Sunday 12 January 2020

Demystifying post-GFC economics; the problem with scarcity; interest rates; long political cycles; and the end of history

The post-GFC era has given rise to widespread investor confusion, as macroeconomic and market outcomes have deviated from the received economic wisdom about what 'ought' to have happened. Old hands have been particularly wrong footed, as their tried and true mental and financial models about how the world operates, which worked so well during 1980-2007, have failed them. Traditional monetary policy has stopped working, and many economies (e.g. Europe) have remained sluggish and unresponsive to very low, or even negative, interest rates. Low rates were supposed to stimulate investment and consumption, and yet both have remained weak. "Unprecedented" unconventional monetary stimulus (in quotation marks as very similar policies were tried - with similar results - in Japan during the 1990s) in the form of QE has been undertaken, but despite this vigorous 'money printing' which was expected by many to result in inflation, we have had disinflation bordering on deflation, with inflation stubbornly refusing to rise towards central bankers' 2% trend-rate goal.

Government deficits and debt-to-GDP have risen markedly, and yet long government bond rates have fallen precipitously, in many instances into negative territory - something many previously deemed impossible. Aren't the 'bond vigilantes' supposed to enforce fiscal discipline, and drive up interest rates as the credit-worthiness of governments declines? And despite the general sense of malaise, including often extended periods of weak growth, stock markets have continued to rise, defying widespread calls over the past decade for imminent doom.

Bonds and stocks were also supposed to move in opposite directions, as falling rates signalled deteriorating growth, which was good for bonds but bad for stocks, and vice versa. Many traditional 60/40 stock-bond portfolios are structured on this basis, due to the putative diversification benefits that derive therefrom. And yet stock prices have risen even as bond yields have fallen. Some have concluded from this that 'the bond and stock markets are telegraphing very different messages' (i.e. the stock market that growth is strong and improving; bond markets that it is weak and deteriorating), when in reality they may well be telegraphing a third common variable that has been missed. And more than anything else, there has generally been a pervasive sense of ill-ease; that something is amiss; that surely the Fed and other central banks are singularly to blame; and that unintended negative consequences inevitably await.

So what's going on here, and why has everyone got it so wrong? If you don't understand something, its invariably because you are looking at reality through a false prism, and there is something wrong with the mental models you are using to interpret reality. What has happened is that a lot of investors - many of whom pride themselves of being independent thinkers - have unwittingly accepted a lot of conventional economic wisdom uncritically, without thinking more deeply about what might be happening. The process calls to mind Keynes' famous quote: "Practical men who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist". And instead of going through the laborious and uncomfortable process of reexamining long-held beliefs, most of these investors have instead contented themselves with simply blaming the Fed, while preparing for the inevitable doom that surely awaits.

I have been giving these issues a lot of thought over the past decade, and I have reached a very different conclusion about what is happening. While the intellectual influences that have contributed to the perspective I outlined below are diverse, and a lot of it are also my own original insights, the Japanese economist Richard Koo has probably contributed more to the development of my thinking of these issues than any other singular source (I highly recommend his book The Holy Grail of Macroeconomics; Dumas' book Bill From the China Shop was also highly influential to me when I read it in 2008). With the mental models I am currently using, which I hope to outline below, there is nothing at all surprising or unusual about what we are currently seeing; indeed, it is exactly what we ought to expect. Some potential/speculative futures are discussed towards the end of the article.

The problem with scarcity

Traditional economics is premised on the fundamental notion of scarcity. This extends to both the consumptive and investment realms, where: (1) consumer wants are considered infinite and always in excess of the financial resources of consumers (which in turn reflect resource constraints in the real economy), requiring those wants be rationed down to the highest priorities; and (2) businesses always have a larger number of investment projects they would like to undertake than the available supply of funding, which requires capital be rationed (which in turn ensures capital has an appreciable cost).

When these criteria are met, traditional monetary policy (and a lot of traditional economic theory) works just fine (and continues to work today in most of the emerging world). If the economy is sluggish, the central bank can lower rates, making access to capital more affordable, and because access to capital was previously a constraining factor holding back demand, the release of this constraint will boost the economy. When rates fall, consumers are able to borrow at more affordable rates to finance their (now slightly less) constrained consumptive desires, while businesses' access to affordable capital rises, allowing them to finance more investment projects, and quicker. Both investment and consumption can therefore be reasonably expected to rise if the cost of capital is lowered (particularly because investment is also linked to the level of consumptive demand - higher consumptive demand requires additional supply-side investment/capacity to meet that demand).

