business cycles


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It’s one of the most important questions this year: Where are bond yields in the United States heading next? For Jeffrey Sherman the answer seems to be obvious: «Up», he signals with his thumb while at lunch at the Los Angeles headquarters of DoubleLine Capital. The Deputy Chief Investment Officer at the renowned fixed income boutique of bond king Jeffrey Gundlach expects more turmoil for financial markets and draws parallels to 1987, the year of the monster crash. At this time, the lively and approachable Californian spots the most attractive opportunities in the commodity sector since commodities tend to perform well in the late stage of the cycle.

Mr. Sherman, tensions in the financial markets are rising. As someone who likes financial history, what are your thoughts when you look at the big picture?
From a short-term perspective, it sure feels like 1987: a little spookiness in the stock market and yields rising. So there are a lot of parallels to 1987. For example, tariffs, a weak dollar and a new Fed Chairman. And remember, there was the crash before the crash. That year, the stock experienced some jitters already in April and about six months later you had the big crash on Black Monday.

That day in October 1987 the Dow Jones suffered its biggest loss in history. At that time people pointed to electronic trading and new financial products like portfolio insurance. Do you spot similar risks today?
People blame quants, people blame algorithms, people blame risk parity. But I’m not convinced. The reason we had this sell off is not algos or risk parity. It’s because of humans. For instance, we all have been told that ETF buyers are buy and hold investors forever. But they’re buy and hold investors until they’re not, until they panic. That’s why these websites for electronic trading like Betterment and all the other Robo-Advisers were down on February 5th. I think even Fidelity had an issue because of the huge volume. So why did all these people try to log in? They weren’t logging in to buy, they were logging in to sell!

What’s next for stocks?
I think you’ll see it again. If bond yields rise you are going to see another scare. It’s the velocity, it’s the speed at which this correction happened: 10% in roughly three to four days, that’s a big move. But what’s interesting is that the bond market was not behaving in a manner which is consistent with the recent past. It didn’t seem like it wanted to rally. Bond yields essentially ended flat that week if not slightly higher. To us, that causes us pause. It means that this correction was an equity market story and bonds weren’t even paying attention to it. Basically, the bond market said: look we continue to trade on fundamentals. We have bigger deficits, we have a growth story, so yields need to be higher.

So what has changed in the bond market?
What has changed is the tax cut. The tax plan really started in the middle of September and that’s when you saw the bond market reacting. That’s when President Trump felt he had to do something and it took him and congress the rest of the year to get it done. At that point, the market had shifted from its disinflationary mindset to a moderate inflation mindset. And that’s the repricing that has been taking place.

Is the tax cut really a game changer for the US economy?
As critical as people were initially of the tax cuts, the cuts are beneficial in 2018 for roughly 98% of the working class. That means that there is more money to be spent or saved. Also, there is something about paycheck growth versus one-time bonuses. In the former case, people tend to spend more, especially people low-income earners because they are the spenders by definition. They don’t make enough money to save. So I think there is the potential to get a little bit of inflation. Because if it is that expansion from the consumer, it will look growthy, but it will also look inflationary. But how long it persists is the multi trillion-dollar question.

What’s more, the tax cuts will bloat the deficit even more. What’s your take on that?
We have an administration and a Congress which want to spend money. For instance, Senator Rand Paul was filibustering for about two hours, ranting about the increase in the deficit and then voted for the tax plan. It’s hypocrisy. So I think they will continue with this deficit binge.

How will this impact the midterms in fall?
People are speculating if the Democrats are going to take over. Socially, they probably could. But they are going to have a hard time economically to take over either the House or the Senate; simply because the tax cuts are going to trickle through and many workers are going to get the benefit of minimum wage. So even the people who aren’t truly getting a tax cut are getting a pay hike. They are going to say: “Look how well we did.” So for the Republicans the timing is beautiful. But I think it reverses in 2020. That’s something we have been talking about for a few years: It’s not the 2016 election that really is the one that’s going to be a pivot. It’s going to be 2020. The reason for that is that the deficits are going to explode, and this administration seems to love debt.

