“Companies Prepare Share Buyback Bonanza as Profits Surge”, in the Financial Times.

“US companies announced $484bn in share buybacks in the first four months of this year, the highest such total in at least two decades, according to Goldman Sachs.

“The figure foreshadows a big acceleration in the pace of buybacks, which have already begun to rebound from their nadir last year, when the pandemic encouraged companies to hoard cash in case of a long downturn.”

As you recall from last month’s feature article (“Faster Productivity Growth is Critical. But Will It Happen?”) it is not enough to develop more productive technologies. You also have to scale them up across the economy to achieve sustained gains in productivity and growth.

That requires two critical components:

Investment and a growing supply of employees with the skills needed to make full use of the new technology.
Free cash flow spent on a record level of stock buybacks does not bode well for future productivity growth.

There have been multiple new indicators of rising concern with “corporate zombification”, particularly in the European Union. This represents another potential drag on productivity growth

A new report from the European Central Bank (“Corporate Zombification: Post-Pandemic Risks In The Euro Area”, by Helmersson et al) noted that, “Policy measures aimed at supporting corporates and the economy through the coronavirus pandemic may have supported not just otherwise viable firms, but also unprofitable but still operating firms – often referred to as zombies”.

“This has in turn raised questions about an increased risk of zombification in the euro area economy, which could constrain the post-pandemic recovery.

“Firm-level, loan-level and supervisory data for euro area companies suggest that zombie firms may have temporarily benefited from loan schemes and accommodative credit conditions – but likely only to a modest degree.

“These firms may face tighter eligibility criteria for schemes and more recognition of credit risk in debt and loan pricing in the future. Tackling the risk of zombification more fundamentally requires the consideration of suggested reforms to insolvency frameworks, and better infrastructure for banks to manage non-performing loans.”

In another recent report (“Prevention and Management Of A Large Number Of Corporate Insolvencies”) the European Systemic Risk Board observed that, “A key question is the extent to which support measures in this crisis have had the effect of merely postponing or durably preventing a large wave of corporate insolvencies. In a worst-case scenario, the postponed insolvencies would suddenly materialise and trigger a recessionary dynamic, potentially causing further insolvencies. The current low rate of insolvencies would then be similar to the sea retreating before a tsunami"…

This would lead to knock-on effects:

“A significant rise in corporate insolvencies would translate into higher non-performing loans (NPLs) and impair the banking sector’s ability to finance the economic recovery.”

In addition, “Large-scale government support in the form of loan guarantees have increased contingent liabilities and made the sustainability of public finances more dependent on the recovery of the corporate sector. A surge in corporate insolvencies would result in an additional burden on public budgets on top of the well-known impact of automatic stabilisers during a recession.”

Another new report, from Moody’s, the credit rating agency, found that in the case of US insolvencies, the percent of a debt’s face value that lenders recover is now much lower than in the past, because of lax lending standards during the pre-COVID lending boom.

As Joe Rennison noted in the Financial Times, “The average recovery rate for the holders of bonds and loans was 45 cents on the dollar, rating agency Moody’s found, down from 59 cents in the 2008-09 financial crisis and below the historical average of more than 50 cents.”

The plunge in recovery percentage worsened further down the capital structure. “the company-wide averages downplayed the severity of the situation for specific types of debt. Subordinated bondholders, which sit just one level above equity investors in terms of seniority in bankruptcy, received an average of just one cent for every dollar. This was a drop from 29 cents on the dollar from the financial crisis, and down from 23 cents during the dotcom bust.”

A new analysis from the Wharton School of the University of Pennsylvania (“COVID-19 School Closures: Long-run Macroeconomic Effects”) finds that the potential negative macroeconomic impact of a permanent reduction in labor productivity due to extended school closures (and switch to less effective remote teaching) during COVID has likely been underestimated.

Unfortunately, too many school districts do not appear to be approaching the recovery of student learning losses with any sense of urgency. This has increased skepticism among education analysts that this will ever happen.

These findings align with a previous analysis, “The Economic Impact of Learning Losses”, by Hanushek and Woessmann for the OECD.

“Overall, we project that the productivity losses current K-12 students experience as a result of school closures lead to a 3.6 percent decrease in GDP and a 3.5 percent decrease in hourly wages by 2050 relative to the counterfactual where there had been no disruption to learning.