However, if this increase in demand exceeds the ability of the real economy to supply it, inflation will occur. This is what is known as 'overheating'. If the economy is at risk of overheating (or is overheating), the central bank can rotate the stimulatory dial back down, making capital more costly. Businesses are then forced to defer investment activity (typically by paying down debt and steadily accumulating retained earnings from operating cash flow, until they are able to afford to invest in those new projects from internal savings), while consumers are forced to defer debt-fuelled consumption for the same reason, and perhaps pay down debt accumulated in the past cycle as well. Aggregate demand cools, slowing the economy and reducing inflationary pressures (the Philip's Curve works for this reason). The central bank can then loosen rates once again, and the cycle continues.

Aside from central bank intervention, free market interest rates are also expected to behave in a similar fashion, and drive similar outcomes. If the supply of savings exceeds the demand to borrow those savings to consume and/or invest, aggregate demand will weaken, and interest rates will fall. This will lower the cost of capital, encouraging businesses to borrow to invest, and also encouraging investors to take more risk, as 'risk-free' rates of return decline. It also makes consumptive borrowing less costly for consumers, and encourages banks and other financial markets to supply more funds to such borrowers, as alternative high-return uses of capital moderate.

Aside from stimulating the greater use of aggregate savings on the demand side, traditional economics also argues that lower rates reduce the incentive to save, and therefore also act to reduce the aggregate supply of savings (and simultaneously increase consumption, on the basis that consumption is income less savings). Consequently, as rates fall, both the demand to utilise savings will increase and the supply of savings will decline, resulting in a shortage of savings that results in market interest rates rising. The same works in reverse, it is argued - as rates rise, demand for savings to finance investment/consumption declines, while the supply of savings rises as the incentive to save increase (also slowing consumption). This slows the economy (falling investment and consumption), and the growing excess of supply should lead to a decline in interest rates.

This model may seem superficially good and reasonable, but the problem is that the model assumes the existence of perpetual scarcity, which is an unsound assumption - particularly with respect to investment demand, and also the 'incentive force' on saving behaviour. More pointedly, underpinning this model is the assumption that the propensity to save will always fall short of the propensity to invest and/or borrow to consume, which implies that savings are always necessarily scarce, which is a fundamentally flawed assumption.

Keynes noted long ago the 'paradox of thrift' - for any one individual, saving is a good and prudent thing, but from a systemic point of view, saving subtracts demand from the economy, because one person's spending is another person's income. If everyone suddenly saved 50% of their income, the economy would collapse. In order for those savings to continue to circulate in the economy, they have to be used either to finance real capital investment by businesses (either via equity or debt financing), or they need to be borrowed and consumed by some combination of other consumers or the government. If such savings are not utilised, they will plunge the economy into a deflationary depression.

The assumption of perpetual scarcity is most sound with respect to the consumptive realm. Most people would indeed like to consume at rates significantly above their current level of consumption, but are unable to do so as they are fiscally constrained. However, even here, the assumption is imperfect and to some degree problematic. Firstly, the assumption breaks down at the individual level as somebody gets richer. No matter how rich you are, you can only drink one beer at a time, eat one meal at at time, and fly on one jet at a time. The definition of being rich (to me at least) is when you are 'making it faster than you can spend it'. You go away on an expensive vacation, and by the time you come back, you're investments have passively earned more than you have spent many times over. Wealth compounds but time does not. When rich people surpass this threshold, the assumption of scarcity-constrained consumption breaks down, because past this point, they cannot help but save more and more money (unless and until it is donated to charity).

In economic parlance, the 'marginal propensity to consume' declines precipitously as income and wealth accumulates. Furthermore, the demand for consumption-related debt from the affluent also disappears. If you're already rich, why would you need or want to borrow money to finance consumption? This can have systemic (and political) consequences when income and wealth inequality increases materially, as it has in the developed world over the past 40 years (more on this later). It can easily end up resulting in a situation where those who would like to consume more don't have the money, and those that have the money do not want to consume more. Traditional economic models pay absolutely no heed to these critically important 'distributional effects'.

In addition, the assumption that the median person can and will inevitably borrow more and save less as interest rates fall (the latter due to a 'reduced incentive to save') contains within it many flaws. For a start, debt needs to be paid back (or at least people can't sustainably go deeper into debt or be allowed by banks to carry negative equity to their death bed), and more importantly, most people aspire to retire at circa 65 and enjoy 20 years or more of retirement, and are therefore desirous of accumulating retirement savings (as well as enjoying a debt-free retirement), to fund not only living costs, but the likelihood of escalating healthcare costs/needs as they age.

While the traditional model may well work for those in early adulthood, those in the latter half of adulthood are likely to seek to accumulate savings and reduce debt (at least the sort not backed by assets, such as investment property), regardless of the level of interest rates. Indeed, falling rates make it harder to accumulate savings for retirement, by both reducing the benefits of compound interest during the accumulation phase, and reducing the level of investment income generated by a given amount of previously accumulated savings during the distribution phase, requiring a larger nest egg be accumulated in the first place. Low interest rates could therefore just as reasonably be expected to increase savings rather than decrease them.