And how do you cope with political risks like the Muller investigation form an investor’s perspective?
The Mueller investigation looks bad. I mean that thing gets worse every week or two. But markets don’t care. They only care if there is an impeachment and then you will get a short-term correction. But it’s very hard to impeach the president. Even if the Democrats get it in one arm of congress they would have to get it through the Senate. So they would have to go to trial in the Senate and the Republicans still have a blocking majority there. And the Republicans showed that they’re loyal to Trump. So it’s practically impossible. But there is always political risk in the world. And typically, the flight to quality trade is what works. That’s why you own high quality bonds like Treasuries, Japanese government bonds and things like that.

So where are US bond yields heading in 2018?
I think we’re going to 3.25 to 3.5% on ten year Treasuries. We broke through most levels on the ten year bond and on the thirty year bond. They have broken their downward channels. Coming in the year it was like: “Hey, we will probably test 3% on the ten year by the first half of the year. Then in January it turned into: “You know, it’s probably the first quarter”. Now it’s maybe March because the bond market does not want to rally. But it’s not just technicals. We’re talking about the Fed’s balance sheet, we’re talking about expanded deficits and we’re talking about less revenue coming in for the government. Don’t forget tax cuts aren’t free.

What does that mean for the new Fed chief Jerome Powell and his plans to tighten monetary policy further?
In March he’s going to hike the Federal Funds Rate. But if you want to hike interest rates three or four times this year plus do the balance sheet unwinding then I think we’re going to have a problem early 2019. I think the financial markets will respond and that’s not good for risk assets. So I’m not convinced that the Fed will take this entire path because I think it becomes painful. This was all set up by Yellen around a year ago. Since then, a lot of fundamentals have changed in the debt market. The plan was set up when yields were lower and before we were set to double the deficit. So it’s really hard to say how the path will look like for the Fed. That’s why we were all listening and watching how Powell behaved when he took the stage this week. It looks like the Fed is going to be more hawkish. But If you want to finance all that debt, you kind of need some dovish people on the board of the Fed. You don’t really want Hawks on there.

Where do you see the biggest risks if something goes wrong?
It’s not that we are extremely bearish on the world. But if rates go up it will put some upward pressure on spreads. And if you respect financial history, what the Fed has always done is hike until something breaks. We definitely had the debt build up. Looking at debt to GDP, people talk a lot about a bond bubble. But it’s not in the treasury market and it’s not in the housing market. It’s in Corporate America.

What’s wrong with Corporate America?
Many companies really lived on due to this low interest rate environment. Zombie companies, those that earn less than they pay in interest, are on the rise again. That’s why you have to watch the corporate market. Right now, it’s not a problem. But let’s say we go to 4% on ten year Treasuries. Does a 6% high yield bond make sense? Probably not. It’s probably 9% or 10% because you have to worry about refinancing. So this is something that hasn’t really happened historically. In fact, the high yield market lived through the entire secular bond bull market. So if we go into this structural bear market, the junk bond market is toast. You are going to have 30% to 40% default rates. That’s extreme thinking. But let’s just take it back down: A 4% on the ten year bond seems completely plausible. So how do you think these risk assets respond? And what does it mean for other markets? People have become complacent with high yield bonds. They assume they don’t default hardly ever. But we know that’s not true. There’s a reason they carry this kind of rating.

Junk bonds tend to act more like stocks in their market behavior than other bonds. What’s your outlook on equities?
One of the most dangerous things is naive extrapolation. Last year, most equity markets advanced more than 20% in dollar terms. So I think some of the risk this year is this naive extrapolation of this recent experience. It’s this recency bias that people think that it just can continue forever. So the risk is that people get complacent and think that equites can always go up.

What is your recommendation when it comes to investing in stocks?
In the US, it’s very difficult to say stocks are cheap. In terms of valuations, when you think about the Cape ratio for instance, you have roughly a 33 ratio on the US market, something closer to 22 to 23 on Europe and about 18 on emerging markets. So what you see is that the European market and emerging markets are a lot cheaper. Also, if you buy into this thesis that we will continue to have this coordinated global growth story, then the emerging markets should be the biggest benefactor. So the ideas is that if you want to deploy new money into equities it’s probably best to kind of shy away from the US because everybody knows the story about the tax reform already. US stocks are priced I won’t’ say to perfection but to a pretty rosy scenario. So if yields push significantly higher it’s really hard on a discounted cash-flow basis to rationalize all of that.

