Startup Slump Not That Surprising

What is the state of entrepreneurship in America?

Fortune columnist Geoff Colvin recently wrote about this topic in a recent issue. He cites "surprising" research suggesting that the rate of new company formation has fallen sharply over the past 30+ years.

Interestingly, the research found that a turning point occurred around 2000 whereby the economy generated fewer young, high-growth firms.

So what happened? Colvin states that the academics/economists who produced the research are still searching for answers.

I don't dispute the negative implications to the U.S. economy of fewer startups that Colvin cites such as stagnating wages, long-term unemployment and low productivity growth. He also suggests that venture capital firms are competing to invest in fewer higher-growth startups which may be driving up company valuations to unjustified levels.

Actually, I don't think this research is surprising at all. The finding of fewer high-growth startups since 2000 correlates rather nicely with the decision by the Bush Administration to weaken the U.S. dollar in a misguided attempt to stimulate exports.

With the decline in the value of the U.S. dollar during the 2000s, limited investment capital largely migrated away from promising new business concepts into hard assets most impervious to currency depreciation. This helps explain the bull market in residential real estate, gold, and other inflation hedges.

Of course, there are a number of notable high-growth startups founded since 2000 cited by Colvin that are thriving today including Facebook, Uber, and Airbnb, but it is impossible to measure the promising ideas that never received funding because capital was instead diverted to hot investments of the day which were hard assets.

Another factor in subdued risk-taking on the part of entrepreneurs, admittedly difficult to quantify, is the poor overall business climate. Entrepreneurs tend to find their way around government barriers to success, such as a rising regulatory burden and poor fiscal and monetary policies, but on the margin I suspect getting a business off the ground has been a lot more difficult in recent years.

A better supply-side policy mix, that is lower taxes on capital and income, free and open trade, a rollback in burdensome regulations and a stable monetary policy would do wonders for entrepreneurship in America. Unfortunately, there are no presidential candidates even talking about such a mix as part of a plan to revive a frustratingly moribund U.S. economy.

Are Unconventional Presidential Candidates Making Investors Nervous?

I recently met with clients and prospects to discuss my firm's investment outlook. Naturally, investors are nervous given the rough start to the year for global equity markets and are eager for answers as to what exactly is going on.

Markets are complex adaptive systems. Therefore it is virtually impossible to discern the collective wisdom of countless investors with diverse perspectives to pinpoint what is moving markets at any given moment. That's why I am skeptical when a talking head on CNBC or Bloomberg TV says with certainty that X is moving the markets.

That said, I gave it my best shot by highlighting a number of factors that I believe are impacting markets of late.

The key risk in my mind is that markets are signaling a monetary policy error committed by the U.S. Treasury Department and the Federal Reserve. A weak and unstable fiat dollar has wreaked havoc across the globe during most of the past 15+ years as demonstrated by the misallocations of capital (i.e., malinvestment) to housing and the production of raw commodities such as crude oil, copper, and iron ore. "Money illusion" drove all manner of capital investment literally into the ground and away from concepts that would result in true wealth creation. Pundits believed that many commodities were becoming scarce when the real answer was the currency that commodities are predominantly priced in, the U.S. dollar, was being devalued.

The "financial crisis" of 2008 and the current ongoing recession within the energy and basic materials sectors would never have occurred under a stable dollar.

The rapid strengthening of the dollar over the past few years, as measured by the fall in the price of gold and decline in the value of the CRB Index, has crushed commodity prices. Additional investment in the production of many commodities can no longer be justified at current prices. Investments in infrastructure and labor made when prices were much higher are no longer viable. Massive capital spending cuts and worker layoffs continue to be announced. If prices persist at current levels, a rising number of bankruptcies is likely to follow. The market must cleanse itself from the result of poor investment decisions.

A second possible reason is developing risks of another European banking crisis brought on by the European Central Bank's (ECB) negative interest-rate policy (NIRP) as well as the refusal of the European political class to implement pro-growth economic policies to stimulate moribund economies.