“Government tax revenues decline and, consequently, government debt cumulates more quickly. Higher debt along with less total savings by individuals with lower incomes leads to a lower real capital stock, lowering wages and GDP further. By 2050, the nation’s capital stock will be 4.1 percent lower and government debt will be 5.2 percent higher.

“Note that current primary schoolers will be aged 34 to 40 in 2050, so the drop in their productivity will continue to affect the economy for many years afterwards.”

In the United States, President Biden’s fiscal stimulus proposals have run into political opposition in the US Senate from the Republican Party, due to that body’s arcane (and arguably unconstitutional) “filibuster” rule, the impact of which is to effectively require 60 votes for most pieces of legislation.

Some of the opposition is due to concerns that the amount of proposed amount of stimulus is excessive, and could lead to a sustained increase in inflation.

Other opposition seems more rooted in pure political obstructionism, whose goal is a weak economy going into the 2022 congressional elections, which in turn could produce Republican majorities in the House and Senate.

The net results of continuing delay will likely be an increase in uncertainty that damps down the growth in consumption and investment spending, and thus economic growth.

“Human Capitalists”, by Eisfeldt et al

SURPRISE

“The widespread and growing use of equity-based compensation has transformed high-skilled labor from a pure labor input to a class of "human capitalists." We show that high-skilled labor earns substantial income in the form of equity claims to firms' future dividends and capital gains.

“Equity-based compensation has dramatically increased since the 1980s, representing forty percent of total compensation to high-skilled labor in recent years. Ignoring equity income causes incorrect measurement of the returns to high-skilled labor…

“In our sample, including equity-based compensation in high-skilled labor income reduces the total decline in labor's wage-only income share relative to total value added since the 1980s by over 30%. The inclusion of equity-based compensation also eliminates the majority of the decline in the high-skilled labor share.”

Stories about supply shortages and price increases (e.g., in semiconductors) are increasingly in the news as vaccinations and fiscal stimulus drive the recovery of demand. It is important to understand the underlying dynamics, and keep three points in mind.

In complex supply chain networks, the importance of different companies often follows a power law – a problem at most of them has little impact, but a problem at some of them can have a very large impact.

For example, in “Quantifying Firm-Level Economic Systemic Risk From Nation-Wide Supply Networks”, Diem et al note that, “Crises like COVID-19 or the Japanese earthquake in 2011 exposed the fragility of corporate supply networks. The production of goods and services is a highly interdependent process and can be severely impacted by the default of critical suppliers or customers. While knowing the impact of individual companies on national economies is a prerequisite for efficient risk management, the quantitative assessment of the involved economic systemic risks (ESR) is hitherto practically non-existent, mainly because of a lack of fine-grained data in combination with coherent methods.”

The authors develop a new method for analyzing the entire Hungarian economy at the company level. They find that, “a tiny fraction (0.035%) of companies has extraordinarily high systemic risk impacting about 23% of the national economic production should any of them default.”

Perhaps the best-known case of this today is TMSC’s large market share in the production of advanced semiconductors.

The authors continue, “firm size alone cannot explain the ESR of individual companies; their position in the production networks does matter substantially.”

In this regard, a key uncertainty at this point is how many of these critical suppliers have closed during the pandemic, and how long it will take to replace them.
(see also, “Ten-tier and Multi-scale Supply Chain Network Analysis of Medical Equipment: Random Failure and Intelligent Attack Analysis”, by Lavassania et al).

Another point to emphasize is that the supply constraints we are seeing today are a logical consequence of the pandemic’s initial shock to demand, in response to which many companies cut back on their orders from suppliers in order to conserve cash. Simultaneously, there was a shock to supply as many companies closed down (e.g., restaurants and schools).

Now that they are convinced the economy is recovering, many companies are simultaneously placing new orders with their suppliers, which has resulted in a combination of price increases and delayed fulfillment.

They are also trying to get their former workers to return, with varying levels of success. For example, unvaccinated workers may fear doing so, while women who were forced out of the workforce by school closings may be unable to return (and may not do so until they see what is going to happen in the autumn, when schools are scheduled to reopen).

