“You do not need to know precisely what is happening, or exactly where it is all going. What you need is to recognize the possibilities and challenges offered by the present moment, and to embrace them with courage, faith and hope.” ― Thomas Merton

We’ve written in the past about the difference between thinking you can predict the future (hint: you can’t) vs being aware of the range of possibilities and the range of probabilities of each possible outcome. We’ve explored these concepts in posts such as Investing Under Conditions of Uncertainty and Pick Your Poison: Implicit vs Explicit Forecasts, both of which focused on how we think about incorporating macroeconomic assumptions into our evaluation of individual company investments.

Our message has been that while investors cannot hope to accurately forecast the behavior of the economy over the short term, it is inescapable that investors must maintain a set of expectations about the long-term path of macroeconomic variables. If investors do not make these expectations explicitly, then they do so implicitly, often without realizing that these assumptions are driving their individual company assessments.

When thinking about the future range of possibilities, not only for the economy but for anything related to how human society will operate, we can often look to history for guideposts. Could inflation in the US jump to 10% or more at some point in the future? Well it did in the 1970s, so this does seem to be a possibility we should consider. Could inflation jump to crazy levels like 50% or 100% a year or more? While this has happened in failing states such as in Germany after World War I, Zimbabwe in the years just before the global financial crisis or Venezuela in recent years, there is no precedent for hyperinflation in functional economies. And so, unless we are also willing to forecast the possible failure of the US economic system, it is very unlikely that we will see hyperinflation over any meaningful investment time horizon.

But despite the range of possible outcomes for inflation being relatively wide, until just recently it was very clear what American monetary authorities believed was the acceptable range of inflation outcomes. There was broad agreement that inflation should be guided towards a target of 2% while also never letting inflation rise much at all above 2% other than for very transitory periods. But this summer, the Fed updated their monetary policy framework saying:

“The Federal Open Market Committee has adjusted its strategy for achieving its longer-run inflation goal of 2 percent by noting that it “seeks to achieve inflation that averages 2 percent over time.” To this end, the revised statement states that “following periods when inflation has been running persistently below 2 percent, appropriate monetary policy will likely aim to achieve inflation moderately above 2 percent for some time.”

Thus, the Fed changed the range of possible inflation that they would accept. Had they had this policy in place over the last decade, they may never have begun raising interest rates the way they did from 2016 to 2018 (and then subsequently had to reverse in 2019). While the Fed cannot completely control inflation, they are the most powerful actor in the global economy in influencing the rate of inflation. So, while previously it may have been logically inconsistent to think that inflation could run at 3% for a number of years, even while the Fed kept rates low, the Fed has now signaled that this sort of economic outcome is not off the table.

The best way to understand what happened at the Fed, is through the lens of The Overton Window. At Ensemble Capital, we believe the Overton Window is moving, not only in relation to the Federal Reserve policy towards inflation, but across a range of very important social contracts that govern the economic possibilities. We think it is critically important that investors pay attention to these shifts and consider to what extent the shifting Overton Window changes the possible range of explicit or implicit expectations they have about the future.

The Overton Window

The Overton Window is a concept named for Joseph Overton, a political theorist. Overton argued that the range of political policy possibilities was not directly related to any politician’s individual preferences, but rather by the range of options that are politically acceptable to mainstream voters. This range of politically acceptable outcomes changes over time, but at any given moment, only policy options that fall within the Overton Window have any hope of becoming reality.

(Source: Hydrargyrum via Wikipedia)

As the diagram shows, the Overton Window covers the range of options that are considered Popular or Sensible, but once a particular policy is only deemed Acceptable, its odds of becoming reality start falling. Radical or Unthinkable proposals have no chance of actually being implemented, even if they are completely possible in a practical sense.

This short video from the MacKinac Center for Public Policy, where Overton worked until the time of his death in 2003, offers a simple, two and half minute explainer on the Overton Window.