Third, some claim that sovereign wealth funds (SWFs) of resource-based countries such as Saudi Arabia and Qatar are putting selling pressure on equities as they raise cash to plug huge budget gaps created by the decline in the price of oil.

I was pleased to see that this week's edition of Barron's highlighted yet another reason I presented to clients for the volatility and fear in markets. One that seems to fly under the radar of most commentators. It is the impressive rise of two unconventional presidential candidates in Donald Trump and Bernie Sanders.

John Tamny also made this case in a provocative article a few weeks ago at Forbes Opinion.

As Barron's writes,

The rise of outsider presidential candidates Donald Trump and Bernie Sanders is more than a fascinating political story. Their ascendancy—Trump’s in the Republican Party, and Sanders’ among Democrats—could be one more reason why stock markets are under pressure and could remain so for awhile.  

Many market pundits are too focused on the latest Chinese economic data, oil-price movements, or negative-interest-rate chatter to connect the dots between the presidential-primary results and the stock indexes. By taking such a traditional view of market-moving developments, they might be overlooking a story that is leading news reports every day and night.

It is clear that the electorate is fed-up with the establishment of both major parties. Establishment Republicans are seen as spineless and unwilling to take a stand against President Obama's agenda. Meanwhile, Democrats are not exactly enamored with the Clinton Machine. The Democratic Party has turned decidedly to the left in recent years and Hillary simply doesn't excite the base. There is also growing unease with her possible legal problems if (and when) the Department of Justice finally decides to recommend she be indicted for crimes related to her mistreatment of state secrets and the use of a private server to hide communications from the public eye.

Both Trump and Sanders are candidates that have generated the most excitement among the base of their respective parties (note: Sanders is not a registered Democrat but caucuses with them as a member of the Senate. He labels himself a democratic socialist.)

The problem with both is that their policies, if implemented, would be a disaster for the U.S. economy.

Trump may be a relatively successful businessman, but he is an economic illiterate. His signature issue is trade. He believes trade with China and Mexico is "killing us" and would seek to implement massive tariffs on imports. This could easily lead to a replay of the disaster that was the Smoot-Hawley tariff in the 1920s. Other anti-growth stances include tighter restrictions on immigration and the possibility that he would govern as a rogue, with little patience (like Obama) with the separation of powers.

Sanders thinks the federal government is too small and doesn't spend enough on entitlements. Therefore, he has proposed a single-payer health care system, free public college tuition, and massive income tax increases on the wealthy. He also wants to "crack down" on Wall Street for perceived kid-glove treatment by the feds in the wake of the previous recession.

Of course even if Trump or Sanders is elected doesn't mean that his agenda will be implemented carte blanche. The House of Representatives is widely expected to stay under GOP control. The Senate is a toss-up and would likely lean toward the party of the winning presidential candidate. Fortunately, divided government is generally a positive for markets because it tends to derail an ambitious chief executive.

Even if Trump were elected with a GOP-controlled House and Senate, it is difficult to imagine a relatively conservative House leadership willing to go along with Trump on starting an all-out trade war with China.

Betting markets indicate a Trump v. Clinton matchup with Clinton still the overwhelming favorite to win. But a lot can happen between now and November. If Clinton is indicted, I believe that all bets are off.

Therefore, it appears investors should gird themselves for more volatility in the weeks ahead.

Are Lower Oil Prices Leading to Recession?

About a month ago Don Luskin, CIO at Trend Macrolytics LLC, wrote an op-ed in the Wall Street Journal claiming the U.S. is in recession due to falling oil prices.

According to Luskin,

"The drop is entirely the result of America’s supply-side technology breakthrough with horizontal drilling and hydraulic fracturing—“fracking.” 

This is a common view among the usual crowd of investors (including energy analysts and strategists), market pundits, and economists.

There is no denying that improvements in hydraulic fracturing technology have led to impressive increases in oil-well productivity in the various shale oil basins throughout the U.S. And the decline in oil prices is beginning to have an adverse impact on the industry as companies begin to slash capital spending and lay off workers. On the margin, supply and demand dynamics has some influence of course. But step back and think, has global supply and demand shifted so drastically over the past year or so to account for such a massive drop in crude oil? Or for that matter, so many other raw commodity prices.