So where do you spot more attractive opportunities for investors right now?
Commodities is our choice investment for investors to get diversification at low prices. It’s an area that tends to do well late in the cycle. It’s a fundamental story.  The consumption side has been increasing and there’s upside to that. If we go from 3.5% global GDP growth to 4% that changes the consumption dynamics significantly. Also, commodities are cheap by historical levels which means it looks like they have room to run. People have kicked them out of their portfolios because of how bad they did for years. It’s an asset class that has underperformed the S&P 500 since the financial crisis every year. But if you get some inflation it’s going to be exhibited in this part of the market. Commodities aren’t perfect on inflation. But they’re pretty good when you have changes in unexpected inflation – and that’s what investors are waking up to.

And which commodities do like most?
I like industrial metals. Copper is kind of iffy at times. However, there’s a strong case for nickel due to demand from electric vehicle production. And if we get growth, zinc still looks interesting because it’s used in galvanizing steel. So I think industrial metals have momentum. I’m optimistic for the precious metals as well. If we do get inflation signs you will see that in the gold and silver price. What’s more, I still think oil goes higher. I think demand will pick up and we will get back to $80. Maybe not this year. Maybe it takes two years. But if the growth story is true the energy market is too cheap still.

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The lesson to be learned was not that QE or zero interest rates are omnipotent in supporting stock prices. The lesson was not that valuations are irrelevant, or that “this time is different” in ways that investors cannot comprehend. The lesson was not that low interest rates make stocks “cheap” at any price. Rather, the lesson was that in the presence of zero interest rates, yield-seeking speculation can persist even in the face of obscene valuations and recklessly overextended conditions. So while one can become neutral, one has to defer a hard-negative market outlook until the uniformity of market internals explicitly deteriorates (signalling a shift toward increasing risk-aversion among investors).

Based on a century of market evidence, I concluded that the distinction is the psychological preference of investors toward speculation or toward risk aversion. Moreover, I found that the most reliable measure of those preferences was the uniformity or divergence of market action across a broad range of internals, including individual stocks, industry groups, sectors, and asset classes, including debt securities of varying creditworthiness. That distinction proved to be extraordinarily valuable. The combination of extreme valuations and deteriorating market internals is precisely what allowed us to anticipate the 2000-2002 and 2007-2009 market collapses.

A few more assertions about the financial markets may be useful to discuss. One with appeal to many investors is the idea that valuations may be high on an absolute basis, but that stocks are still “cheap relative to interest rates.” This too is wrong, but wrong in an interesting way.

As I’ve detailed previously (see The Most Broadly Overvalued Moment in Market History), investors often misinterpret the form, reliability, and magnitude of the relationship between valuations and interest rates, and become confused about when interest rate information is needed and when it is not. Specifically, given a set of expected future cash flows and the current price of the security, one does not need any information about interest rates at all to estimate the long-term return on that security. The price of the security and the cash flows are sufficient statistics to calculate that expected return. For example, if a security that promises to deliver a $100 cash flow in 10 years is priced at $82 today, we immediately know that the expected 10-year return is (100/82)^(1/10)-1 = 2%. Having estimated that 2% return, we can now compare it with competing returns on bonds, to judge whether we think it’s adequate, but no knowledge of interest rates is required to “adjust” the arithmetic.

One intuitive way to evaluate the impact of interest rates is to consider the effect of a given departure of interest rates from normal levels. For example, consider again a $100 cash flow that will be received 10 years from today. If the typical return on such an investment is 6%, the current price will be $55.84. But suppose we expect returns to be held down to just 4% for the first 5 years, then 6% after that. In that case, the current price will be $100/[(1.04)^5 x (1.06^5)] = $61.42. That’s 10% higher than our previous calculation. Why? Because in order to reduce the return from 6% to 4% for the initial 5 year period, the price has to increase by 2% x 5 years = 10%.