The model that lower rates decreases the incentive to save (and vice versa) therefore ignores real world realities - people do not live forever, and need to save for retirement and time-shift their consumption, and they need to do this regardless of prevailing interest rates. And demographic considerations - where a long period of falling birth rates result in the median age moving into the late 40s or above - could reasonably be expected to result in a significant increase in the propensity to save and decreased propensity to borrow and spend that is noticeable at the aggregate level.

The degree to which these dynamics are not understood by people that should know a lot better is as astounding as it is disappointing. In the post GFC era, we have heard repeated claims from central banks and policymakers around the world that 'banks are not lending' in response to stagnant or declining consumer debt. It has always been assumed that this is because the banks lack the capacity to lend (inadequate capital or liquidity), or because they are being excessively risk averse (to some extent true after the trauma of the GFC, but not to the extent claimed). The assumption that a lack of supply of funds has been the source of the problem has laid behind a lot of central bank policies designed to boost bank liquidity. However, no thought has been given to the situation where a lack of demand for credit may be the primary issue - consumers may simply have no desire to borrow money and go further into debt, while the rich have already maximised their consumptive desires and have no need or desire to borrow. In other words, contrary to policymaker belief, there is no scarcity of supply of borrowable funds - there is actually a lack of demand.

However, the most significant problem with the scarcity model is how it pertains to business investment. Real capital investment (distinct from secondary portfolio investment, where one investor merely exchanges cash for stock, and the vendor stock for cash, which results in no net cash absorption) does not take place in a vacuum; instead, businesses invest capital only where they see an economic reason to do so - particularly in countries like the US where companies are generally run with a focus on RoE and shareholder value maximisation. In such countries, companies will not borrow money to make additional investments/add capacity - even at very low rates - unless there is a compelling business rationale. If not, they will just use excess FCF to pay dividends/buy back stock. After all, if your existing factories are only operating at 70% utilisation, why one earth would you want to build a new one?

This can easily result in a situation where growth in consumption is weak due to growing inequality, demographic factors and consumers savings for retirement, which leads to a reduced need for further corporate investment, regardless of interest rates or the availability of funding. In other words, access to finance ceases to be the constraining factor; it is not that companies lack access to capital, but rather they do not have a sufficient number of worthwhile capital projects to invest in.

The causes for reduced demand for capital investment - particularly relative to to the growing availability of capital supply - actually runs a lot deeper than just this. Aside from the factors discussed above, the need for new capital investment is generally driven by three factors: (1) population growth; (2) the emergence of new technologies that are capital intensive to roll-out; and (3) the actual roll-out of #2.

Population growth is fairly self-evident. If population is growing either through natural increase or net migration, more of everything is needed. This will drive a certain degree of ongoing investment. It is no coincidence that economies with a lot of net migration (US, Australia, Canada, UK, etc) have performed 'better' than those without (in quotation marks because per capita statistics often tell a very different story), and that Japan has performed the worst, given the viciously and unprecedentedly negative demographics the country is facing. On a per capita basis, Japan has actually grown only slightly more slowly than Western peers over the past 30 years, but because it's population is shrinking, the excess of savings and the weakness in investment demand dynamics has been by far the most pronounced.

More interesting are #2-3, which can be thought of as comprising two axis on a 2D plane that drives investment cycles. In order to have a major capital investment cycle, there first needs to be the emergence of a new technology that is capable of providing a new product or service, or providing an existing product or service more efficiently (and which is also capital intensive to roll out). Secondly, you need to roll that technology out to reach a saturation point of the installed base, which depending on the technology, can often take many decades. This dynamic is best highlighted by way of example.

Let's say the railroad is invented. That's the invention. The next thing you need to do is take maximal advantage of this technology by rolling out railways across the country/world to the point where further penetration of the technology no longer adds any value and so is therefore not required. That requires a tremendous amount of capital investment, in steel production, locomotive production, and construction activity and the like, and it will take a very long time. However, at some point, you will reach a saturation point where you have built enough railways. At that point, the investment demand will revert to sustaining levels, unless a radical new technology capable of improving it arises. At that point, there would be another major investment cycle as obsoleted capital stock is replaced with upgraded capital stock.

