It is hard to shake a stick without hitting an economist these days. And given how lousy a job they have been doing forecasting the economy, we would argue that a giant stick is needed so that we can hit more of them!
We want to focus on two economists with different ideas, Thomas Malthus and Joseph Schumpeter—different in areas of focus and outlook. We start with the downer, the quintessential pessimist, Malthus.
Malthus proposed a theory in the late 18th century that population growth was exponential while food production was linear, leaving no option to avoid catastrophe other than population control. No one can state it as eloquently and depressingly as Malthus, “The power of population is so superior to the power of the earth to produce subsistence for man, that premature death must in some shape or other visit the human race.” Suffice it to say; he wasn’t invited to that many bashes (author speculation, unconfirmed). However, it would have been fun at a party, if he did attend, to holler whenever he sampled the hors d’oeuvres, “Hey Tom, how many peasants do we need to kill for you to have that one?”
Though his theory was specific to population growth and food production, we see it aligned with the “zero-sum” line of thinking. Zero-sum is a term from game theory, and it assumes that in a game played between two participants, if one wins, the other party loses, with no change in the total sum of wealth. In other words, it relies on the belief that the total wealth at play is static, or—and we’re stretching here—in the case of Malthus, the idea that some items are limited and near fixed. We are taking some liberties with this line of thinking by attempting to highlight that what zero-sum thinking and Malthus’s views have in common is the omission in their theories that factors outside their purview may lead to a dramatically different outcome from that presented by their theory. Malthus did not include in his thoughts an adequate view surrounding farming productivity and yield enhancement. Because of that, his theory has been wrong since proposed. Since introducing his theory, the global population has increased tenfold, and current food production is 20% above the need. Malthus and those promoting zero-sum ideas limit their arguments to an incorrect and static view of the variables within the equation, leaving us with only unpleasant options surrounding restriction and sacrifice when human ingenuity has produced better outcomes for an ever-growing world population.
And this is where we turn to the other economist, Joseph Schumpeter. Coming on the scene about a century after Malthus, Schumpeter came to be known for his appreciation of entrepreneurship and innovation and their positive effects on the economy. He criticized the Malthusian ideal—arguing against economic models that froze all but a few of the variables. He reasoned that the arbitrary reduction of economic complexity to a monotonic view of inputs (i.e., if this, then that) would lead to false confidence in a policy decision that was likely to be wrong.
Schumpeter was an optimist (concerning economic growth) and promoted the belief that human ingenuity was the primary driver of economic prosperity. His work attempted to show that waves of innovation spurred economic growth. Innovation was brought on by individuals acting as entrepreneurs, aiming to offer new products or services to fill a need or reduce some economic inefficiency. He promoted the idea of creative destruction whereby new products would displace lesser products and bring about new opportunities and new, more stable economic outcomes.
Why do we bring these two up?
A Malthusian perspective focuses on the eventual—if the population grows exponentially, the world will eventually run out of food. A Schumpeterian view aims to address near-term opportunities—if the soil is enhanced with fertilizer, crop yields will increase this year. Malthus sees resources being depleted eventually with no expectation of adaptation or modification, with the only option for a healthy society being the restriction of consumption. Schumpeter considers the intermediate-term benefits driven by innovation and the increased efficiency that comes from it as a likely means to meet the needs of expanding populations.
Today, we see both theories permeating our lives, with Europe an excellent case study.
The EU energy crisis offers an example of the two theories in action. European governments have been the most active in converting to renewable energy sources. They have taken a Malthusian approach to conventional sources by instituting barriers to fossil fuels to address fears of rising global temperatures. At the same time, enormous efforts have been made by the private sector to explore innovative solutions to produce cleaner energy sources. The situation in Europe highlights the ramifications when those two theories are enacted yet not managed to perfection.
For a decade, countries within the EU have been shutting down energy sources that generate CO2 and nuclear. France and Germany have been leading the transition by outlawing oil fracking and extraction with the hopes that Russian natural gas would act as a bridge to enacting their renewable energy plan. Unfortunately, that plan failed. With the Russian/Ukraine war cutting off a material amount of their energy, they are faced with no easy answers to their winter energy needs. This mismatch in timeframes where the long-term desire to move off fossil fuels has not been matched with innovative solutions ready for large-scale use has seen German energy costs increase tenfold in the last year. Energy price inflation is bleeding into almost all other goods and services as the EU industrial complexes are forced to shut down production. With no quick relief in sight and higher energy prices rippling through the economy, the result appears to be higher-for-longer inflation.
This inflation is from man-made scarcity. And it appears there are only two paths to take: reduce the scarcity by re-opening conventional energy supplies or cut demand to the point of equilibrium. The former is politically unattractive and the latter results in a deep European recession. With the European Central Bank raising rates as an attempt to thwart inflation, it appears they have chosen the second path.
Hangover
What follows is not a segue from the prior conversation but a separate reflection on liquidity. We frequently discuss liquidity within the investment market. Liquidity is the amount of money that flows within the system. Think of it as the oil in the engine—it lubricates the moving parts, allowing them to move with less friction and wear. Our models revolve around identifying market liquidity changes, watching for when it becomes scarce, and risks disrupting the economy. We have been highlighting liquidity issues starting in late 2019. The monetary and fiscal stimuli in response to the pandemic offered some reprieve, but those acts have driven higher inflation and masked underlying weaknesses. With a concerted effort by central banks to contain inflation, this tightening liquidity phase will likely last a bit longer and result in a bit higher than expected interest rates.
If we are entering a period of lower liquidity, it may not be just the investment market negatively impacted. It is hard to assess excess liquidity’s indirect benefit on the economy accurately. Real estate transactions might take longer to complete; credit card limits might be reduced; zero-interest installment payment plans might end; start-up funding might become smaller and harder to obtain. The time to go from idea to production to self-sustaining sales will likely stretch. Companies will likely need more investments at a time when investments become harder to find.
We have not seen a sustained decline in money within the system for more than 40 years. Determining what its impact will be is tough. Very tough.
These concerns inform our current defensive positioning. With pundits arguing the extremes, peddling an all-or-nothing solution to investing, we sit in-between. From our perspective, being entirely out of the market is a very rare situation involving a banking crisis. We are not there, but we are hunkered down for a challenging period during an anticipated global economic reset. We sit with 35%+ cash for our equity-only strategies, and our balanced strategies have less than half the equity of their respective benchmarks. Over our time writing this newsletter, we have described market tops and bottoms as processes, not points in time. We wish we could pinpoint market inflection points but can’t, like all others. The most we can say is that we are in a market-bottoming process now. We know that these are the times that opportunities present themselves and need to be balanced in our views in order to act on them.