Accordingly, if you believe that market valuations should be tightly related to the level of interest rates (the correlation actually goes the wrong way outside of the 1970-1998 period, but let’s assume otherwise), it follows that if interest rates are expected to be 3% below average for the entire decade ahead, market valuations ought to be 30% higher than historical norms. The problem is that the most reliable valuation measures (those most tightly correlated with actual subsequent market returns in cycles across history) are currently between 130-160% above their respective historical norms.

An additional theory crossed my desk in recent weeks, which is that corporate profits are enjoying a “winner take all” phenomenon, which will allow large, dominant companies to retain monopoly-like profit margins indefinitely. Now, there’s no question that many internet-related companies have benefited from network effects that have substantially contributed to their size, as well as their market capitalizations. The question is whether this effect now dominates the profit margin behavior of U.S. corporations more generally. One anonymous analyst, who we like quite a bit for his (or her) analytical approach even when we wholly disagree, recently proposed that profit margins might be more broadly affected by this sort of systematic “winner take all” dynamic.

To that end, Patrick O’Shaughnessy compiled some data by separating companies into five bins based on their profit margins, and then charted the aggregate profit margins of each bin (chart below). The analyst proposed, “If our explanation is correct, then the aggregate profit margins of the higher bins should have increased more over the last few decades than the aggregated profit margins of the lower bins. Lo and behold, that’s exactly what the data shows.”

My response to this is straightforward. The conclusion is wrong, but it’s wrong in an interesting way. That’s not a criticism of either analyst, just an issue with the conclusion being drawn, and it provides an opportunity to learn something valuable. The problem here is that the analysis is an artifact of selection bias.

To illustrate, I generated 100 geometric random walks, and then sorted them into quintiles based on their ending values. It should be clear that the members of the top bin are, by definition, the ones that have benefited the most from randomness, and the members of the bottom bin are, by definition, the ones that have suffered the most from randomness. Even though the underlying paths are random going forward, grouping them by their ending values and then looking backward gives the impression that there is some systematic “winner-take-all” process at play.

That’s not to say that we can reject the possibility of a “winner-take-all” dynamic, but what’s actually required to demonstrate it is to sort the series at some point T, and then show that subsequent outcomes are systematically biased in favor of the early winners. Again, there’s no question that many internet companies benefit from this kind of dynamic (though their market capitalizations already vastly extrapolate the continued expansion of those network effects). For the market as a whole, however, I remain convinced that the main story behind profit margin expansion in recent years has been weak growth in real unit labor costs, and that this is likely to change in the years ahead, as the combined result of weak demographic growth in the labor force, substantially less slack in the U.S. labor market, and limited benefits from labor outsourcing on unit labor costs, given that lower wages often go hand-in-hand with lower productivity.

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In the fall of 2014, portfolio manager Dylan Grice did not know Donald Trump would run for President of the United States.

But it seems he did know that Trump would win.

It was a different time. Two years ago it seemed like the world was finally emerging from the slow economic growth it had experienced since the end of the financial crisis. The stock market was riding high, deals were getting done at record rates, and companies had no problem selling their bonds no matter what their grade. It seemed like we, the world, would soon get rich again.

But in a note called ‘Vampires, credit and cycles of trust,’ Grice rejected that notion.

“One trend we’re particularly concerned by is the increasing prominence and relevance of ‘tribal’ fault-lines long invisible to the rest of the world,” he wrote.

Something dark and divisive was taking over the world. While the market carried on as if everything was fine, confrontations of all kinds were on the rise. The cooperation between nations; between governments and their people; between people and corporations; was falling away. Grice could see it, and he knew that eventually, it would consume a market in deep denial.

“What we do think we know is that financial markets are playing with a very cooperative mind-set while the key players and factions in the outside world are not. Non-cooperators are on the ascendency and the investment climate will soon reflect this.”

Why is this? It’s simple. Markets do not function without trust and cooperation. Meanwhile, as Grice laid out in this paper, human history moves in cycles of trust — in peaks and troughs of cooperation.

We the world in 2016 are descending into the trough of a trust cycle that peaked with the end of the Cold War and the cooperation that followed until September 11th, 2001. In this downward spiral there can only be pain and conflict until we learn to trust one another again.

