Politics and markets collide

Political economy, once considered an interesting academic aside, is now front and centre in investment thinking. Decades of ideology masquerading as economic truism have resulted in the predictable polarisation of wealth, and that is now starting to become an unavoidable fact in anticipating the direction of markets. Even the investment bank Morgan Stanley is starting to think of the consequences (must be a little strange, investment banks thinking of consequences). Gerard Minack is arguing that politics is now becoming crucial (“intrusive” he calls it):

Politics seems set to be a more intrusive factor for investors in developed markets. This would represent a major reversal from the trend of the past 20-30 years. Politics seems set to become a bigger factor for investors for a number of reasons:

First, policy makers usually take centre stage in periods of macro stress, and they remain central figures in the extended unwind of the credit super cycle.

Second, and more importantly, the government has moved from being part of the solution – typically, policy makers aim to remedy a cycle problem in the private sector – to being part of the structural problem. As is well known, public sector finances in the developed world are on an unsustainable path, something now reflected in rising stress in sovereign markets.

Third, the Great Recession and the trend increase in income inequality may put a question mark over the 20-30 year shift to laissez-faire policies (particularly in financial markets), and the perceived benefits of globalisation. Deregulation and globalisation were two of the fundamental supports for the long bull market in developed world equities that started in the early 1980s. (The fundamental improvements led to strong trend increase in earnings. The credit super cycle led to a trend increase in valuations. Combined, these factors led to the extraordinary bull market in risk assets – particularly DM equities – that started in the early 1980s.)

It is an interesting situation, because for a long time politicians in developed economies have done two things, each cowardly. They have washed their hands of any attempts to influence markets, because that would be “picking winners” and against the prevailing neo-liberal orthodoxy which says that governments should not “intrude” on the purity of market forces. And then, lacking any vision, they have concentrated on fear as a means of winning elections. The first has been a disaster of regulatory omission that has resulted in the GFC (and possibly GFCs). The second does not augur well for showing any decent direction in markets or social outcomes. This we have the fear driven band aid non-solutions in Europe and the complete failure to bring the banksters to book in America because of the fear they were too big to fail.

So Minack is probably right when he is downgrading developed market equities, although perhaps not for the right reasons. The cycle of the financial system and corporates benefitting from government largesse or collusion has reached its end:

It is not clear how these changes will play out. But it seems likely that politics will become a more important factor for investors. This prospect is another factor that may contribute to a trend de-rating in DM equities.

The particular danger for equity investors is that corporates appear to have been the principal beneficiary of the structural changes of the past 20-30 years. Income to labour has fallen as a share of GDP in most developed economies. This is the flip-side of rising profit share of GDP (that is, profit growth persistently out-stripping GDP growth).

Moreover, not only has labour incomes been squeezed as a share of GDP, but inequality has also increased. Exhibit 1 shows median household income in the US (in constant dollars) by income levels. It seems that globalisation and the use of more cheap Asian labour has depressed returns to relatively unskilled labour in the developed economies.

The second trend is that while wage income was stagnating, voters were counting on the largesse of government to provide another offset. Governments in many developed economies were committing to providing social benefits – notably health and retirement support – that lie behind the structural fiscal black hole. Exhibit 2 shows the IMF’s estimate of the cost of health care and ageing.

Although difficult to quantify, it seems plausible that these two trends took the political sting out of the weak, and increasingly unequal, benefits to labour seen over the past 20 years. The forward looking point is that these two emollients have now proven to be unsustainable. Moreover, the poor macro outlook – lacklustre growth or perhaps recession in the developed economies – is likely to exacerbate pressure on the political leadership to address this income shortfall.

Effectively, policy makers in developed economies are now hemmed in by market pressure to fix the unsustainable fiscal pressure, at a time when political heat may increase from the weak income growth of the median household/voter.

As we have seen in the periphery of Europe, financial austerity is not popular. A long-term study of the political response to austerity confirms that instability increases with public sector cutbacks. Exhibit 3 shows the incidence of political problems (measured as average number of incidents per year per country) tends to rise in fiscal austerity.