Another example is air travel. Global RPKs are still growing at some 5% a year, aided by continuing growth in low-cost carriers and rising incomes in the developing world. This continues to drive the need to produce more planes to meet this demand. This trend will continue for a long time as emerging country consumers become richer. But at some point, no matter how rich you are, you don't want to do any more air travel. The constraining factor for many affluent people is no longer the cost of travel, but how much time they want/need to spend sitting in an uncomfortable seat at 40k feet being capitulated around the world at 900km/h. At some point, no matter what people's incomes, the demand for more investment air travel will stop. At this point, scarcity will cease to function. No more airports, Boeing factories, or net aircraft fleet investment will be required beyond sustaining requirements, unless there are major new innovations. If a new plane was invented, for instance, that was twice as fast and a half the cost (very doubtful this will occur), you would then need to retrofit the entire existing fleet, which would drive another significant investment cycle.

In short, if the pace of technological innovation slows down, there will be less need for major retrofitting capital investments, as saturation levels are reached. Today, we have some investment cycles in new technologies - notably in cloud computing infrastructure and associated implementations, as well as software development across a variety of fronts. Regulatory-driven investments into renewable energy is another source of capital demand/absorption (trying to colonise Mars also seems to be an excellent way to - shall we say - 'absorb a lot of capital'). However, in general, outside the world of software and ICT, the pace of technological development has rapidly decelerated - particularly in more capital-intensive fields - which has coincided with an increasing degree of saturation of developed-market material consumer wants (as oppose to services demand). Most consumers now have enough clothes, food, appliances, cars, and other toys.

Furthermore, technological innovation today is also increasingly making the material world more efficient, and contributing to the consumption of less resources. In the past, more was the order of the day. More cars. More clothes. More food. More stuff. Now, ICT and the rapid development in computing power is helping us to do more with less. The sharing economy improves resources utilisation, and IoT/AI will continue to drive radical enhancements in the efficiency of resource usage across a variety of industries. This is further contributing to savings outstripping investment demand.

Finally, one other thing that has been exacerbating the increase in total capital supply in an environment of declining demand/need for capital is rising life expectancies, which I blogged about here. While the thesis is hard for many people to accept, and encountered some scepticism, all you really have to do is consider how much capital Warren Buffet or Charlie Munger could have accumulated had they passed away aged 65, and compare how much they have actually accumulated at ages 85-95. Capital compounds geometrically, and when you combine increasing inequality with rising life expectancies, you increasingly have the capacity not only for very large fortunes to accumulate, but for the aggregate supply of savings/capital to mushroom alongside that fact (although in the case of Buffett, charitable donations are resulting in the recirculation of some of those funds). Buffett bemoans the lack of worthwhile places to allocate his US$130bn cash hoard, but his geometric accumulation of capital, along with many others, is a core reason why. There is increasingly simply too much capital/savings, and not enough worthwhile places to invest it. Many investors don't like to accept it, but the world does not owe you a high return on capital.

What it all adds up to is that capital scarcity has been declining, as the supply of savings has increased, while the demand for the use of those savings to finance investment and/or borrowing for consumption has fallen. In other words, savings have ceased to be scarce or a constraining factor holding back economic growth. There is no - and never has been - any guaranty savings/capital will always be scarce, and hence able to command a high return, and a lot of the confusion investors are experiencing gives way as soon as that reality is understood. Indeed, none other than Karl Marx once said that in the long run, interest rates would go to zero as the capitalists would run out of things to invest in, and at that point there would be no choice but to redistribute the capital. To some extent, he is right and that is what is happening and - irrespective of intermediate cycles and whether we have or have not already reached that point - will probably inevitably occur in the very long term, as the global population peaks, and we reach a technological plateau (although we are still a long way away from that point globally).

Some people believe in exponential technological progress. I'm more in the S-curve camp. This is because while the level of accumulated human knowledge and data continues to increase rapidly, the human capacity to absorb, assimilate and integrate that information - at the individual level - is finite and time constrained. The more we discover, the harder and longer it takes for people to discover meaningfully new insights. People cannot spend the first 60 years of there life learning all the prerequisites they need to make new discoveries. They need to make a living. We have already reached the point of radical specialisation, which introduces its own set of problems, as increasingly 'range', or combinatorial insights from multiple domains, is required for breakthroughs. Furthermore, 'science' can only take as so far, as we remain constrained by the laws of physics/nature. To the extent I am right about this, it seems inevitable that the long term sustainable rate of interest will trend towards zero in the long term (or even be negative, if savings remain in structural excess), although as I note below, there is ample capacity for volatility on the way through.

Making sense of what is happening

With the above context in mind, we can finally begin to find ready explanations for a lot of the phenomena that has confounded investors over the past decade which I referenced in my first three paragraphs. The above analysis makes reference to an excess of savings, but technically this claim is inaccurate, in the sense that - international imbalances aside - in the aggregate, net savings must equal investment (with net savings a composite of gross savings by some economic participants, less net borrowing by other economic participants, including most notably, governments). In other words, any gross savings in excess of investment demand must be dissipated by governments and/or consumers dissaving. Whether the propensity to save is tending to exceed the propensity to invest/borrow can only be inferred from the direction of interest rates, but the tendency of interest rates to continue to decline as debt levels rise, is strong evidence that excess savings is the push/causal factor; rising debt levels the outcome.