And that takes a great deal of time, and in that time, suffering.

Make America Tribal Again

I needn’t expound on the tribal nature of Trump’s campaign. It was about keeping people out of America, not bringing people in. It was about returning to a past the country lost, not opening our minds to the future we should, and inevitably must, face.

In no other part of Trump’s policies is this more evident than in his toxic talk of global trade. It is as vicious as it is unfair.

Never mind that global trade has been on the decline for the last 5 years, never mind that Americans have lost a thousands of jobs to automation rather than globalization. None of that matters. Trump’s rhetoric about China, about Mexico, about NAFTA, about the Trans Pacific Partnership, is not about facts, it’s about feelings.

And it’s certainly not about cooperation or peace either. It is about an aggressive tit for tat in which the United States has already been offended.

In Trump’s mind Americans – the citizens of the most rich and powerful country in the world – are victims. And we victims, he believes, are entitled to take back what is ours. This combination of victimisation and entitlement is one of the most dangerous combinations in human nature.

So again, we can turn to Grice’s paper. Credit, as Grice points out, comes from the Latin word for trust. Like credit, trust takes a long time to build but just moments to destroy. It is a cycle — when trust reigns there are always those who see a way to take advantage. Slowly, then, as others observe the success non-cooperators are enjoying, trust breaks down into utter chaos.

Over the past century we’ve completed roughly two cycles in which credit (and trust) has boomed and then gone bust, resulting in massive sovereign debt defaults.

Those two periods were the 1920s into the Great Depression and the 1970s into the 1980s when many emerging markets defaulted after commodities prices collapsed.

As for the Great Depression, it was with an uncooperative mind-set that the US — its back angrily turned against the world after World War I and struggling with economic inequity — enacted the Smoot Hawley Tariff in 1928, which put tariffs on 20,000 imports.

It was supposed to help farmers struggling with a modernising world. What it did was tip the world into the Great Depression.

“As a result, US trade halved within years, and global trade weakened even more, even if it continued at low levels within regional trading blocs such as the Commonwealth and the remnants of the Gold Bloc,” wrote Deutsche Bank strategists in a recent note to clients.

“The rise in protectionism served as an important catalyst to the global recession.”

That recession was the crystallization of our distrust, and that trust was only rebuilt after the world was entirely remade through the violence of WWII.

There’s nowhere to run

It is fair to say that the world staved off chaos with the bust of our last financial crisis through careful cooperation. But cycles find a way of asserting themselves. With Trump’s election, with Americans’ demonstration of failure to trust each other and the world, we have joined the darkness Grice was talking about.

“Moreover, Trump’s election victory comes at a time when support for free trade policies and multilateralism is flagging elsewhere. Protectionist parties are poised to do well next year in elections in European countries such as France and the Netherlands. And the UK referendum result means that one of the EU’s strongest advocates for free trade no longer has any influence over EU trade policy,” wrote analysts at Oxford Economics in a recent note.

“The upshot is that there is now a significant risk that the world enters a period of rising trade barriers and tit-for-tat trade wars. Along with an ageing population and fading benefits from technological change, this will help to keep global growth well below its pre-crisis pace for a long time yet.”

Slow growth, if Grice is correct, is the rosiest scenario here. In his paper he discussed the close relationship between debt, inflation and ultimately default. Sovereign and corporate debt has climbed in a time of low interest rates, but those interest rates are rising.

“… this long upswing in debt ratios suggests inflation risk to be a real inflation risk to be a real threat. This would indeed be more consistent with the internal dynamics of trust and cooperation,” he wrote.

And inflation is coming. Trump’s anti-globalization policies will bring it on, as Deutche Bank analysts pointed out in a recent note:

Another important implication is that de-globalization is inherently inflationary. The benefits of trade for productivity growth are well established in economic theory. The disruption of global value chains would constitute a particularly negative supply-side shock that lowers potential output. If multinational corporations were forced to re-onshore production on the basis of prohibitive trade barriers, the likely rise in wage costs as well as in producer import prices would likely be passed on to consumer prices. Slower productivity growth is strongly associated with higher inflation.

