Gargoyle Theory
Hayekian inspired views on our current macro environment
I wrote a thread last month on what I called the Gargolyes of Capitalism, which is a framework for how I think about the relationship between financial markets and the real economy. In Adam Smith’s world the invisible hand guides the allocation of resources and production in an economy to the optimal location. In my Hayek inspired theory, Gargoyles fill with rage when the link between the financial economy and the real economy become a farce, and then seek to restore order by taking their money back through inflation, lowering asset prices, and forcing people out of jobs.
The riches generated and asset price increases we have observed over the last couple years are insulting to the idea of an economy that retains a tight link between fundamental value and financial markets. When too many people who produce no real value grow rich, the entire structure and incentive of capitalism is threatened.
Malinvestment
Gargoyle theory is built on top of Hayek’s concept of malinvestment. Hayek claims interest rates that are too low results in more investment going to long-term projects relative to short-term projects. In his definition ‘too low’ means below what is called the natural rate of interest. This is a rate is a rate we can’t directly observe, but the rate required to keep the economy at full employment, maximum output, and without increasing inflation.
The problem we observe is that once interest rates rise again, these malinvestments which made sense at lower rates, can become worthless. This is currently not part of most mainstream macroeconomic models. I think that’s a mistake. In terms of empirically explaining some amount of what we’re currently experience, it has validity:
The reasoning looks something like this:
If you can borrow large sums of money at a very low rate, you can consider bankrolling projects that may not generate returns for a very long time. If the cost of money increases, this stops working. This can also permit investment in projects that are barely profitable if money is free. And then become unprofitable once money becomes expensive again.
This effect on the time-value of money can also result in certain types of under-investment. If the central bank is keeping money near zero, saving is less useful, so you may consume more than you otherwise would.
The strong claim here is that the central bank is moving the interest rate away from what the free-market wants, and this distorts our economy. However, you don’t have to take this strong view. You can acknowledge that some manipulation is actually good, as it allows the central bank to avoid liquidity spirals during events like covid, or to target optimal rates of employment, while recognizing this distortion takes on some risk.
What angers Gargoyles?
In the long-run, a financial economy and fundamental economy need to converge. It cannot be that we all become rich from financial markets without this corresponding to an increase in efficiency and output from the real economy. Here are the areas I’m paying close attention to in our economy.
Distorted asset prices anger them.
The purpose of a financial economy is to direct resources where they generate the highest consumer surplus. Financial markets are our collective attempt to predict what we will want to consume in the future, and to fund production and technology to get us to our future consumption. If asset prices are distorted, it means we are directing too many resources, capital and labor, towards parts of the economy that are less important, potentially underinvesting in parts of the economy that are more important.
We often get these predictions wrong even when markets are operating properly. But financial markets the last few years have had a couple pathologies that resulted in asset prices not reflecting the structural economy.
The first is that during covid, we know the personal savings rate shot up. Cheap interest rates should mean less saving. Only with the US being a consumer driven economy, and everyone at home due to covid, combined with generous stimulus, what were we going to spend our money on? We know that retail traders increased. Did we invest in dogecoin? Or did we consume dogecoin?
If you google ‘dogecoin hiring’ you get hits. Did we mean to encourage dog money firms to have the resources to poach engineers from productive tech companies? Or was this an unintended consequence of a strange phenomena of betting with stimulus money? If it’s the latter (it is), gargoyles are angry.
The second is related to leverage. John Geanakoplos in his seminal paper shows that leverage allows for heterogenous subsets of the population to gain outsized ability to price assets. In other words, if some people get access to tons of cheap leverage, they get an outsized ability to set the price on an asset. I emphasized the relevant parts from this segment from his paper:
These buyers are willing to pay more, perhaps because they are more optimistic, or they are more risk tolerant, or they simply like the assets more. If they can get their hands on more money through more highly leveraged borrowing (that is, getting a loan with less collateral), they will spend it on the assets and drive those prices up. If they lose wealth, or lose the ability to borrow, they will buy less, so the asset will fall into more pessimistic hands and be valued less.
In the short-run, this can result in wildly appreciating assets when a small hyper-optimistic group is pricing certain assets. While shorting is a mechanism to restore order, it’s generally a risky idea to short in a bull-market. The market can stay irrational longer than you can stay solvent. Or as WSB says, “we can stay retarded longer than you can stay solvent.”