No longer are we just governed by markets, it seems. Trouble is, it does not seem we are governed at all.

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Comments

  1. Nice macro view.

    Morgan Stanley, like all investment banks need to be viewed by what they do and not by what they say. Reading many ASX stock reports shows how MS act in the market.

    Governments claim to know all mostly and what’s good for us, but as we see more and more by failing to liaise effectively and just stumbling with badly thought out policies to stay in power is a net loss for us all.

    The system is broken, and I’d like to know how it can be fixed, as faith in political parties of all forms is on the decline.

    Thanks for the post.

  2. Is it now considered acceptable to suggest that governments should be picking winners and engaging in industry policy ?

    I thought the collapse of socialism settled that matter once and for all.

    Centrally planned manufacturing, infrastructure, agriculture and military industries saw waves of failure resulting in crumbling industries, widespread famines and mass poverty.

    Trust me, we don’t need political leaders with vision… if they had real vision and a sense of how markets work, then they wouldn’t be politicians, they would be entrepreneurs in the private sector.

    • +100 Jono – “Trust me, we don’t need political leaders with vision… if they had real vision and a sense of how markets work, then they wouldn’t be politicians, they would be entrepreneurs in the private sector.”

      Totally agree with this comment.

      • Yeah, but no, but yeah, but no…

        What we need is a political system which actually encourages people with vision to get involved and make the country a better place.

        Obviously the financial rewards/sacrifices is a stumbling block. As is Australia’s “tall poppy” mentality — why leave myself open to all the low-brow public scrutiny and mud-slinging (case in practice: Malcolm Turnbull) when I can simply retire and/or continue to play in private space?

        For all its shortcomings, the US is brilliant at encouraging its smartest and most creative to participate in the public system — whether as a stepping-stone to plum private jobs, or as a means to “give back” once you’ve succeeded in corporate world.

  3. While there has been a stampede to disavow “markets”, the fact is that the only part of the world economy that has any chance of sustained growth from here, are the Southern and Heartland States of the USA which did not have a property bubble, thanks to true free markets in urban development, including at the urban fringe. Low taxes, “small government”, and employment law that does not penalise the employer, obviously helps too.

    It is entirely appropriate that the Governor of Texas, Rick Perry, should feel 100% certain that he has a mission to save the USA by applying “the Texas miracle” to the whole. I find it sickening that “free markets” are blamed for a systemic problem that was only averted by that part of the world that actually did still have something closest to free markets in those areas that count the most; especially urban land.

    The monster, cancer “finance sector” that has swallowed a bigger and bigger share of total profits made in the economy, just happens to the the biggest successful rent-seeker riding on regulatory, fiscal and political DISTORTIONS to free markets.

    • Absolutely right. But you wouldn’t argue the banks didn’t playa a role in that as well as would you?

      Glass-Steagall worked for a long time before it was trashed.

      We don’t no politicians. We need politicians that can create a context of sustainable rules so that liberalism can flouirsh.

      • I think we agree. All I am saying is, every regulatory distortion, eg urban growth boundaries, has “unintended consequences” that pro regulation, anti free market people will NEVER blame on the regulations. They MIGHT blame the rent seekers who cashed in on the opportunities created by the distortions.

        I think far too much blame has been put on financial INSTRUMENTS per se, when the real problem was a failure to price risk accurately. If the great mass of investors decided that there was “no risk of serious disasters”, and over-invested in insurance underwriting, that would not make insurance under-writing something wrong or destructive. Mortgage backed securities and derivatives have nothing wrong with them either. “What went wrong” can be summed up in one sentence. “House prices never fall”.

        • There is a problem with the view that holds free markets are the solution to all the problems we have. And that problem is this. It was one of the most-free markets – the market for financial assets of all kinds, but especially for CDO’s and other quasi-fungible exotica – that mis-priced their inherent riskiness in such spectacular fashion and with such disastrous, globally-distributed consequences.