These are all ideas that Trump has discussed in one way or another as beneficial to the United States, but they’re not. They’re detrimental to the entire world.

And, it is with great regret that I inform you that it is a world we all live in.

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CHAPEL HILL, N.C. (MarketWatch) — September is an awful month for the U.S. stock market, regardless of how you slice and dice the data.

Since the Dow Jones Industrial Average was created in the late 1890s, September has produced an average loss of 1.1%. The 11 other months of the calendar, in contrast, have produced an average gain of 0.8%.

Furthermore, September’s awful record can’t be traced to just one or two terrible years. On the contrary, the month has an impressively consistent record at or near the bottom of the rankings.

“If a convincing explanation for the September effect were ever found … the historical pattern would quickly disappear.”
Larry Tint, chairman of Quantal International
In fact, as you can see from the accompanying chart, September was a below-average performer in all but one of the dozen decades since the late 1800s. And in more than half of those decades, it was in 11th or 12th place in a ranking of monthly average performance.
Does this terrible track record mean you should “sell in September or get dismembered,” to quote a clever phrase that hedge fund manager Doug Kass recently used in an email to followers?

I’m not so sure.

Awful as September’s record is, bad stats are not, in and of themselves, sufficient reason to make portfolio changes. Correlation is not causation, after all. And, try as I might, I have yet to come across a plausible explanation for September’s record.

And I have tried. Every year around this time, I have asked you to submit your hypotheses for why September should be so awful, and none that has been submitted up until now has been able to withstand statistical scrutiny.

(These are the most popular hypotheses: 1. Investors are more prone to sell stocks when they return from summer vacation; 2. Many mutual funds have fiscal years that end Sept. 30, leading them to engage in “window-dressing” during the month; and 3. Investors are forced to sell equities in September to pay the sky-high tuition bills they’ve just received from their kids’ private schools and colleges.)

Some of you will take this discussion as a challenge to find the “real” explanation for September’s dismal record, but Lawrence Tint advises you not to waste your time. Tint is the former U.S. CEO of Barclays Global Investors and currently chairman of Quantal International, a risk-management firm.

In an interview, Tint told me: “If a convincing explanation for the September effect were ever found, savvy investors would immediately begin jumping the gun by selling in August, others in turn would try to beat them, and the historical pattern would quickly disappear. Unless you or I are able to discover something nobody else knows about, by the time we know why a pattern exists, it’s too late to profit from it.”

In other words, two preconditions must hold in order for it to make sense to bet that September will continue to be awful for stocks. First, the month’s dismal record has to be more than a mere statistical fluke of the historical data. Second, the reason for its terrible performance must remain a mystery.

Good luck with that.

To be sure, there may be other good reasons to avoid the stock market in coming weeks. In fact, I’ve suggested a couple in recent columns — everything from excessive bullish exuberance among market timers to an extremely overvalued stock market.

But note carefully that if you choose to act on those other reasons and build up a cash position in coming sessions, you will be doing so for reasons having nothing to do with the calendar soon to read “September.”

The reason historically was harvest time. Many commodities were sold at this time, thus depressing prices. This would have occurred for a long time. Today, it’s not an issue, but somehow the pattern remained and September is just a bad month for stocks. This can often carryover into October.

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I haven’t had much time to write about economic theory in a couple of years, but this snippet is worth a response.

“People work in order to convert their time into a unit of account,” he said. “We call that money, and it’s an invention that allows us to store time.” Most people have stored little or none. So when they receive money, they quickly purchase necessities; food, shelter, health care. “People who are able to save money inevitably purchase real estate, stocks, bonds – all of which are alternative vehicles for storing time.” One share of Google stores 30 hours of work for the average American, or 30 minutes of copying-and-pasting formation documents for the average hedge fund attorney. “Bill Gates has stored enough time to fund a 1bln person army for 20 years.”