Shortages at the lower levels of industry supply chains (e.g., of semiconductor chips) are causing shortages and/or price increases at higher levels (e.g., reduced production of new automobiles, which has causes a sharp increase in demand for and prices of used cars, and a sharp increase in rental car prices, as those companies can’t get new cars to replace the ones they sold off to raise cash to survive the pandemic).

A final point is that these supply chain phenomena are mostly transitory.
Eventually, supply will catch up to demand and most short-term price increases will slow (whether they will reverse remains to be seen).

“The American Economy, Circa 2021”, by Tyler Cowen

“Spending on cars and trucks is 15.1 percent higher than it would have been on the 2019 trajectory; spending on furnishings and durable household equipment is 16.6 percent higher; and spending on recreational goods is a whopping26 percent higher.

“Altogether, durable goods spending is running $348.5 billion higher annually than it would have been in that alternate universe, as Americans have spent their stimulus checks and unused travel money on physical items.

“The housing sector is experiencing nearly as big a surge. Residential investment was 14.4 percent above its prepandemic trend, representing $90 billion a year in extra activity. And that was surely constrained by shortages of homes to sell, and lumber and other materials used to make them. It is poised to soar further in coming months, based on forward-looking data like housing starts.

“Another bright spot is business investment in information technology. The tech industry has been comparatively unscathed by the crisis. Spending on information processing equipment in the first quarter was 23 percent higher than its pre-pandemic trend, and investment in software 7.4 percent higher.

However: Spending on transportation services remains 23 percent below its prepandemic trend, recreation services 31 percent, and restaurants and hotels 19 percent.

Those three sectors alone represent $430 billion in “missing” economic activity — largely equivalent, it’s worth noting, to the combined shift of economic activity toward durable goods and residential real estate.”

“A Policy Matrix for Inclusive Prosperity”, by Rodrik and Stantcheva

SUPRRISE

This short but highly useful paper proposes a 3x3 matric to understand issues related to increasing “inclusive prosperity” in the economy.

“The discussion of policies can be organized around two questions or dimensions. First, which income group is the target of the policies intended to counter inequality or economic insecurity? Is it mainly the low-income households at the very bottom of the income distribution? Or is it rather the middle classes, who have traditionally had access to good jobs, but are increasingly facing reduced standards of living and growing economic insecurity in many nations? Is it instead the high-income or high wealth households at the very top that keep concentrating more economic power – as well as political power, possibly -- individually and through stocks in large corporations? Policy priorities will naturally differ depending on whether the target is the poor at the bottom, the middle classes, or the top of the income distribution…

“The second question relates to the stage of the economy where the intervention takes place. A useful and increasingly frequently used distinction, is between “predistribution” and “redistribution” policies.

“In this terminology, “redistribution” policies are ex post policies, that transfer income and wealth once they have been realized (e.g., redistributive transfers, progressive taxation, and social insurance). They reshape inequalities after the economic decisions regarding employment, investments, or innovations have been made.

“We will use the term postproduction policies instead to denote these policies.

“Pre-distribution” policies are those that directly shape the working of and outcomes generated by markets. We find it useful to further split pre-distribution policies into two categories: pre-production and production stage policies.

“Pre-production policies determine the endowments that people bring to the market, such as education and skills, financial capital, social networks and social capital.

“Production-stage policies are those that directly shape the employment, investment, and innovation decisions of firms.

“Overall, the resulting classification entails a three-fold distinction between preproduction, production, and post-production policies.”

“The EU’s Future Hinges On Italy’s Recovery Fund Reforms”, by Andrea Capussela in the Financial Times

“The government of Italian prime minister Mario Draghi is putting the finishing touches to an investment and economic reform programme that is to be powered by some €200bn in EU grants and loans.

“This is likely to be the largest national allocation from the EU’s €750bn post-pandemic recovery fund for the bloc’s 27 member states. On the success of Draghi’s proposed reforms hang the prospects not just for Italy’s economic revival but for the fiscal and political integration of Europe.

“The EU grants and loans should help to spur growth in Italy after a contraction in gross domestic product last year of 8.9 per cent, the worst annual slump since 1945.

“But such growth may not be enough in itself to reverse Italy’s long-term relative decline.

“If Draghi’s national unity government were to succeed in overcoming Italy’s deep-seated structural weaknesses with the help of the EU funds, the benefits for Europe could be immense. In Italy itself, Euroscepticism would be dealt a blow.