Some key points:

• The Overton Window does not say what is good or bad, it only describes the range of possibilities that society will accept.
• The authorities do not decide where the Overton Window lies, rather society collectively defines the Overton Window and authorities operate within the window.
• The Overton Window is not static. It moves over time, typically slowly, but occasionally rapidly. These changes are triggered by a range of different inputs, but notably one key trigger for abrupt and large shifts in the Overton Window are major society-wide crises.

While the Overton Window concept is meant to describe political possibilities, the concept has broader application to any situation in which a group of people are collectively making decisions. Here’s a simple example:

• On March 9^th of this year I met in person with a client in Ensemble Capital’s offices. We didn’t shake hands and we kept some social distance, but it didn’t occur to me or the client to cancel the meeting. At this point, meeting in person was Policy and canceling the meeting would have been Unthinkable or at least Radical.
• On March 12^th, my kids’ school canceled in-person classes due to concerns about COVID.
• On March 14^th, my teenage son asked to go hang out with his friends. My wife and I weren’t sure what to do as the COVID news kept getting worse, but ended up telling him no. At this point, him meeting in-person with his friends had become Acceptable, but was no longer Policy or even Sensible.
• On March 16^th, the San Francisco Bay Area became the first region in the nation to declare a mandatory shelter-in -place order. Every single in-person business or personal meeting was immediately canceled by the nearly 8 million residents. On that day, and ever since, meeting in-person with clients is no longer the Policy of Ensemble Capital, indeed it has become Unthinkable or at least Radical. This doesn’t just reflect a change made by our firm. Not a single client has even asked to meet in-person and most of our clients would question our judgement if we invited them to come meet with us in our office.

Seven days. In seven days, what had been Policy became Unthinkable and what had once been Unthinkable became Policy. The Overton Window shifted. This was not a unilateral decision made by us. It was a shift in what society deemed to be the range of possibilities.

What is amazing about the Overton Window is that most of the time you aren’t even aware it exists. The possibilities that are Unthinkable are not thought of as not possible due to current social norms, rather they are viewed as actually impossible. But when the window shifts, it is hard to even remember how things used to be. I bet some of you reading the timeline above may question why I was willing to meet a client in person on March 9^th. But of course, at the time, it would be been Unthinkable, or at least Radical if either I or the client had canceled the meeting. The fact that looking back today it seems like such common sense that the meeting should have been canceled, is evidence that the Overton Window has shifted.

The Overton Window is always shifting. But typically is shifts slowly enough that we don’t even notice it is moving until one day we look back to a time a decade or more in the past and think to ourselves “can you believe we used to do/think….?”

But in a crisis, particularly a major crisis that impacts many people and persists for a long time, the Overton Window can move very quickly. So quickly, that rather than adapting to the new range of possibilities, many people assume that the new possibilities being discussed are Radical or Unthinkable and they assume that at some point everyone will “come to their senses” and go back to thinking the way they used to. This is a very dangerous mistake for investors to make.

So where is the Overton Window shifting today? As you read the passages below, keep in mind that the Overton Window does not describe what is good or bad, only the range of possibilities that society will accept. It is most useful for investors to recognize when a previously Unthinkable or Radical idea has become Acceptable. An Acceptable idea may never become Policy and may drift back out of the Overton Window over time. But if you wait to identify or think about these shifts until an idea has become Policy, then any investment opportunities (or risks to avoid) will have already played out. So don’t take our comments below as predictions or policies that we are advocating for, but rather ideas that we believe are entering the Overton Window and so must start being considered as possibilities.

Inflation

As described above, the Federal Reserve has already adopted a new Policy on inflation. Their prior Policy on inflation failed to achieve their goal of persistent 2% annual inflation for over a decade. Many market participants expected inflation to move much higher as the Fed engaged in massive monetary easing after the Financial Crisis. But that inflation never arrived. More recently, as the unemployment rate reached historically low levels, the Fed began raising interest rates believing that the labor market conditions would trigger inflation. But any inflation that did arrive was extremely transitory.

The Fed no longer views any inflation of over 2% as a signal that they must reduce their support for the economy. Rather they see getting inflation over 2% as a sign that they are succeeding and do not plan to start tightening monetary support unless evidence builds that inflation is shifting towards a persistent 2%+ level.

