We are either at a four-decade opportunity to lock in rates at cycle high or at an inflection point where we have a full paradigm shift to a Schumpeter moment of creative destruction in economic policy via a government overreach.
Opportunity or destruction? Sounds like an easy choice, but the problem is that the opportunity is a function of a malfunctioning market and economic model built on state interventionism, whereas the Schumpeter creative destruction is the natural process of economic and social evolution.
We see three distinct scenarios with attached probabilities:
- Opportunity – the world has indeed reached peak policy rates (50%)
- Government overreach – ever-increasing intervention and regulation to keep the economy afloat under the old model (35%)
- Creative destruction (15%) - resetting the economy to market-based distribution, accepting full economic cycles
Based on real rates being too positive, we see a fallout from sectors and consumers with financing needs. Fallouts are already starting among green transformation companies such as offshore wind developers, as their projects’ economic value goes deep into the red under current interest rates.
The consumers may have spent their Covid savings and with the cost of credit cards, mortgages and cars at two times the historical average, they must slow down their spending.
There is also risk of a liquidity event as governments continue to issue debt at a speed which leaves traditional buyers of their credit bloated with underwater titles.
We see both an economic slowdown and a liquidity event as equally likely.
It’s kind of ironic to write about a government overreach as a future event as it is already happening. The amount of new regulation is concerning, not for its intentions, but for its execution, which is red tape to infinity.
Europe will introduce their Carbon Border Adjustment Mechanism from 1 October, which is really an old classic trade term for a protectionist tax barrier. Green regulations and ESG measurements are the talk of town in the ivory towers of politics and central banks. They want to be seen as ‘doing something’ and in that process, they are distorting private solutions and initiatives. But despite the failure to change the direction, they will argue, “The problem is not too much focus on regulations and government policies, but rather that there is too little!”
Maybe a quick ‘Economics 101’ is needed. Anything which is not productive will fail, unless, of course, governments keep them artificially alive. That is a very likely scenario.
Crowding out private capital and initiative is never a good idea. It will lead to rising deficits, unsustainable debt levels and a need to introduce maximum cost to everything from capital to prices. Think price, rent and yield-curve-controls, as politicians centrally steer the economy to align and ‘protect’ the voters. In this scenario, terminal rates will go higher, probably to 500-550 bps in the US 10-year benchmark yield.
The libertarian economists continue to return to Schumpeter’s theory of an economic model that needs a recurrent forest fire which resets the parameters and advances through innovation and more productive methods. A crisis which create a new foundation for an upswing.
The risk here is probably that it needs to be induced from the ever-growing inequality. Between young and old generations, and between small and mid-sized enterprises and multinational companies, and between the haves and have-nots. I doubt the economic model will move to this scenario. Too much political capital is invested in the current belief of keeping everything steady and avoiding recessions at all cost.
There is a chance that voters have had enough. For now, the right wing, particularly in Europe, is gaining in polls with their commitments to the individual over the government.
For an old-timer like me, this smells a lot like the 1980s, when Arthur Laffer’s supply economics became the economic fashion and post the Great Financial Crisis in 2008, when Koo introduced the concept of balance sheet recessions. Fast forward to today, who is in the economic headlights again? Laffer and Koo!
The 1980s was the antidote to 1970s big government of price control, high energy prices, breakup of Bretton Woods, high wages and inflation and devaluations.
Remind you of something?
The exercise for all of us is to figure out what the next cycle is, based on the doctrine that it is often the opposite of what was just there.
Maybe the right answer is that we will see all three scenarios over the next ten years?
First the opportunity, then the government overreach and then the transition to Schumpeter’s creative destruction.
That’s my bet. The world wants to, and probably can, extend-and-pretend one more cycle, but in order to take one more round of the current economic model, it now must ‘protect’ everybody and everything. This means that the cost of capital can no longer rise, because otherwise we move directly to the Schumpeter moment.
The King is dead. Long live the King.