“Elsewhere, critics of European fiscal transfers would find it harder to contend that EU money poured into Italy is a waste. Supporters of integration would be on stronger grounds in arguing that the time is ripe for completing the EU’s economic and monetary union, still only half-built more than 20 years after the euro’s launch.”

“However the challenges that must be overcome to achieve this optimistic outcome are immense.
“Productivity rose between 1995 and 2019 by little more than a quarter of the Eurozone average. GDP per capita fell to 10 per cent below the Eurozone average from 9 per cent above.

“Yet in that quarter of a century, some Italian governments made reform efforts that were more intensive than those of many other EU countries. Except for during the past decade, a lack of investment was not the problem.

“Rather, the reason why these efforts achieved little boils down to the weakness of the rule of law and of political accountability in Italy. This sets the country apart from its Eurozone peers and is Draghi’s biggest challenge…

“The heart of the question, as so often in Italy, will be the implementation of investment plans and reforms that look good on paper but need to be put into actual practice.”

“The Corporate Erosion of Capitalism”, by Oren Cass from American Compass

SURPRISE

Most of the productivity benefits to the economy from new technologies are embodied in new capital investment. If the level of investment is low, so too will be the rate at which productivity benefits appear.

This critical new research “provides a systematic, firm-level study of declining business investment and the recent transformation of the typical American corporation’s business strategy to one that disgorges cash to shareholders while failing to replenish its capital base. The study uses the Standard & Poor’s Compustat database to analyze the cash flows of all companies headquartered in the United States and publicly traded on the NYSE and NASDAQ from 1971 to 2017.

“Firms are placed in three categories:

1. A Grower is a firm with capital expenditures in excess of earnings before income, taxes, depreciation, and amortization (EBITDA), which taps capital markets to finance investment.

2. A Sustainer is a firm that makes capital expenditures greater than its consumption of fixed capital and also returns cash to shareholders, with EBITDA sufficient to do both.

3. An Eroder is a firm that consumes its fixed capital faster than it makes new capital expenditures, while still returning cash to shareholders, though its EBITDA would be sufficient to replenish its capital base.

“In short, a Grower is the archetypical user of the financial markets. A Sustainer is the archetypical successful capitalist enterprise. An Eroder is a strange type of firm that seems to harvest its own organs for its shareholders’ short-term benefit.

“While not all firms fit these categories, the vast majority do, accounting for 90% of market capitalization over the past half century.

“The American economy has undergone a dramatic transition in recent decades, from one in which most large firms were Sustainers and very fe were Eroders to one in which Eroders predominate.

“During 1971–85, Sustainers averaged 82% of market capitalization and Eroders 6%. By 2000, these shares had shifted to 59% and 19%, respectively. In 2009, Eroder market capitalization surpassed Sustainer market capitalization for the first time. In 2017, Sustainers accounted for 40% of market capitalization and Eroders for 49%; Growers averaged 9% of market capitalization during 1971–85 versus 3% in 2017.

“The problem is not that the economy is transitioning toward more asset-light industries; this analysis evaluates companies’ investment relative to their own capital bases, not an arbitrary level of expected investment.

“Further, the same pattern emerges within sectors from manufacturing to information. Within the manufacturing sector, the Eroder share rose from an average of 7% during 1971–85 to 47% during 2009–17. Within the information sector, which includes media, communications, internet and software companies, the Eroder share rose from 2% to 52% in those respective periods.

“As a result of this behavior by firms, the share of GDP flowing out of the operating economy has risen steadily. Net outflows averaged 1.5% of GDP during 1971–85 and 1.8% of GDP during 1971–99, but that rate more than doubled to 4.0% during 2009–17.

“The investment shortfall over this latter period is $3.1 trillion. This offers almost a mirror image of the decline in net nonresidential investment for the economy as a whole, from an average of 4.3% of GDP during 1971–85 and 3.8% of GDP during 1971–99 to an average of 2.3% during 2009–17.”

A number of new papers and posts focus on the changing nature of the economy and the apparent logic guiding the Biden Administration’s policies

In “Foundations of Complexity Economics”, Brian Arthur provides a succinct overview of how complexity economics differs from traditional approaches (a complex adaptive system approach is one of the foundations of our belief system at the Index Investor).

