of this process for in the words of George
Bernard Shaw “A government which robs Peter to
pay Paul can always depend on the support of Paul”
 
capital. There is no way to create capital other than
through savings and hard work - a message to which
western governments are reluctant to listen. Printing
money seems alluringly easy at first, but it does not
create capital, and worse, the inflation it creates
ultimately causes long lasting harm to the production
structure of the economy. To ask a rhetorical
question, what possible outcome does the Federal
Reserve expect by increasing the base money supply
(M0) of the world’s reserve currency 200% in 24
months - a stronger currency, low food and energy
prices, a robust economy?       
 
I believe that until the developed nations stop
engaging in capital destroying activities and our
capital base recovers, it will be difficult for sustained
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Agcapita Update (continued)
real growth to take place. A depleted and declining
capital pool, combined with enormous expansion of
the monetary base and negative real interest rates are
creating the ideal conditions for an extended period
of stagflation in the west.  With this backdrop in mind,
perhaps this is an appropriate time to engage in
some “what if” analysis.  west for investment returns?
 
NPMs have allowed vast amounts mispriced risk to
accumulate in the financial system and are eager
to foster more in the form of higher nominal prices
in real estate and equities.  Even if we assume a
small probability of the negative outcomes, given the
magnitude of the consequences, investors should
take the time to properly consider these risks.
 
For instance, imagine a world with more than 10%
inflation, minimal real growth in the west, $12/bushel
wheat and $175/barrel oil.  How does your portfolio
and standard of living fare in such a world?
– Are you holding a long duration portfolio of fixed
rate debt investments, particularly sovereign
credits?   
– Are you dependent on consumption growth in the
  
– Are commodities an input cost rather than a profit
centre for you?  
If the answer to these questions is yes imagine if
real growth were to decelerate in the west while
commodity prices/inflation accelerated - stagflation.
Sooner rather than later you should take a mental
walk through your portfolio - be objective and ask
yourself what investments benefit and what suffer in
the world I outlined above and to what degree? 
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