Unwinding the Third Greatest Misallocation of Capital in History
It’s happened twice before. Well, the two world wars are the only examples I can think of in modern history, anyway. The US and European housing bubbles in 2006 may not be far behind though. And yet, economists and investors don’t even pay attention to it: the vast misallocation of capital in our economy.
Is a housing estate on a remote part of the Spanish plain a good idea? Was lending money to people who could not repay loans a good idea? Was securitisation of mortgage risk a good idea? Was it a good idea for Japanese pension funds to buy securitised American mortgage debt?
The answer turned out to be ‘no’ in 2008. And yet, those things happened. So the question is, what exactly did happen and why?
Most people will point to corruption, short-term incentives, moral hazard, and all sorts of other misaligned incentives. And they’d be right, in hindsight.
But this only exposes the presumption that the investments of capital and economic activity that was happening in the build-up to 2008 were presumed to be a good thing, merely because they were happening. If it didn’t make sense, it wouldn’t be happening, was the belief, in other words.
You see, economists do not distinguish between good and bad economic activity. They just (try to) count the amount of it. As Keynes famously explained, it’d be a good idea to get the unemployed to dig holes and fill them back up, because this would raise GDP. He didn’t ponder the value of that GDP.
At least governments had the temerity to build real houses in Ireland and Spain, even if nobody would ever want to live in them.
But what if we bring a qualitative judgement into the consideration? What if some economic activity doesn’t make sense? And some investments of capital are misguided.
This is obviously the case. Some businesses always fail. Entrepreneurialism is largely a matter of trial and error. Of the small or start-up companies I’m a little familiar with, very few end up being successful in the line of business they set out to pursue from the start. They usually find something else more promising along the way and become successful that way.
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But what I’m talking about here is a large-scale misallocation of capital. A reorganisation of the entire economy to serve a purpose which ends up being misguided.
Now, as a German-born, British Australian with a Japanese wife, I’d like to suggest that, if you ignore your nationality and apply the following argument to all nations equally, you can say that the world wars were a very bad allocation of capital. They should and would not have happened if it were up to consumers’ decisions.
But they did happen. Because governments were able to co-opt control of the economy for their own purposes. In some cases, for aggression and others in response, of course.
When the wars ended, the world was left with a vast misallocation of capital. Soldiers coming home looking for jobs, manufacturing geared to the war effort instead of consumer and production demand, ruined farmland, rationing, price controls and plenty more. The economy faced a huge shift in what was to be produced, consumed, by whom, where and using what capital in the subsequent time of peace.
Because economists focus on how much GDP is produced, as opposed to what the makeup of that GDP is, and whether it makes sense, the post-war period was a sharp recession as the amount of GDP fell, followed by booms in most cases. But that post-war period was really about the reallocation of capital towards causes that actually made sense in a peacetime economy.
I want to argue to you today that we are in the same situation thanks to the pandemic and the response to it. Our economy is geared to the wrong things given our future. We face a vast reallocation of capital. And that promises to be disruptive well before any boom.
Now you might argue that our efforts to hold back the pandemic were worth it. But your views on that topic aren’t relevant to the point I’m trying to make. The world is changing back to a post-pandemic system. And a lot will have to change.
Most of us expect some sort of boom as the economy reopens toward the new normal.
Tourism being the most obvious example given the…bear market…it presumably faced during the world wars and more recently. Can you imagine what would’ve happened to cruise ship companies’ shares in the world wars, with their ships commandeered or sunk…
Well, after the wars, the industry would’ve had to rebuild itself. Starting from a very low base. An economist would measure this as a drop in GDP because the ships that had been busily moving a lot of stuff for the war effort were suddenly left moving, not much. The recovery did, of course, follow, eventually. But not before a tough period.
The current energy crisis is another example. Many of the energy intensive parts of our economies would’ve been struck especially hard during the pandemic’s lockdowns. Manufacturing, trade, transport, and more.
Now we are experiencing the disturbance of trying to bring energy back online to serve the economy as it recovers. And we’re discovering it’s not easy to do. There are shortages, not just out-of-control price spikes.
There are also vast overinvestments in sectors which the pandemic encouraged. PPE, healthcare equipment, health research, technology, and other parts of the economy are likely to experience a hangover as things go back to normal.
Will the regional housing markets hold up as the disadvantages of working from home become more obvious? I lasted about a year and a half working from home in 2014 because hay fever in Melbourne took my breath away, literally. But being alone in tropical Queensland was tough too. So I moved to Europe.
The key part of the coming turmoil that investors need to be aware of is that the reallocation of capital from parts of the economy that don’t make sense to those that do involves a period of low GDP growth and investment returns.
In fact, according to the Austrian School of Economics, whose theories I largely follow, the definition of a recession is largely the reallocation of capital, not the lack of GDP, which is merely a symptom of such reallocation. Whatever the economy was going before the recession didn’t make sense. The recession is a period of change towards what does make sense.
That’s also why preventing recession delvers lower economic growth. You preserve unproductive industries. But that’s another story.
What does the reallocation of capital actually mean? It means companies producing the ‘wrong’ things in the ‘wrong’ ways go bust, and the companies that can do it better buy up those assets and get going.
That’s bad news for investors. There is disruption and loss before improvement and a boom.
Investors need to be keenly aware that the world may well have changed after the pandemic, as it had after the First and Second World Wars. But that the end of a gigantic misallocation of capital is not a boom, but a bust.
A huge proportion of the economic activity that we lost must be brought back, which is not easy and involves a drop in GDP and likely investment returns.
And a huge proportion of the pandemic-related economic activity currently taking place likely doesn’t make sense anymore or won’t soon. Again, this is a misallocation of capital which must be corrected. And such corrections take their toll on investments.
The narrative you are being sold about how our economies will recover fails to make a distinction for the fact that the capital in our economy has gone through the third largest misallocation of capital I can think of. The energy crisis is just one example of a consequence. Plenty more are lurking in our stock markets.
Until next time,
Editor, The Daily Reckoning Australia Weekend
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