Because consumers have generally been reducing their debt burdens in the post-GFC years, and corporates have not needed to borrow to finance investment, it has generally fallen on the government to do the borrowing. In the absence of this 'borrower of last resort', the economy would enter a downward spiral leading eventually to depression. The latter would ultimately achieve the same thing - balancing net savings and investment - but through a much more painful route: crushing savings by hammering corporate profitability - a key source of savings - and mass unemployment, which thwarts consumers' ability to save, while forcing the government into deficit anyway by having their tax income crater. This is precisely what happened during the Great Depression.

Knowing this, it is easy to see why government bond rates have fallen even as government debt levels have risen. The answer is that most observers have misunderstood the direction of causality. The government is being forced into borrowing to absorb excess private sector net savings - just as it has had to do in Japan since the 1990s. This is why investors such as Kyle Bass, who don't understand this stuff, have been calling in vain for a government debt crisis in Japan for years and years to no avail. The push factor has been too much net savings - which has pushed down interest rates - and the 'pull' factor government borrowing to absorb those excess savings. Furthermore, even in the pre-GFC years, the prime mover of the debt/housing bubble was not consumers' desire to borrow, but instead the push factor of excessive global savings, which created huge demand for yield assets that had the effect of pushing down rates and promoting the relaxation of credit standards that induced people to borrow. The speculative appetite to borrow and buy houses only came later once the boom was well established.

In addition, QE does not have the same effect has 'helicopter money', but instead actually has the counterproductive effect of making the existing savings glut imbalance even worse (which highlights how extraordinarily ignorant central bankers are to the dynamics outlined above - they have completely misdiagnosed the problem). Helicopter money would be received by the average consumer and spent. It would stimulate aggregate demand, and would eventually be inflationary. However, QE doesn't operate this way; the CB instead purchases bonds off wealthy individuals, corporations, investment funds, and banks. The prior owners of these assets were either wealthy individuals who are already consuming at their maximum desired level, or the middle class (via investment funds) who are saving for retirement. These funds were therefore already in the 'investment' bucket, and therefore destined for reinvestment into other alternative financial assets, rather than reallocated to consumption, and the 'trickle down' effect has only been modest.

What happens with QE is that these entities wind up with a whole lot of newly minted cash instead of bonds. What they do with that cash is not spend it, but look for alternative investments. That has the effect of pushing down interest rates and driving up asset prices, and percentage cash allocations fall via the mechanism of the price of other assets going up, rather than absolute cash holdings going down (because when this cash is used to buy stocks or other assets off other investors, the cash simply moves to the vendor's account, in something of a pass the parcel as investors try to trade out cash for something more appetising), and ultimately the cash just ends up being held as excess reserves by banks, held on behalf of their customers. This is why QE has not been inflationary. In order to be inflationary, the funds would either have to be consumed, or used to fund real capital investment, but the latter will only happen if real capital investment is capital constrained, which is is not.

Access to capital had already ceased to be a constraining factor for economic growth, and that is why we have not seen more investment and inflation. Instead, US corporates have continued to return more and more capital to shareholders via buybacks - the exact opposite. US corporates literally have access to far more capital than they know what to do with. Most of the borrowing that has occurred and has been stimulated has gone to finance of M&A (notably via private equity), rather than finance new capital stock, which is the 'worst' type of increase in debt. The amplifying effect of QE on the excess supply of capital has, however, likely contributed meaningfully to the VC unicorn tech bubble, which has been a short term economic stimulus, but one with dubious long term durability.

Meanwhile, negative bond rates are also much easier to fathom when you understand the impact of QE in combination with negative short term policy rates, which we have seen in Europe. For reasons we have discussed, QE simply results in investors holding more cash, which results in banks ending up with excess reserves, as the said investors have to park the cash somewhere. When short rates are (for e.g.) -0.5%, banks have to pay the central bank 0.5% a year to hold the funds for them, which means they will look for any and all ways to 'get rid of the cash', in a sort of pass the parcel with other banks. If you have to pay -0.5% on excess deposits, and are desperately trying to get rid of cash, buying bonds at a -0.2% yield seems like a much less bad idea than it otherwise would.

Low but still positive long rates of say 0.2% also make a tonne of sense when you realise banks have a zero risk-weight on government bond holdings, and can fund those purchases at -0.5%, or at worst, 0.0%. They are doing that, however, because there is no consumer or business demand for credit capable of absorbing their excess cash reserves. They have no where else to put the money. Yet authorities continue to say, gee banks aren't lending - it must be because they don't have enough liquidity - so let's do more QE so banks have more funds they can lend. The end result is to massively exacerbate the excess of liquid savings looking for any sort of home possible.