          There are problems with the way markets operate. This is not controversial. For example, markets tend to become highly concentrated (think about banking, insurance, retailing, brewing, iron-ore mining, publishing and broadcasting, the production of packaging materials, oil refining, glass-making and rail-freight in Australia, to name just some). Monopolized markets function in ways that are highly detrimental to their customers (usually consumers) as well as their suppliers (usually other businesses).

          There are numerous other examples of “market failure”. The siting, construction and operation of the Fukushima power station is one that comes readily to mind. The owner of the station, TEPCO, is a privately-owned utility. Yet they clearly did not make “the best” available choice about where to locate the station, how to design and construct it, or indeed whether to build one at all. Once again, the primary issues are the mis-evaluation of risk and the spill-over of costs arising from mistakes.

          The consequences of poor decisions by privately-owned businesses are felt by society as a whole, even though the wider population will generally have no direct pecuniary stake in the businesses involved.

          This is true of so many industries – banking and finance, insurance, food and drug manufacture, health-care, energy production and distribution, mining, transport, forestry, fisheries and agriculture, water supply, manufacturing, telecommunications, the media, to name only the most obvious – that it is just disingenuous to declare that “free markets” are some form of magic bullet.

          They are not. Private entities mis-price risks, shift costs (that is, dump their losses on others), manipulate prices, collude with competitors, deceive investors, coerce suppliers and customers, manipulate public officials, devour each other and conceal risks, all the while usually enjoying the benefits of limited liability.

          There is just no question that the public – who have to pay the bills when things go wrong – can claim a a common-welfare interest in the regulation of markets.

          The problem with the financial markets is that most of the players are just so huge they have the ability to cajole, co-opt, corrupt, coerce or consume even the most powerful elected officials. This is the real public policy issue – how to down-size the ubiquitous too-large-to-fail banks that now dominate the entire global economy.

  4. I do not agree with Gerard Minnack’s or SoN’s premise here at all.

    Politics have been extremely influential in the past 30 years even if the rhetoric says otherwise. Its bad regulation that has got us into this mess not lack of regulation. Add to that exemption from certain regulation for the bankster cronies of the pollies and you have the recipe for systemic failure. This is not something that is new.

    The reason no one can come up with any constructive solution is that all the powers that be in public and private enterprise are stuck in a system they created. The addict has to admit their addiction to start the road to recovery.

    • Agreed Deep T.

      The US govt in particular has a long history of bailouts even before the current crisis. Their bail out of the airline industry was only a decade ago yet it was already forgotten, not to mention the bailouts of various companies and industries in prior decades.

      Regulation in the US has been massively corrupted, and a lot of the “innovations” in financial markets can be linked back to govt intervention (ie sub-prime mortgages being rolled into RMBS was a result of the S&L bailout by the US Govt).

      We have been a bit better at it here, at least we allowed HIH to fail (though lately we have been following everyone else). HIH was a prime example of how failure can be a net benefit, esp when it comes to regulation (as much as APRA gets bagged on here, it is miles better now than it was before HIH).

    • I can agree with this comment, because it reflects a noticeable shift in the Western world away from competitive and open free markets towards crony capitalism where large industries form powerful lobby groups and have huge sway over thousands of pieces of legislation, which acts to regulate away any threats of competition.

      Licensing and mandatory standards are used to crush small competitors and to entrench a large businesses position in the market.

    • Awesome post Deep T…that is why I am hoping for a major recession and clean out of the financial and political elite. Nothing short of this will purge what needs to be purged.

      • You are way too optimistic – nothing will get purged until people power overcomes the money power.

      • Agree Stavros its the hard time where the gains are made to improve the future.

        I dissagree with Mavs comment about people power though. Given the small size of australian voting blocks – particularly at state level people power is one of the causes of our current problems.

        Industries that inefficiently employ people receive huge political influence and support at the expense of others. High living standards (and workplace standards) can only be achieved by efficient utilisation of labour.

        Forestry 40 years ago employed thousands of individual fellers and operators in high danger environments and received huge political support at all levels. Today with a high level of automation the industry is a pariah.