As the gulf between people’s income has grown, the amount of stored time has accumulated in fewer hands. “Wealthy people convert their hours into financial assets so that they can accumulate excess hours relative to their fellow man. But the average worker is simply thinking how to exchange hours for dollars and then exchange those for food.” Central banks face a different problem altogether. They need to get people who’ve saved time to exchange it for something other than clever inventions that store it. They’ve largely failed. So now, everything that stores time is extremely expensive and offers little or negative return, while the pace of economic activity slows. “The problem that we face now is that there is simply too much time that’s been saved. Another way of saying it is that there’s too much capital in the world, in too few hands.”

To restart the system, capital needs to exchange hands or be destroyed, spurring people to rebuild their store of time, rather than just save it. “It is an elemental truth that at some point, through inflation, war, or confiscation and redistribution, this imbalance will correct, and the system will then restart.”

The quote addresses ‘time preferences’. It addresses the choices available to any individual who is involved in an exchange of property rights. This is only addressed tangentially. Property rights are exchanged and stored as ‘money’. This rather begs the question, what exactly is money?

An individual can: [i] exchange money directly, [ii] hold money as cash, [iii] save [invest] money. These are all time preferences.

Investing requires free market interest rates. We do not currently have these as the Central Banks around to world seek to hold nominal interest rates low. There is still however the ‘natural rate of interest’.

In paragraph three, the author asserts that capital needs to be destroyed or change hands. Capital will likely be destroyed, but these are mal-investments.

Mal-investments  are predicated by artificially low nominal interest rates, which, we currently have and have had for quite some time, since the late 1980’s when Greenspan took over the Fed Chair.

Currently we are reaching the end game of artificial rates.

Of course should ZIRP/NIRP end, all business that exists because of these artificial rates, the mal-investments, will likely collapse, which is the destruction of capital that the author refers to.

This would almost certainly lead to a major bear market, which is the bear case. We saw a taste of it in 2008. The unemployment shot through the roof. There are not many ‘depression proof’ industries, the pain is felt everywhere.

Currently, the next internet/housing bubble is most apparent in social media, which relies on advertising revenue for almost 100% of its revenues. This is a problem and is a major destination of current mal-investments.

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Three of the most important objectives for economic policy are:

  1. Achieving full employment
  2. Keeping inflation low and stable
  3. Maintaining financial stability

Larry Summers’ secular stagnation hypothesis holds that achieving these three goals simultaneously may prove very difficult. (See Larry’s statement of the case and a collection of short pieces on the subject by prominent economists.)

The term “secular stagnation” was coined by Alvin Hansen in his 1938 American Economic Association presidential address, “Economic Progress and Declining Population Growth.” Writing in the latter stages of the Great Depression, Hansen argued that, because of apparent slowdowns in population growth and the pace of technological advance, firms were unlikely to see much reason to invest in new capital goods. He concluded that tepid investment spending, together with subdued consumption by households, would likely prevent the attainment of full employment for many years.

Hansen proved quite wrong, of course, failing to anticipate the postwar economic boom (including both strong population growth—the baby boom—and rapid technological progress). However, Summers thinks that Hansen’s prediction was not wrong, just premature. For a number of reasons—including the contemporary decline in population growth, the reduced capital intensity of our leading industries (think Facebook versus steel-making), and the falling relative prices of capital goods—Larry sees Hansen’s prediction of limited investment in new capital goods and an economy that chronically fails to reach full employment as relevant today. If the returns to capital today are very low, then the real interest rate needed to achieve full employment (the equilibrium real interest rate) will likely also be very low, possibly negative. The recent pattern of slow economic growth, low inflation, and low real interest rates (see below) motivates and is consistent with the secular stagnation hypothesis.

Notice, by the way, that the secular stagnation story is about inadequate aggregate demand, not aggregate supply. Even if the economy’s potential output is growing, the Hansen-Summers hypothesis holds that depressed investment and consumption spending will prevent the economy from reaching that potential, except perhaps when a financial bubble (like the housing bubble of the 2000s) provides an additional push to spending. However, Summers argues that secular stagnation will ultimately reduce aggregate supply as well, as growth in the economy’s productive capacity is restrained by slow rates of capital formation and by the loss of workers’ skills caused by long-term unemployment.