This is how you end up with the environment we have seen: relatively weak growth in investment and consumptive demand; falling consumer debt; rising fiscal deficits and government debt burdens; falling interest rates; and rising asset prices. It's also how you end up with a breakdown in the historical inverse correlation in the performance between bonds and stocks - they are both going up as capital has ceased to be scarce and a precipitously falling cost of capital is driving up the price of everything. And the truth is, as high as asset prices have gone so far, it is not inconceivable that we could end up with the biggest asset bubble of all time the way things are going - eclipsing even the bubble (as I argued here). It seems to be a logical outcome should the current trajectory continue, as rates go to zero or below, and the huge excess of liquid savings desperately seeks out any and all sources of cash flow return, driving asset prices to the stratosphere.

This explains also why market have done so well, despite sluggish growth, and this being one of the most hated bull markets of all time. General expectations have been for an imminent economic fallout and major bear market for a decade now, as the unintended consequences of experimental monetary policy comes home to roost, and yet it hasn't happened. Many investors have suffered badly betting on disaster while stocks have risen and risen, and then risen some more. There is no euphoria (outside of certain spots in tech) - markets have gone up not because people are wildly bullish, but because investors have increasingly been dragged - kicking and screaming - into stocks as there has been no where else to obtain a reasonable return, as bond yields have plumbed new lows.

The end of history? How politics might alter the trajectory

Over the past decade, investors have failed to grasp the above dynamics, and in general have been awaiting an inevitable 'normalisation' of interest rates. Had they grasped the above, they would have realised that low rates were not merely reflecting central bank behaviour, but more structural forces, and were likely to have gone to zero regardless of central bank policies (although probably not negative). And the proof is in the pudding - rates that are 'too low' are supposed to lead to inflation, and they haven't, and if we don't have inflation, then it is hard to argue that rates are 'too low' (QE is a different question). Too low on what metric? Certainly not too low such that it has resulted in excessive demand for capital relative to its supply - that would have been inflationary (although, without doubt, QE has been a bad policy and has created more problems than it has solved).

Furthermore, investors would have been a lot more reluctant to hold a lot of cash; short stocks and bet on a crash; and short government bonds on called for a government debt crises, had they understood these dynamics. With the fundamental driver being a structural excess of savings, made worse by central bank policies, the likelihood of an equity and asset price bubble of unprecedented proportions, coupled with zero/negative interest rates, was far from impossible, while the likelihood of a spike in government bond rates and widespread government defaults was exceedingly remote.

However, one thing I have noted recently is that after a decade of being wrong, many investors are now finally coming around to the view that rates are going to be low forever right when some of the conditions that have underpinned the status quo are - for the first time in a decade - at risk of changing course. As usual, investors are behind the curve. Declaring that rates are set to remain forever low at this point (as opposed to it being merely possible/probable) seems to me to somewhat akin to Fukuyama's famously inaccurate call in the early 1990s that we had reached the 'end of history'.

While I do think the general trajectory of rates will be towards zero in the long run, much as has been the case in Japan to date, I think there is nevertheless a risk of intermediate periods of turmoil where rates do go meaningfully higher, driven by an escalation in inflation. However, the mechanism by which this might occur, and hence the source of the risk, seems poorly understood to investors, because it derives from the political rather than economic sphere, and will require a change in course.

It seems to me that a clue as to the potential fundamental chink in the armour of the 'low forever' thesis lies in something I referenced relatively early in the article: the fact that the vast majority of consumers are in fact still subject to scarcity and are under-consuming relative to the level at which they would prefer to, coupled with rising political trends towards populism. They may not want or be able to borrow more, but they would sure prefer to consume more, given the opportunity - particularly experiences (travel) and various other labour-intensive services.

Capitalism is great for driving innovation and efficient resource utilisation, but it has an important Achilles heel, which is that it tends towards increasingly extreme wealth inequality over time - a tendency which is only being exacerbated at present by trends in technology. Taken to a large enough extreme, wealth inequality will eventually crash the entire system, much as it did in 1929. Imagine, for instance, that Warren Buffet came to control close to 100% of national income and wealth (I always like to use an extreme example to highlight an immutable principle that continues to apply when scaled down to a more realistic level). Aggregate consumptive demand would collapse to virtually zero, and you'd have an unimaginably bad depression.