What Luskin and many others miss is that the strength of the U.S. dollar is the reason for the decline of global oil prices (and the general decline in commodities overall as measured by the CRB Index). Neglect of the dollar by the Administration under clueless U.S. Treasury Secretary Jack Lew and secondarily by a hapless Federal Reserve Board is why it is wreaking such havoc in markets across the globe.

Crude oil is priced globally in U.S. dollars. As those dollars appreciate in value, the best market indicator being the price of gold, it takes fewer dollars to purchase a barrel of oil. Recall, oil rose to >$100 per barrel back in 2011 as the dollar was plummeting in value (gold having peaked at just under $2,000/oz.). It didn't rise to this level because there was a global shortage of oil or because demand suddenly rose sharply. The weak dollar was driving a global commodities boom.

If oil remains below $50 per barrel for an extended period of time, there will be more pain to come in terms of layoffs and capital spending cuts in extraction-related industries. Commodity-dependent emerging market nations will also suffer from additional painful adjustments. The market must cleanse itself of malinvestment wrought by "money illusion."

If recession does come to the U.S., it will be due to this process and it will be a good thing.

Why? Because a reorientation of investment capital away from energy extraction in the U.S. and towards "first order goods" that John Tamny describes in a recent column will eventually redound to the benefit of our economic well-being. Extracting raw commodities from the earth is not particularly profitable and can be done by countries far less advanced than ours. Our comparative advantage lies elsewhere in technology and health care, for example.

What the U.S. (and world) economy desperately needs is a stable dollar that is defined as fixed weight of gold. Fiat currency schemes simple don't work. The damage floating currency values do the economy by disrupting vital market price signals is being abundantly demonstrated before our eyes today.

Baum Takes A Closer Look At Loopy Economics

As author of a blog dedicated to highlighting Keynesian nonsense, the title of Caroline Baum's December 16, 2015 article on Economics21.org, Pent-Up Nonsense and Other Loopy Ideas from 2015, piqued my curiosity. Caroline is a veteran economics journalist who does an excellent job challenging conventional wisdom.

In point #1, Pent-up Nonsense, Baum criticizes the use of "pent-up" demand as a reason to explain weakness or strength in consumer spending. As humans, our wants are unlimited; they are never satiated. However, consuming is not the problem. Acquiring the means to consume is. We must produce first in order to consume. Since our production is our demand, politicians should remove as many barriers to production as possible to maximize output. Barriers include high taxes on income and capital, trade restrictions, onerous regulations, and unstable money.

In point #2, Lower Oil Prices Are Not Like a Tax Cut, Baum asks a great question, why are lower oil prices assumed to be the equivalent of a tax cut? While consumers may have more money in their pockets due to lower gasoline prices, those businesses and individuals tied to the oil and gas industry have that much less to spend and invest. Total spending is unchanged, only its composition has shifted. The "windfall" is an illusion.

I quibble somewhat with point #4, The Uncertainty Principle. Baum is skeptical of citing economic policy uncertainty as a reason why businesses are reluctant to invest. Yes, of course the future is uncertain. But I don't believe federal laws, such as Sarbanes-Oxley, Dodd-Frank, and Obamacare, which run thousands of pages long with rules that will be written in the future by unelected bureaucrats, make for an environment conductive for business investment and expansion.

In Happy New Regulatory Year, the Wall Street Journal editorial board states that over 82,000 pages of new and proposed rules were added to the Federal Register in 2015. The editorial also notes the Obama Administration has generated six of the seven most prolific years of regulating in the history of the country. Instead of focusing resources and effort on creating value, businesses must instead divert more of the same to activities that are required to keep the bureaucrats at bay.

Federal Reserve monetary policy is another potent source of uncertainty. David Ranson demonstrates in The Fed is Holding Rates Down for All the Wrong Reasons, a consistent inverse relationship between month-to-month volatility in the federal funds rate (the rate the Fed targets via open-market operations) and the subsequent year's real GDP growth.

