Morningstar Magazine - October/November 2016 - 46

Strategies Monetarism Through the Looking Glass Why has monetary expansion failed to promote growth in the real economy? Tax Wise 51 Permanent Tax Savings and Techniques 52 A Primer on Bond Math, Part II 56 Investment Research ETFs: The Case for Multifactor ETFs Funds: The Rise and Fall of New Funds THE ECONOMY Laurence B. Siegel and Paul D. Kaplan Quant U 61 Negative interest rates in Europe and Japan. Itsy-bitsy, teeny-weeny positive interest rates in the United States. One round of quantitative easing after another. An economy that stubbornly refuses to grow. Have we gone through Alice's proverbial looking glass? Best Ideas 64 66 68 Manager: Sizing Up a Property Portfolio Passive: Growing Appetites Equity: Sailing With a Tailwind In 1946, Henry Hazlitt, the great explainer of economics to the masses, distinguished between good and bad economics: The bad economist sees only what immediately strikes the eye; the good economist also looks beyond. The bad economist sees only the direct consequences of a proposed course; the good economist looks also at the longer and indirect consequences. The bad economist sees only what the effect of a given policy has been or will be on one particular group; the good economist inquires also what the effect of the policy will be on all groups.¹ In thrall to Hazlitt, we distinguished good from bad monetary economics: Bad [monetary] economics...looks at the initial impact [of an action]. We see interest rates fall at the time that the Fed buys the Treasuries and conclude that interest rates have fallen. However, the initial fall in interest rates is only the first of a sequence of events that will result in interest rates rising. [Bad monetary economics] assumes that because the Fed intends or wants to lower interest rates, it will succeed in doing so. There is no reason to expect this. It fails to distinguish between real and nominal interest rates.²,³ We told a story in which the Nobel prize-winning economist Milton Friedman was a hero: In his presidential address to the American Economic Association in 1967, Friedman showed that the [Keynesian] Depression-era paradigm was bad economics.⁴,⁵ He noted that the theory focused exclusively on short-run effects and confused real and nominal quantities. Through the Fisher effect, he explained, expansionary monetary policy leads to higher rather than lower interest rates. There is no long-run trade-off between inflation and unemployment, as Friedman's contemporary, Edmund Phelps, had recently demonstrated.⁶ Expansionary 1 Hazlitt, Henry. Economics in One Lesson. New York: Harper & Brothers, 1946. 2 Kaplan, Paul D., and Laurence B. Siegel. "Good and Bad Monetary Economics, and Why Investors Need to Know the Difference." Paul D. Kaplan, editor, Frontiers of Modern Asset Allocation, Hoboken, N.J.: John Wiley & Sons, 2012. 3 It was the great American economist of the early 20th century Irving Fisher who first made the key distinction between real and nominal interest rates. Nominal interest rates are what we observe in the market. However, because investors care about real values (how much can be obtained in goods and services), investors care about real interest rates rather than nominal rates. According to Fisher, the difference between nominal and real interest rates is the expected rate of inflation. Hence, the nominal interest rate is the real interest rate plus the expected rate of inflation. 4 Friedman, Milton. "The Role of Monetary Policy." American Economic Review, March 1968. 5 According to John Maynard Keynes, in his 1936 book, The General Theory of Employment, Interest, and Money, the level of employment in the economy depends on "aggregate demand," which is the sum of consumer spending, business investment spending, and government spending. If business investment spending is too low, the economy will settle on a low level of employment so that many people will be out of work, as was the case during the Great Depression. The remedy is to expand government spending sufficiently high to get the economy back to full employment. To this day, this is the position of Keynesian economists. 6 Phelps, Edmund S., "Phillips Curves, Expectations of Inflation and Optimal Unemployment over Time," Economica, Vol. 34, No. 135 (August 1967), pp. 254-281, 46 Morningstar October/November 2016

Table of Contents for the Digital Edition of Morningstar Magazine - October/November 2016