Capitalism is great for the supply-side of the economy, but a sustainably healthy demand-side requires that the level of income and wealth inequality not be allowed to become too extreme, lest consumers cannot afford to purchase goods supplied by the owners of capital. The supply-side determines the capacity of an economy to produce goods and services, but the demand-side determines the actual level of goods and services demanded and produced (up to the economy's capacity limit, demand creates supply in the economy, not the other way around, as the Austrian school of economists falsely believes). If those with all the money don't want to consume, and those that want to consume don't have the money, the economy will collapse. This fundamental limitation of free market capitalism is poorly understood by a lot of economic conservatives.

When wealth inequality reaches extreme levels, there are only three ways the imbalance can be resolved. The first is a 1929-32 type depression (wealth inequality last peaked in 1929) which wipes out all the banks and most companies and hits a giant reset button. The second is a swing to left wing economic policies (as opposed to centre left) that leads to a combination of income/wealth redistribution, improved bargaining power for labour, and eventually inflation; and the third - somewhat counter intuitively for many I'm sure - is a long period of negative interest rates. Any of these outcomes are theoretically possible. Without regulatory intervention, 2008 could easily have morphed into a #1 reset, but the actions of the authorities decisively ruled that option out. Instead, we have so far gone down the road of #3.

It is common to hear people argue that low/negative rates are exacerbating wealth inequality, but that is not in fact true. In the short term and on paper it may initially appear that way, as low rates induce asset prices to rise, but these rising asset prices reflect a fall in the prospective returns on capital, which in the long run is a negative for capital accumulation/compounding, and a negative real return on capital in the bond market actually acts as a de facto wealth tax, which is a form of redistribution (as wealth and income is transferred from wealthy bondholders to governments, who spend and redistribute money to the middle and lower income classes). If rates stay negative for a long time, a very substantial amount of wealth will be redistributed over time in this manner. In this respect, contrary to common perception, negative interest rates are actually part of the solution, rather than part of the problem.

However, while #1 seems very unlikely, and #3 appears the most likely to me, #2 is also possible, and the risks in that regard have risen meaningfully in the last few years, right when most investors are finally capitulating to the conclusion that rates are destined to remain low forever. We are already starting to witness a rise in populism, and although this has superficially been associated with 'right wing' populism, in actuality - as I discussed here - this mislabelling actually reflects an incipient inversion in the traditional left-right political spectrum.

In the past, the left was the party of the working classes/labour, and the right the party of business. However, in modern times, the left has been captured by the liberal, rich elite, and has let its focus drift to identity/minority issues, and the priorities of rich liberals including climate change, while abandoning its traditional mainstream working class voter base, which traditionally economically conservative parties have started to swoop in and capture. Trade barriers, and policies to restrict immigration to improve the bargaining power of labour, for instance, have traditionally been left wing policies, as they are good for labour and bad for capital/business. Ultimately, however, the label doesn't matter - it's the actual set of policies and their effects which are important.

However, while populism has only taken a mildly left turn to date (economically), there are no assurances it will stop there, and we could quite easily see a move much further to the left in coming years. Bernie Sanders and Elizabeth Warren, for instance - two leading Democratic contenders - have campaigned for radically higher taxes on the rich, including wealth taxes as high as 8% on billionaires, in the case of Sanders (Warren advocates for 3%). Jeremy Corbyn's UK's policy prescriptions were also more left wing than any prescription we have seen in the Anglo-sphere in quite some time. While none of these candidates have a critical mass of support yet, with populism on the rise the future trajectory of policy remains highly unpredictable.

Stepping back from the contemporary political fray, it seems to me the bigger picture, long term causal meta could well be this: right wing policies are good for supply but - in the long run - bad for demand (due to rising inequality), while left wing policies are bad for supply but - in the short run - good for demand. When you've had too much left wing policies, as was the case in the 1970s, you end up with a stagnant economy and high inflation. This gives rise to a desire for change amongst the electorate, which takes expression in ballot box outcomes. In the case of the late 1970s/early 1980s, discontent with the status quo resulted in the election of Thatcher and Reagan for this reason.

Initially, when policy swings to the right, it is good for growth; the rich get richer, sure, but the poor and middle classes also get richer. That is because in a stagnant economy with high inflation, underinvestment happens, and a lower cost of capital and more investment is desperately needed. There is too much demand and not enough supply. However, with right wing economic policies, after a long enough time, supply catches up and overtakes demand, at which point you start to see downward pressure on interest rates as the supply of compounding, reinvestable savings starts to outpace capital investment needs. Falling rates result in rising house prices and ultimately induce the middle class to go on a borrowing binge, and this continues - perhaps for 2-3 decades or more - until the middle class cannot afford to take on more debt (or no longer wish to do so). That point was reached in 2008 in the US/Europe, and is at/approaching that point in Australia at present.