Complexity economics is not based on a single “representative agent.” Instead, it assumes that agents differ, that they have imperfect information about other agents and must, therefore, try to make sense of the situation they face. Agents explore, react and constantly change their actions and strategies in response to the outcome they mutually create.

“The resulting outcome may not be in equilibrium and may display patterns and emergent phenomena not visible to equilibrium analysis. The economy becomes something not given and existing but constantly forming from a developing set of actions, strategies and beliefs — something not mechanistic, static, timeless and perfect but organic, always creating itself, alive and full of messy vitality.”

In the Wall Street Journal, Greg Ip describes the difference between “the Old View” and the “New View” of economics (“How Bidenomics Seeks to Remake the Economic Consensus”):

“If you studied, practiced or wrote about economic policy in the past few decades you probably absorbed certain rules about how the world worked: governments should avoid deficits, liberalize trade and trust in markets. Taxes and social programs shouldn’t discourage work.

“This canon came to be known globally as the ‘Washington consensus’ and in the U.S. as neoliberalism. The latter label has always been more popular with its critics than its adherents. Nonetheless, by fusing the free-market foundations of classical liberalism with some redistribution and regulation, the term broadly described the economic policy of western leaders from Ronald Reagan and Margaret Thatcher through Bill Clinton and Tony Blair to George W. Bush, Barack Obama and David Cameron.

“Neoliberalism has since fallen from grace under former President Donald Trump and now President Biden. But where Mr. Trump’s populism was never grounded in economics, Mr. Biden’s embrace of bigger government is: not the economics of the establishment but of left-wing thinkers in academia and think tanks and on Twitter.”

On his Grumpy Economist blog, John Cochrane summed up Ip’s central concerns:

“Old View: Scarcity is the default condition of economies: the demand for goods, services, labor and capital is limitless, their supply is limited. ...faster growth requires raising potential by increasing incentives to work and invest. Macroeconomic tools—monetary and fiscal policy — are only occasionally needed to deal with recessions and inflation.

“New View: Slack is the default condition of economies. Growth is held back not by supply but chronic lack of demand, calling for continuously stimulative fiscal and monetary policy.

“Old View: Fiscal policy shouldn’t push unemployment below the level that causes inflation to rise, which would force the Federal Reserve to raise interest rates.
“New View: Fiscal and monetary policy should push unemployment as low as they can because low unemployment doesn’t cause inflation and if eventually it does, that’s socially much less costly than persistent unemployment.

“Old View: Because savings are scarce, government budget deficits push up interest rates and crowd out private investment and should be avoided except during recessions.

“New view: Low interest rates globally show that savings are plentiful and demand is chronically weak, so deficits aren’t harmful and may be necessary. Larry Summers has labeled this secular stagnation. “Modern monetary theory”—which few economists, even on the left, embrace—goes further, arguing deficits never crowd out private investment or raise interest rates.”

Old View: Social programs should be targeted to those who need them most because money is scarce. Aid should encourage work because that raises gross domestic product and confers dignity.

New View: Because money isn’t scarce—see above—aid can and should be universal so that no one falls between the cracks. GDP and paid work are overrated because much of what makes life worthwhile, such as caregiving, is generated outside the market. This is the rationale for universal basic income and, to some extent, Mr. Biden’s expanded child tax credit.”

“Old View: High tax rates on income and profits discourage work and investment while high minimum wages reduce employment for the low skilled. Market mechanisms can achieve social goals such as lower greenhouse gas emissions more cheaply than fiat regulations.

“New View: Monopoly power and barriers to market entry are pervasive, enabling the rich and corporations to accumulate far more wealth and profits—and pay workers less—than a truly competitive market would permit. Higher tax rates have little effect on incentives and higher minimum wages have no effect on employment. Market mechanisms like carbon prices perpetuate existing inequities.”

Ip concludes, “Bidenomics is more a political movement than a school of economic thought. The Democratic base has moved left, energized by inequality, climate change and the coronavirus pandemic, as well as by Mr. Trump and the Republican Party’s rightward shift. That base now seeks, through Mr. Biden, to reshape the economy and society for years to come.