        The agriculture industry has enormous political power due to high employment. Because of that influence efficiency gains have only been made when the waste became overtly excessive, the wool stockpile for example.

  5. Minack must be pulling our collective legs with his comment….

    “Second, and more importantly, the government has moved from being part of the solution – typically, policy makers aim to remedy a cycle problem in the private sector – to being part of the structural problem. As is well known, public sector finances in the developed world are on an unsustainable path, something now reflected in rising stress in sovereign markets.”

    Someone appears to have conveniently forgotten how a large component of the current problem with public sector finances in much of the developed world was recently and suddenly acquired?

    • +1. Also forgotten is that the unsustainability of US finances wouldn’t be such a problem if they taxed the top-end anywhere near what they tax the middle class.

      • Russell – see my below post. I think its fair to say the public debt being taken on was still a political failing…not a market failing.

        They made massive profits taking massive risks and then when those risks backfired, the Government came and saved the day.

        Do you think the banks woukld have taken those risks if they didnt think the Government was going to backstop them?

        The market players will always take a handout or bailout if its on offer – the onus is on politicians to be strong and refuse to intervene when companies go bust. Let the chips fall where they may

  6. Citigroup Inc. (C) and Bank of America Corp. (BAC) were the reigning champions of finance in 2006 as home prices peaked, leading the 10 biggest U.S. banks and brokerage firms to their best year ever with $104 billion of profits.

    By 2008, the housing market’s collapse forced those companies to take more than six times as much, $669 billion, in emergency loans from the U.S. Federal Reserve. The loans dwarfed the $160 billion in public bailouts the top 10 got from the U.S. Treasury, yet until now the full amounts have remained secret.

    http://www.bloomberg.com/news/2011-08-21/wall-street-aristocracy-got-1-2-trillion-in-fed-s-secret-loans.html

  7. This is turning into a good thread. I agree with most of what has been said. I do not believe for a moment, all this stuff about “systemic risk”. I think the finance sector needed some “toughlove”. Reagan would have told them where to go.

    I firmly believe that had they been OBLIGED to do so, Wall Street would have held an urgent summit conference and done what it took to save themselves. A few firms should have been let go, a few mergers and so on, lots of jobs pared and bonuses axed. They could have done it.

    “Systemic risk” was a bluff that stupid, preening, hubristic politicians fell for. No-one does more damage to the whole concept of free markets and free enterprise, than “crony capitalism”. Ayn Rand’s opinion about these people was far stronger than Karl Marx’s. Marx regarded them as useful idiots in provoking eventual glorious revolution in reaction. Ayn Rand said they should be hung.

    • This is history re-written to protect an archaic and endangered ideology. In 2008, at the height of the banking crisis, no bank could borrow from any other bank (and nor would any bank lend); even the most secure, financially-stable and risk-averse borrowers were being denied credit. Ultimately, for a few hours, the foreign exchange markets ceased to function because the banks would not accept each others promises in relation to settlement of their daily transactions. The global payments system basically ceased to exist and a calamitous contraction in trade instantly ensued. It is not an exaggeration to say the whole global economy was imperiled by the paralysis in the markets.

      There is this absurd idea that this should have been allowed to continue unchecked and that the resulting “purge” would have been in some way restorative; that the system would have sprung back to health, more vigorous than before.

      This is pure fantasy. To prevent wholesale economic catastrophe, the public sector had to rescue various parts of the banking system and guarantee the solvency of system. In the UK, where this was taken further than in most other places – their banking sector had become grossly engorged with lousy loans – the public sector will be weighed down for decades.

      Much against their will, but surely with the better interests of UK households and businesses in mind, the UK Government nationalized around half of a banking industry it did not want and cannot afford. This was the direct result of failed management by the owners of the banks involved, and of completely feeble supervision by the regulators.

      These events argue for more and better regulation, not less. They argue for the need to have many more and far smaller banks. They argue for the need for financially and administratively robust public sectors.