After this point, a continuation of right wing economic policies results in the rich continuing to get richer, but now the poor and middle classes start to stagnate and get poorer. This happens as the deleterious effects of rising income inequality more than offset ongoing (slower) growth. This results in an inevitable rise in political tensions, as growing grass roots discontent leads to increasing desire for change. It also explains why today's elite is so unable to comprehend what is happening and why populism is rising - from their perspective things are great - never better. Their incomes and wealth continue to mushroom. But large parts of the population are getting left behind. It also explains why 'outsider' candidates such as Trump have found such appeal, as traditional candidates are all part of the elite - the rich who have been getting richer - and therefore have ceased to understand and represent a growing proportion of the electorate, or cater to their growing sense of malaise.

If my model is right (and it is admittedly still speculative and unproven at this point), it seems to me the next step in this long cycle would logically be for a swing back to the left, and in my view it has already started, as trade and immigration tensions have risen (which are policies designed to improve the bargaining power of domestic labour). As noted, an initial swing to the left is bad for supply but good for demand - particularly coming from a point of significant inequality - and in the initial stages of a swing left, the rich get poorer but the poor and middle class get richer, as wealth and income is redistributed from the rich to the poor. Furthermore, coming from a position of already sufficient/excess supply, a decline in trend-rate growth in supply does not manifest as an issue for some time, because there is already an output gap to exploit. However, if the swing to the left last long enough and goes far enough, you eventually get to the point where demand overtakes supply, and you end up with inflation, rising rates, and eventually stagflation. At this point, the rich get poorer, and the poor and middle class get poorer too. At this point, the populist impulse becomes to swing back to the right, and the process starts all over again.

We see these kinds of oscillations between left-wing and right-wing populism in South America all the time, where the cycles are much shorter. In the West, we have had a long 30-40 year swing to the right (economically), which is longer than the investment careers of most investors alive today, so people are ill-prepared for the consequences of any major systemically-important political shift, and are unlikely to envisage the potential consequences. Indeed, as Jacob Mitchell of Antipodes said recently in an interview, a whole generation of investors has been taught to 'ignore politics', but he noted that that perspective might increasingly be the wrong position to take in the future. I completely agree with him in principle (although how that its actioned, I'm not so sure). What also remains to be seen is whether the various structural factors tending towards lower rates, including the effect of technology, outweigh the economic effects of changing political policies. On that I do not know.

The mechanism that more left wing policies that are stimulatory to demand (and ultimately inflation) will likely take will probably be a combination of significantly higher fiscal spending, as well as a more aggressive push for higher taxes on the rich - particularly in the form of wealth taxes, which have been relatively rare tax to date. There is a very substantial and growing opportunity for politicians to campaign to the middle classes about the injustice of the current system and the need for radical redistribution, and surveys indicate that Millennials are a lot more pro socialism and anti capitalism than prior generations, and also own relatively little capital (and generally can't afford houses). People that don't own any capital are usually less supportive of capitalism than those that do.

In the US, free universal healthcare and free university education will probably be the initial volleys, including also potentially UBI. It is quite possible it does not stop there, however, until meaningfully negative economic outcomes manifest (which will likely take a while), as the dynamics of politics is such that one always needs to promise more/something different from the incumbent to get elected; the tendency towards entitlement-inflation therefore well entrenched for this reason.

One of the reasons productivity growth has slowed down in recent decades is that a larger and larger portion of the economy is being subsumed by less and less productive sectors, such as education and healthcare, where costs continue to mushroom. There is still rapid innovation and productivity growth happening in software and ICT, and to a lesser extent manufacturing, but the portion of the economy this encapsulates has become smaller. If the government continues to expand significantly in size; government deficits rise high enough; and wealth and other income taxes on the rich increase sufficiently, it is entirely conceivable we could end up in a world where a scarcity of capital returns, and inflation increases - as unlikely as that may now seem/feel (including to me). This is particularly the case as baby boomer's are now starting to retire, and so are starting to pass their point of peak savings activity in the lead up to their retirement years, while the fiscal burden of state-guaranteed pensions will also continue to escalate in coming years as well.

What ultimately ends up happening is anyone's guess. Predicting the long term outlook for interest rates is particularly difficult, as one scenario is redistribution via negative interest rates for an extended period of time, while the other is via inflation and radically higher rates - both opposite ends of the continuum! The former could also be expected - initially at least - to potentially lead to one of the biggest equity bubbles of all time (if not the biggest), while the latter could lead to asset price carnage even worse than the early 1970s.

I feel very fortunate that my investment approach does not rely on predicting macro outcomes such as these, or variables such as interest rates. I plan to keep doing what I always do - find stocks trading at low prices relative to their likely future distributable cash flow. A margin of safety, and low prices/rapid cash flow payback is always the best hedge against an uncertain future.