“The problem with economic policies subordinated to political imperatives is that they have no limiting principle: if $3 trillion in stimulus is OK, why not $6 trillion? If a $15 minimum wage is harmless, why not $30?

“Mr. Biden can ignore limiting principles for now for one reason above all: interest rates are near zero. In fact, Fed Chairman Jerome Powell is the single most important player in Bidenomics. But low rates and the Fed’s relaxed attitude toward inflation are products of today’s circumstances, not permanent new features of the economy. The longer Bidenomics proceeds as if limits don’t exist, the more likely it is to hit them.”

For the past 25 years, William White, formerly of the Bank of Canada and later the Bank for International Settlements, has had an acute understanding of the problems building up in the global macroeconomy and financial system. His forecasts have been spot on, and too often ignored (such is the fate of Cassandras). He recently published a trenchant critique of the current situation.

In “The Full Case Against Low and Negative Interest Rates”, White warns that, “There are several reasons why unprecedentedly low interest rates will probably not stimulate demand and may even threaten financial stability” …

“Concerns have been raised that unprecedented policy responses might increase uncertainty and suppress the “animal spirits” necessary to motivate sustained spending. Turning to the components of demand, consumption might also suffer if low rates of accumulation mean people must save more to meet retirement goals.

“Perhaps more importantly, there is reason to believe that the effectiveness of monetary stimulus diminishes with extended or repeated use. Lower rates induce people to borrow and to spend today what they would otherwise have spent tomorrow. The ratio of global debt (governments plus households and corporates) to GDP had in fact risen by over 50 percentage points prior to the pandemic.

“However, if the spending is used for unproductive purposes, as is often the case, then the buildup of debt eventually becomes burdensome and slows future spending. In short, there is a negative feedback loop. At first, this can be offset by ever more aggressive easing but, as the headwinds grow stronger, monetary policy eventually ceases to work at all” …

“A bigger problem is that, if monetary stimulus is sustained for a long period, then undesirable side effects accumulate. The first of these is the higher debt level, which increases systemic risk…

“However, debt accumulation is not the only unintended consequence of relying on monetary stimulus.

“Such policies also threaten financial stability in various ways. They pose a danger to the survival of financial institutions and to pension funds by squeezing net returns on traditional assets.

“Moreover, institutions subject to such threats then “reach for yield” in an attempt to compensate, often leaving themselves open to risks that they had not anticipated and have no experience of managing. A related concern is that of growing “moral hazard.”

“Every time a problem materializes, the central banks or regulators create another safety net to protect the exposed, which then encourages them to behave even more badly.

“Similarly, unusually easy monetary conditions over long periods can threaten the effective functioning of financial markets. In recent years, we have documented: recurrent “flash crashes”; waves of Risk-On and Risk-Off behavior; persistent “anomalies” from normal price relationships; growing evidence that normal “price discovery” has been suppressed; and finally, the near-collapse of the US Treasuries market in September 2019 and March 2020.

Moreover, easy monetary conditions lead to continuing increases (bubbles?) in the prices of virtually all financial assets and often to real assets (like houses and other property) as well.

“For a long while, these price increases can mask the other undesired consequences of easy monetary conditions but, as “fundamentals” eventually reassert themselves, a price collapse can easily follow.”

“Sovereign Debt In The 21st Century: Looking Backward, Looking Forward”, by Mitchener and Trebesch

How will sovereign debt markets evolve in the 21st century? We survey how the literature has responded to the Eurozone debt crisis, placing “lessons learned” in historical perspective.

The crisis featured: (i) the return of debt problems to advanced economies; (ii) a bank- sovereign “doom-loop” and the propagation of sovereign risk to households and firms; (iii) roll-over problems and self-fulfilling crisis dynamics; (iv) severe debt distress without outright sovereign defaults; (v) large-scale “sovereign bailouts” from abroad; and (vi) creditor threats to litigate and hold out in a debt restructuring.

“Many of these characteristics were already present in historical debt crises and are likely to remain relevant in the future. Looking forward, our survey points to a growing role of sovereign-bank linkages, legal risks, domestic debt and default, and of official creditors, due to new lenders such as China as well as the increasing dominance of central banks in global debt markets.

“Questions of debt sustainability and default will remain acute in both developing and advanced economies.