The Fed cannot reduce market (nominal) interest rates below zero, and consequently—assuming it maintains its current 2 percent target for inflation—cannot reduce real interest rates (the market interest rate less inflation) below minus 2 percent. (I’ll ignore here the possibility that monetary tools like quantitative easing or slightly negative official interest rates might allow the Fed to get the real rate a bit below minus 2 percent.) Suppose that, because of secular stagnation, the economy’s equilibrium real interest rate is below minus 2 percent and likely to stay there. Then the Fed alone cannot achieve full employment unless it either (1) raises its inflation target, thereby giving itself room to drive the real interest rate further into negative territory by setting market rates at zero; or (2) accepts the recurrence of financial bubbles as a means of increasing consumer and business spending. It’s in this sense that the three economic goals with which I began—full employment, low inflation, and financial stability—are difficult to achieve simultaneously in an economy afflicted by secular stagnation.

Larry’s proposed solution to this dilemma is to turn to fiscal policy—specifically, to rely on public infrastructure spending to achieve full employment. I agree that increased infrastructure spending would be a good thing in today’s economy. But if we are really in a regime of persistent stagnation, more fiscal spending might not be an entirely satisfactory long-term response either, because the government’s debt is already very large by historical standards and because public investment too will eventually exhibit diminishing returns.

Does the U.S. economy face secular stagnation? I am skeptical, and the sources of my skepticism go beyond the fact that the U.S. economy looks to be well on the way to full employment today. First, as I pointed out as a participant on the IMF panel at which Larry first raised the secular stagnation argument, at real interest rates persistently as low as minus 2 percent it’s hard to imagine that there would be a permanent dearth of profitable investment projects. As Larry’s uncle Paul Samuelson taught me in graduate school at MIT, if the real interest rate were expected to be negative indefinitely, almost any investment is profitable. For example, at a negative (or even zero) interest rate, it would pay to level the Rocky Mountains to save even the small amount of fuel expended by trains and cars that currently must climb steep grades. It’s therefore questionable that the economy’s equilibrium real rate can really be negative for an extended period. (I concede that there are some counterarguments to this point; for example, because of credit risk or uncertainty, firms and households may have to pay positive interest rates to borrow even if the real return to safe assets is negative. Also, Eggertson and Mehrotra (2014) offers a model for how credit constraints can lead to persistent negative returns. Whether these counterarguments are quantitatively plausible remains to be seen.)

Second, I generally agree with the recent critique of secular stagnation by Jim Hamilton, Ethan Harris, Jan Hatzius, and Kenneth West. In particular, they take issue with Larry’s claim that we have never seen full employment during the past several decades without the presence of a financial bubble. They note that the bubble in tech stocks came very late in the boom of the 1990s, and they provide estimates to show that the positive effects of the housing bubble of the 2000’s on consumer demand were largely offset by other special factors, including the negative effects of the sharp increase in world oil prices and the drain on demand created by a trade deficit equal to 6 percent of US output. They argue that recent slow growth is likely due less to secular stagnation than to temporary “headwinds” that are already in the process of dissipating. During my time as Fed chairman I frequently cited the economic headwinds arising from the aftermath of the financial crisis on credit conditions; the slow recovery of housing; and restrictive fiscal policies at both the federal and the state and local levels (for example, see my August and November 2012 speeches.)

My greatest concern about Larry’s formulation, however, is the lack of attention to the international dimension. He focuses on factors affecting domestic capital investment and household spending. All else equal, however, the availability of profitable capital investments anywhere in the world should help defeat secular stagnation at home. The foreign exchange value of the dollar is one channel through which this could work: If US households and firms invest abroad, the resulting outflows of financial capital would be expected to weaken the dollar, which in turn would promote US exports. (For intuition about the link between foreign investment and exports, think of the simple case in which the foreign investment takes the form of exporting, piece by piece, a domestically produced factory for assembly abroad. In that simple case, the foreign investment and the exports are equal and simultaneous.) Increased exports would raise production and employment at home, helping the economy reach full employment. In short, in an open economy, secular stagnation requires that the returns to capital investment be permanently low everywhere, not just in the home economy. Of course, all else is not equal; financial capital does not flow as freely across borders as within countries, for example. But this line of thought opens up interesting alternatives to the secular stagnation hypothesis, as I’ll elaborate in my next post.

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