While this reaction function is now official Federal Reserve policy, financial markets are currently pricing inflation to average just 1.7% inflation over the next five years and only 1.85% over the subsequent five years. This means that either financial markets have not yet recognized that the Overton Window has shifted, or the market does not believe the Fed will actually follow through, or the market believes the Fed is not actually all that influential in managing the rate of inflation. Thus, either financial markets are mispriced or the power of the Federal Reserve is greatly exaggerated.

This shift has major implications for bond yields, companies’ ability to raise prices, wage increases for middle and lower income workers, and the size of fiscal stimulus that Congress can approve without the Fed feeling like they need to tighten monetary policy in a way that would blunt the impact of the fiscal spending. Indeed, despite his long history of publicly voicing concerns about Federal deficits and the level of Federal debt (doing so as recently as mid-February of this year), Fed Chairman Jay Powell is now begging Congress to spend more money.

Whether the shift at the Fed is the right or wrong policy is a different question. But as Peter Hooper, Deutsche Bank’s Global Head of Economic Research put it, “[Powell’s] lasting legacy I think will be the important shift in the orientation of Fed policy. It’s as important as what Volcker did in the 1980s.”

Paul Volcker is credited with crushing the high rates of inflation that existing at that time and creating the conditions under which high levels of inflation have been a non-issue for the last 40 years. Here is William Poole, a former Fed president describing the massive impact of Volcker’s change to official Fed policy.

“Volcker, in office only two months, took the radical step of switching Fed policy from targeting interest rates to targeting the money supply… We’ve learned a lot from that period. For starters, ideas matter. Bad economic advice, much of it from economists, contributed greatly to policy mistakes in the pre-Volcker days… Without his bold change in monetary policy and his determination to stick with it through several painful years, the U.S. economy would have continued its downward spiral. By reversing the misguided policies of his predecessors, Volcker set the table for the long economic expansions of the 1980s and 1990s.”

Modern Monetary Theory

With the shift at the Federal Reserve, it is now clear that the previously accepted economic models of inflation have failed. We now know that those models that were previously Policy are wrong. They may not be wrong in all economic environments, but they failed for a decade and so it has now become Policy to recognize that these previously accepted models are no longer Sensible.

A few years ago, the concept of Modern Monetary Theory (MMT) started to enter the public consciousness. While this theory is not new, it was previously considered Unthinkable. Starting a couple of years ago, the Overton Window began to shift with MMT sliding from Unthinkable to Radical. When Congress approved a simply massive level of spending back in March, market participants began to realize that one way to view this action was as a real-time experiment in MMT informed policy. Not that either the Democrats or Republicans who voted on a bipartisan basis did so because of MMT, but rather because MMT adherents argue that this massive level of government spending will not result in increased inflation nor will the large associated deficit, or the increase in government debt, prove to be problematic.

A full description of MMT is beyond the scope of this post. But in June, prominent MMT economist Stephanie Kelton published The Deficit Myth, which offers an incredibly accessible explanation of MMT that is easily understandable (and frankly enjoyable) for non-economists. In fact, the book is a major, mainstream best seller which is a rare feat for any economics book.

And it isn’t just that the public is increasingly open to these ideas. In July of this year, Bloomberg Businessweek profiled MMT wunderkind Nathan Tankus. 28-year old Tankus doesn’t have a college degree, let alone a PhD in economics from an Ivy League university. He is a textbook example of a heretic in the halls of traditional economics. A Radical espousing Unthinkable ideas on economic theory since he began building an online following in 2015 at age 23, the Bloomberg profile highlighted how interest in Tankus’ work has exploded within those traditional institutions from which he would have previously been excluded.

Whether Tankus theories are correct is a matter of debate, but there is no doubt he is a bonafide genius.

Here’s Bloomberg:

“After the Fed began announcing a series of extraordinary measures to rescue the U.S. economy, Tankus wrote 21 long pieces in 31 days. “Sometimes that meant staying up until 5 or 6 a.m.,” he says. “It was unbelievable breakneck speed.”