Now as the central bank begins to raise rates again, is it enough that these assets simply deflate a little, and we all return to our otherwise hot economy with low unemployment? Not if structural economic decisions were made on this basis. If that happened, those structures need to revert either to the past, or to some new equilibrium. What this should look like is layoffs, bankruptcies, and transitions to more productive jobs. Those dog money engineers need to go back to Amazon to help increase Amazon’s earnings per share, and make all of us who own Amazon through indices, money.
Asset prices can drop much faster than people can find new jobs, and firms can restructure their financing. In order to restore order we’re starting to see tech companies are starting to ramp up layoffs, there were more at Coinbase recently. It may extend beyond layoffs though, which leads into the next section.
Firms that have no right to live anger them, and need to be killed.
There is no formal definition of a zombie firm, but the general concept is it is a firm that has more debt than it can realistically pay-off yet is able to keep financing its payments given low interest rates, living on as a ‘zombie.’ There are reasons to believe some of these zombie firms are going to be in trouble, as the rate of firms with higher ratios of interest expenses to revenue is increasing. For now, these firms are not going bankrupt.
This is an affront to a well-functioning economy. If a firm is going to go bankrupt at some point, but is able to survive due to central banks setting low interest rates, it would be better for it to go bankrupt today.
Based on Bloomberg’s definition, we see that a little over 600 firms in the Russell 3000 index are categorized as zombie firms. While this has increased recently, rates have been low for the past decade of easy money. Is it possible that none of these zombie firms can survive a high-rate environment? I’m not sure. Still, it represents a lot of ‘dry tinder’ that we need to pay close attention to
We can also triangulate on this by looking at bankruptcies. American bankruptcies dropped significantly during covid, as a result of the cheap cost to borrow money, and fiscal support. This is concerning for two reasons: The first is obvious, which is the government has kept firms alive that would have gone bankrupt if covid didn’t occur. The second is that covid should have encouraged a structural shift in our economy, as we move more to remote work, so we might have even wanted to see bankruptcies go up as our economy transitions to a new post-covid economy.
If we look at the time-series of bankruptcies, we see while bankruptcies have been on a downward trend, they accelerated downward during covid.
Even the head of the European Commission is concerned. This article on the bailouts from the EU notes the decrease in bankruptcies.
“You can already see that in quite a number of member states the rates of bankruptcies in the 2020 is lower than in any year before,” Guersent said. “That indicates that probably we have zombie companies hanging round. As long as this remains limited, probably it’s an unavoidable side effect of this type of policy.”
The question we need to ask ourselves, is how many deferred bankruptcies have we generated over the past two years, and what will the realization look like, as bankruptcies start to climb back up?
People either retiring early, or working in the wrong job, angers them.
We notice that people are coming out of retirement. Inflated asset prices triggered a retirement they could not afford.
We can also look at real-estate, we have had a record number of real-estate agents. What jobs did these people have before? Is real-estate agent still the most valuable place for them to be? Or was their temporary switch due to the huge real-estate asset inflation a transition away from a more productive job?
I know a lot of people who quit their jobs to do something that probably produces less value than their original job. I suspect a lot of people reading this post know a few people like this as well. They quit to join highly risky, long-term projects, or pre-revenue growth companies. These are companies that wouldn’t have attracted funding before, but suddenly so much money appeared out of nowhere.
We all pay for this mismatch. All the components in our basket of consumption these people used to contribute to, are now a little more expensive, and instead we have additional real-estate agents or NFT artists. It’s also worth noting that our basket of goods being more expensive is equivalent to inflation. Only it’s inflation due to a misallocation of productive resources, rather than monetary policy.
Parables
Part of why I unmoor myself from the standard approach in academic economics (which is great in its own way) and think through parables of Gargoyles, is from an admission that formal structure can’t explain a lot of phenomena that we observe. As much as the field has progressed from Smith’s invisible hand, we still are unable to fully appreciate how these gigantic, complex markets and human systems operate.
Markets so thoroughly decentralize information, that in order to speculate at the order of an entire economy, we need a lot of heuristics. The best heuristics are ones that bound the set of what can happen based on invariants of human behavior at the micro level. “We can’t all relax and be rich without working” or “We do what’s in our self-interest” can let us reason thoughtfully even under heavy uncertainty.
A central banker once told me “We have the audacity to believe we can improve the economy in the short-run, but in the long-run it is driven by invention.” The heuristic behind gargoyle theory is to look for areas where wealth and opportunity seems to be increasing, but you can’t spot the value creation or invention behind it. When this happens, the wealth is an apparition.