During 2015, how much time and effort was wasted on "Fed-watching" and guessing when the Fed would indeed move to increase the federal funds rate? Is this a productive activity for investors and businesses? Clearly not, but something that must be done when the Fed's activities have such impact on the capital markets and the economy.

Her final point, #5, Two Lumps Are Better Than One, takes issue with the notion that the amount of work in an economy is fixed, such that new immigrants and productivity improvements (e.g. robots replacing humans or using ATMs rather than bank tellers) steal jobs. Not true. Jobs (and the wages they generate) are the result of investment. Wherever there is investment, you will find jobs (e.g. Silicon Valley and until recently in shale oil basins in Texas). Many people believe poor immigrants drive down wages but this is false. John Tamny explains this in Immigration Grandstanding by Ted Cruz Vandalizes Basic Economics. He cites low-wage Detroit to refute this point.

Coming to the Defense of the Gold Standard...Again

Heather Long, an excellent financial columnist at CNN Money, recently posted an article Why Ted Cruz's Gold Standard Push Is A Bad Idea that unfortunately continues a string of misinformed commentary about the purpose and efficacy of a gold standard system.

For example, see recent articles by Binyamin Applebaum in the New York Times, Greg Ip in The Wall Street Journal blog Real Time Economics, Megan McArdle at BloombergView, and Alan Pyke at the website ThinkProgress.org.

What is so frustrating about these articles is that the authors apparently did not seek input from the many prominent advocates actively promoting a return to gold-based money.

Let's take a closer look at Long's article:

"It's a plan that is getting the 'you've got to be kidding me' reaction from the business community. 'I don't think that's going to happen. I just don't believe that would be possible,' says Peter Cardillo, chief market economist at Standard Financial."

This reaction occurs simply because most people don't know, or have never learned, what the purpose of a gold standard system is, why the U.S. officially abandoned gold-based money in 1971, and cling to the easily disproved myth that the gold standard was responsible for the Great Depression. Ignorance is no excuse. There is simply to much good educational material out there. Start with a free resource from the excellent Nathan Lewis, Gold: The Monetary Polaris. Lewis also addressed the issue of the feasibility of a return to the gold standard in The U.S. Embraced A Gold Standard For 182 Years, So Why Is It 'Impossible' Today?

"Most economists now agree 90% of the reason why the U.S. got out of the Great Depression was the break with gold, says Liaquat Ahamed, author of the 'Lords of Finance'."

The fact that the academic economics community almost universally believes this point tells you a lot about the state of the profession these days. Academic economists, particularly those toiling away at elite colleges and universities, are overwhelming from the Keynesian School. Little wonder that a poll taken from such a community would be highly biased against the gold standard. Keynesians believe that government bureaucrats, namely economists with Ph.D's from elite universities, are required to "manage" the economy via the manipulation of currencies and interest rates. A gold standard system takes that power away from them. Under a gold standard system, no one would know who the Federal Reserve Chairman was, nor would anyone really care.

There are a number of excellent commentaries dispelling the notion that the gold standard contributed to the Great Depression, most recently by John Tamny, The Fed and the Great Depression: A Myth That Just Won't Die but also by Nathan Lewis, Did the Gold Standard Cause the Great Depression? and Richard Salsman, Did the Gold Standard Cause the Great Depression?, a review of Barry Eichengreen's book Golden Fetters: The Gold Standard and the Great Depression, 1919-1939 published by the American Institute for Economic Research.

"But there's a major downside to the gold standard that caused President Franklin Roosevelt to get rid of it in 1933: It's akin to wearing an economic straitjacket".

Proposterous. The sole purpose of a gold standard system is to provide a currency with a stable value. A stable currency facilitiates investment and exchange (i.e. trade). A fiat currency system, such as the one the world lives under today, hinders investment and exchange like grains of sand in a moving gear. With a constantly fluctuating currency, investment decisions are impacted by the need to consider future changes in currency values. Will the investor receive dollars in the future worth the same as those committed today? This is a big reason why the derivatives market has grown so huge. Businesses and individuals must protect themselves from constantly fluctuating currency rates (as well as widely gyrating interest rates and commodities as a consequence of floating currencies). Capital that could be better utilized on wealth-creating investments must instead be used to hedge the risks brought on by unstable money.