His posts earned the attention not only of people who share his liberal views, but of ones who just wanted to understand the nuts and bolts of what the Fed was doing. His Twitter followers include reporters from Bloomberg News, the Wall Street Journal, and the New York Times; Peter Orszag, a former Obama administration official who’s the Chief Executive Officer of Financial Advisory at the investment bank Lazard; and Alan Cole, a Senior Economist to Republicans on Congress’s Joint Economic Committee.

… he has followers at the Fed, the Securities and Exchange Commission, the Office of the Comptroller of the Currency, and the Department of the Treasury.”

Starting in early August, just as the Fed was finalizing the changes to their monetary policy framework, the New York Federal Reserve’s Twitter account began following Tankus, adding him to a list of Who’s Who in mainstream economics.

The key point is not that MMT is correct. Rather that the MMT view of the world is now entering the Overton Window and is probably best described today as Acceptable. It is not yet considered Sensible or Popular, but in a strange way it may actually already be Policy in that the massive deficit spending engaged in this year is widely agreed as having been one of the most effective fiscal interventions in history.

While some may argue that the Democrats’ likely (unless they win both Georgia runoff races) failure to win the Senate means large government spending is off the table, the Overton Window is not about which party holds a slight majority in Congress. Rather the Overton Window describes the range of policies that society deems acceptable and both political parties are required to operate within this window.

You can see this already playing out with the Republican controlled Senate authorizing a shocking $2 trillion stimulus bill in March, twice as large as all of the stimulus spending done during the Financial Crisis. And today, Republican Senators are calling for “just” $500 billion in additional spending, while the bipartisan Problems Solvers Caucus, made up of moderates on both sides of the aisle, are calling for “just” $1.5-$2.0 trillion in new spending. Either one of these bills, on top of the over $2 trillion in spending already approved, would have been completely unacceptable prior to COVID. The size of this spending dwarfs anything that voters or a majority of Congress would have considered possible.

The Unthinkable is now Policy.

Unemployment Insurance

One important subset of government spending and the fiscal response to the COVID recession was the enhanced unemployment benefits that were authorized. Pre-COVID, unemployment insurance typically replaced just 40% of lost wages. Imagine losing 60% of your income. It’s better than losing 100%, but still a complete financial catastrophe, especially if you are lower/middle income and thus most of your spending is non-discretionary. But the CARES Act, passed on a bipartisan basis, was designed to make unemployment insurance replace 100% of lost income,

There are two obvious counter arguments against doing full income replacement for the unemployed.

First, there is the argument that the government cannot afford it. This may be the case, although MMT argues that this is not true, especially if unemployment income replacement is delivered in exchange for doing work for the government (a guaranteed job program) rather than simply paying people to do nothing. But since full income replacement actually became Policy (on a bipartisan basis), we don’t have to theorize. We are witnessing a massive economic experiment on an unprecedented scale and so how it works out will greatly influence future government program design.

Second, there is the argument that if we fully replace wages, there is no incentive for people to go back to work. This makes a ton of common sense. Yet the data suggests that full income replacement was not a binding constraint on people returning to the workforce while the program was in place earlier this year. Indeed, a study of the labor market in June showed that 70% of the people on unemployment insurance who returned to work were making more money on unemployment, yet still returned to work.

Why might this be? Well the program was time-limited. The purpose of unemployment insurance is to act as a bridge to help a worker survive financially during a gap in employment. It isn’t supposed to be a welfare program for people who are persistently unable or unwilling to find work (the government has other programs that address this separate issue). So it may be entirely rational for unemployed workers to accept a job at the same or lower pay than they are receiving via unemployment insurance if the job offers longer term stability vs short term support.

Setting aside any opinions about what is fair or affordable, it is simple to observe that people returned to work at record high rates even while the enhanced unemployment benefits were in place. And it is clear that the economic catastrophe of COVID was greatly reduced due to the enhanced benefits as the US economy, and consumer spending in particular, has been much more resilient than feared.