Ask yourself this question: How did the U.S. become the world's economic superpower in less than 200 years while on the gold standard if such a system acted as an "economic straitjacket"?

"'I don't think the average Joe understands the economic impact. During the gold standard, there was high unemployment,' says John LaForge, co-head of real assets at Wells Fargo."

The first sentence is rather condescending; I believe that "the average Joe" indeed knows something is terribly wrong with the current monetary regime and this helps explain the call by presidential candidates Ted Cruz, Rand Paul and others for a reconsideration of using gold to back the dollar.

As for the claim of high unemployment, when exactly? During the entire period when the U.S. was on the gold standard? And precisely why would a currency with a stable value promote unemployment? It actually does the exact opposite. Since a stable currency promotes investment, it also promotes job and wage growth. It appears that Mr. LaForge threw that line out there without thinking it through.

"...The main reason is there just isn't enough gold out there to power major economies."

This is probably the second-biggest myth used to dismiss the gold standard after the Great Depression claim. The effectiveness of a gold standard system does not rely on the physical quantity of gold sitting in vaults somewhere or yet to be mined from the ground. Period. The value of the currency, not its quantity, is linked to gold. As Nathan Lewis wrote recently in Greg Ip Gets It Wrong: What a Gold Standard Really Was, And Could Be,

"From 1775 to 1900, the U.S. money supply (technically known as 'base money') increased by 163 times, from $12 million to $1,954 million. During this time, the total aboveground gold supply increased by about 3.4x due to mining production.  163 is not the same as 3.4" 

In fact, a well-functioning gold standard system would actually require very little gold to be held in reserve. If the public expects the currency value to remain stable into the future, there would be little demand to actually hold physical gold. Paper bills are a lot more convenient to carry/transact with than gold coins or bullion. 

'Beyond hamstringing the U.S. from responding to crises, the gold standard also relies on a commodity that is known for wild price swings."

It is common for gold standard critics (or those who simply are ignorant of how a gold standard system works) to claim that the price of gold is simply too volatile to serve as an effective value peg. Gold hasn't been used in monetary systems throughout human history because it is a shiny metal and looks pretty. The reason for its use is due to its unique characteristics. Essentially all of the gold ever mined is still in existence today. Annual mining production represents only a tiny amount of the total stock globally. It also has few industrial uses. The only real demand is for jewelry (and perhaps dentistry). In other words, gold displays favorable stock/flow characteristics. Therefore, changes in supply and demand have minimal impact on its value.

There's nothing magical about gold. Gold standard advocates would embrace alternatives if the characteristics of any such alternative were superior to gold. Alas, none have ever been identified that work as well as gold.

As for the price volatility of gold, what critics fail to understand is that it is not the value of gold that is changing in price, it is actually the currency that is fluctuating in value. A rising price of gold from a previously stable value indicates inflationary pressures that will eventually be transmitted through the economy, beginning with those goods most sensitive to currency fluctuations such as raw commodities. The opposite effect reflects deflationary pressures.

"If you look at the price of gold, the gold market certainly isn't anticipating [a return to the gold standard]," says economist Cardillo.

It's unclear to me how Cardillo was able to reach that conclusion. If anything, the price of gold falling from ~ $1,300/oz. in early 2015 to ~ $1,075/oz. today is signaling that deflationary pressures are building in the economy due to neglect of the dollar by the U.S. Treasury.

The financial press, echoing their contacts among the academic community, apparently is biased against a return to the gold standard. Recent columns have been anything but fairly balanced with opinion from both sides. Fortunately, there are many great minds out there who understand gold and the importance of gold-backed money, many of which I have cited in this article or are linked elsewhere on this blog.