So while in February of this year, the idea of full income replacement for everyone who loses their job would have been Unthinkable or at least Radical, today it is Acceptable or even Sensible, and it could well become Popular or Policy on a more permanent basis before the next recession rolls around.

This could be a really big deal for economic cyclicality. In a typical recession, businesses realize there is not as much demand for their products and services as they are prepared to supply. So they lay off workers, which cuts income, which reduces demand, which causes businesses to lay people off, etc. If it turns out that there is now societal acceptance of attempting to short circuit recessionary feedback loops, even at massive government cost, the character of consumer spending (which makes up 70% of US GDP) could be very different going forward.

Remote work

Remote work is a perfect example of the crisis triggering a nearly instantaneous and dramatic shift in the Overton Window. Prior to the pandemic, very few people in the US worked from home regularly.

Ever since the rise of the consumer internet in the late 1990’s people have recognized the potential for a shift to remote work. And indeed, the percent of people working remotely did nearly double over the last two decades. Yet even after a quarter century of mainstream usage of the internet, and in the age of ubiquitous high-speed broadband and an internet connected device in every pocket, the shift towards remote work was at best a slow grind.

Managers worried that people working remotely wouldn’t be as productive, that company culture would suffer, that working from home was a “perk” that employees might appreciate but did not serve a business purpose for the company.  But COVID flipped remote work from a perk to a mission critical requirement for any company that hoped to survive. Today, almost every American of every age has learned how to conduct video conference calls, whether to complete work, to connect with friends, or to see their grandchildren.

At Ensemble Capital we began embracing remote work in 2017 and hired our first full time remote employee in another city towards the end of that year. Concerned about the potential impact on productivity and corporate culture, we moved slowly. We spent a year allowing people to work remotely once a week, then another year allowing twice a week.

In 2019 we switched to allowing everyone to make their own decision about where to work on any given day and asked that they work at the physical location that was most productive for them based on the particular task they needed to complete. Going into the pandemic we were averaging about 30% occupancy in our physical office, had hired another full time remote employee outside the Bay Area, and had three more employees switch to full time remote, with one of them moving to another city.

So just before the pandemic started, we had a third of our staff working full time remote, with 20% of our staff living and working outside the San Francisco Bay Area. The two-thirds of our staff that still had their own desk at the office were only using that desk one to two days a week. It was all working just fine for us. We saw no drop off in productivity or deterioration of our culture (although we believe this can only be achieved by companies that embrace remote work from the most senior executives on down and proactively maintain and cultivate a digital corporate community that preserves relationships and key cultural elements.)

But despite the internal success, we knew that working in this way was still Radical and indeed we had both clients and prospective clients question whether working in this way was actually effective. But today the Overton Window has shifted. Today, clients and prospective clients are impressed with our flexible, remote-first culture. Rather than see it as a potential risk, they see it as a competitive advantage that we have research analysts living in different parts of the country bringing cognitive diversity to our investment analysis. When hiring, we’ve gained access to a much larger pool of talent, instead of limiting ourselves to people who just happen to live within commute distance of our physical office (which given the increasing gridlock of Bay Area freeways, was a quickly shrinking radius around our office).

Today, remote work is considered Sensible or Popular. In a year or two, it seems certain that it will be Policy for at least some material segment of corporate America.

We could go on and on. Mean reversion, or the tendency for trends that deviate away from historical patterns to revert back to the long-term average, is a powerful concept that is often the right way to think about the future. In Overton Window lingo, mean reversion can be understood as the way in which outcomes tend to drift back and forth within any given Overton Window range.

But there are times, and today is maybe the most dramatic example that we will ever experience in our lifetimes, when Overton Windows applying to all different aspects of life suddenly shift dramatically.

As theologian Thomas Merton observed in the introductory quote to this post, you don’t need to be able to know in advance how each of the trends we have discussed (or the many other Overton Window shifts occurring that we did not discuss) will play out. Rather you just need to “recognize the possibilities and challenges offered by the present moment, and to embrace them with courage, faith and hope.”

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