Still not convinced? Please read this short, but concise column from none other than Steve Forbes, The New York Times' Leaden Analysis of Gold.

Putting the Blame for Low Interest Rates Where It Belongs

William Poole, a former president of the Federal Reserve Bank of St. Louis and now a distinguished scholar at the Cato Institute, penned a short commentary on November 24 for the Wall Street Journal where he makes a number of points worth elaborating on.

Poole correctly points out that the Fed influences the federal-funds rate, but does not control rates across the yield curve. He instead fingers the low-rate environment on non-monetary conditions, specifically the policies of the Obama Administration. As Poole mentions, "long-term rates reflect weak job creation and credit demand." 

Disincentives to business investment, from poor tax policy and onerous regulations to a unstable dollar, have been the principal reasons why the economic environment has been so subpar relative to prior recoveries. The weak economy is the better explanation of why interest rates are so low.

Capital will always migrate to where it is treated best. Little wonder then that investors have not been so enamored with the U.S. in recent years.

Since 2008, there have been numerous significant tax increases, including hikes in the top marginal personal income, capital gains and dividend tax rates, limitations or phase-outs of personal exemptions and itemized deductions for high-income taxpayers, and a new Medicare tax on investment income.

The U.S. corporate tax rate is among the highest in the developed world. While many countries in the OECD have reduced corporate tax rates in recent years, the U.S. has stood pat. The U.S. is also one of only a few countries that utilizes a territorial tax system which taxes income earned outside of the home country. This has resulted in massive amounts of cash held offshore as U.S.-based multinationals are loathe to repatriate the funds and pay the higher rate.

The uncompetitive corporate tax structure is also cited as a major reason that U.S. multinationals are choosing to relocate to foreign domiciles via corporate inversions.

Politicians in Washington D.C. continue to talk a good game about tax reform, but progress on simplifying the tax code by lowering the rate and eliminating deductions has been glacial. The corporate tax would ideally be eliminated, but that is a topic for another day.

To say that the "fourth branch of government", the regulatory state, has expanded in recent years would be an understatement. It has been hyperactive. The EPA, FDA, FCC, and a plethora of other regulatory agencies have been spitting out burdensome regulations on business at a rapid pace. Combined with the impact of major pieces of legislation, signed into law without much of the details written, such as Dodd-Frank and Obamacare, it is fairly easy to see why businesses may take a more cautious view on investment spending. Economist Bob Higgs coined it "regime uncertainty".

I am quite critical of the Fed's hubris and hope to see it dissolved in my lifetime, but I believe that many commentators, pundits, and investors give this institution far too much credit when it comes to "setting" interest rates or "managing" the economy. [Please see John Tamny's recent commentary on the Fed, "The Fed Can't Spot Nor Can It Stop 'Bubbles,' Nor Should It Try."]

Interest rates are the pricing mechanism in the capital markets, equilibrating the supply and demand for credit. Indeed, rates are being "manipulated" but put the blame where it belongs.  The poor fiscal and monetary policies of the Obama Administration with ineffective pushback by the Republican-controlled Congress are the prime culprits. Big Government is a prosperity deterrent. Low interest rates simply reflect this reality.

Gold and Liberty

My friend Richard Salsman, Ph.D, CFA, President and Chief Market Strategist at economic consultancy Intermarket Forecasting Inc., has generously provided a copy (PDF, below) of his excellent monograph Gold and Liberty published in 1995 by the American Institute for Economic Research.

This document is one of the first I read that helped me to understand and appreciate the critical importance of gold in a well-functioning monetary system.

Salsman discusses such topics as the origins of gold as money, the evolution of free banking, the purpose and mechanics of a gold standard system, government subversions of the gold standard, central banking and gold, and what the future may hold.

The monograph also contains a rich bibliography of source material.

Gold and Liberty is a fascinating and highly-educational read. Unfortunately, far too many policymakers, politicians, journalists, and academics are ignorant about gold and its historical record as the backbone of sound money. In just a few hours, this monograph would provide them with the proper respect and appreciation for gold and the futility of the current system of fiat money.

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