See also:
“Prepare for an Emerging Markets Debt Crisis, Warns IMF Head” by Chris Giles in the Financial Times

“How China Lends: A Rare Look into 100 Debt Contracts with Foreign Governments”, by Gelpern et al

SUPRRISE

“China is the world’s largest official creditor, but we lack basic facts about the terms and conditions of its lending. Very few contracts between Chinese lenders and their government borrowers have ever been published or studied. This paper is the first systematic analysis of the legal terms of China’s foreign lending…

“Three main insights emerge.

First, the Chinese contracts contain unusual confidentiality clauses that bar borrowers from revealing the terms or even the existence of the debt.

Second, Chinese lenders seek advantage over other creditors, using collateral arrangements such as lender-controlled revenue accounts and promises to keep the debt out of collective restructuring (“no Paris Club” clauses).

Third, cancellation, acceleration, and stabilization clauses in Chinese contracts potentially allow the lenders to influence debtors’ domestic and foreign policies.”

“The Economic Effects of Financing a Large and Permanent Increase in Government Spending”, by The US Congressional Budget Office

The authors “analyze the long-term economic effects of financing a large and permanent increase in government expenditures of 5 percent to 10 percent of gross domestic product (GDP) annually. This paper does not assess the economic effects of the increased government spending and focuses solely on the effects of their financing” …

“The review focuses on how taxes on labor income, capital income, and consumption affect how much people work and save. The general finding is that increasing taxes leads to lower GDP and personal consumption. Of the different tax policies examined, consumption taxes are likely to have the smallest effects on saving and work decisions and hence the smallest negative consequences on future economic growth. Finally, deficit financing leads to higher interest rates, a lower capital stock, lower GDP, and a greater risk of a fiscal crisis.”

“2021: The Year of Another Eurozone Debt Crisis?” by Desmond Lachman from AEI

SURPRISE

“Anyone who thinks that we are not on the road to another round of the Eurozone debt crisis has not been paying attention to the goings-on of the German Constitutional Court.

“At the very time that key pandemic-ravaged Eurozone member countries like Italy and Spain are desperately in need of a helping hand from their Eurozone partners, the German court has chosen to throw a spanner in the works for the launching of the Eurozone Recovery Fund.

“That action would seem all too likely to be but a warm-up for the German court to challenge once again the legality of the European Central Bank’s current aggressive bond-buying program aimed at keeping the Italian and Spanish economies afloat.

“Last May, in an attempt to provide much-needed budget support to those highly indebted European countries like Italy and Spain, which had been laid low by the pandemic, the European Union agreed upon the need for a $750 billion European Recovery Fund.

“The novelty of this fund, which was widely hailed as the Eurozone’s Hamiltonian moment, would be the placement of a bond that would be jointly guaranteed by all of the European Union’s member countries.

“Judging from its ruling last Friday, the German Constitutional Court entertains serious doubts as to whether the issuing of jointly guaranteed bonds is consistent with the Lisbon Treaty. In a stunning move, it has put a temporary halt to a German law ratifying the European Recovery Fund, pending an urgent appeal against the legislation by a group of Eurosceptic German citizens.

“While the court’s decision will certainly delay the recovery fund’s ratification at a time that it is sorely needed to provide a boost to the European economy, it is most unlikely that it will derail the fund. Rather, it is more likely that once again the court will find a political fudge to allow the fund to be ratified as it did in its last stand-ox with the European Central Bank.

“The real significance of the German court’s recent decision is what it might mean for the very much more important issue of the European Central Bank’s (ECB) aggressive bond-buying program. This would seem to be especially the case considering that not only has the ECB substantially expanded its bond-buying program in the wake of the pandemic. It has also now directed most of its bond-buying under that program towards Italy and Spain, which have unusually large budget deficits and unusually high public debt levels.

“Under Article 123 of the Lisbon Treaty, the ECB is explicitly precluded from engaging in monetary financing of a member country’s budget deficit. This must make one think that it must only be a matter of time before the German Court locks horns again with the ECB about its bond-buying program.”

See also, “German Court Challenge To EU Recovery Fund Could Last Months” by Arnold et al in the Financial Times

“Insolvency Prospects Among Small-and-Medium-Sized Enterprises in Advanced Economies: Assessment and Policy Options”, by Diez et al from the IMF

“The COVID-19 pandemic has increased insolvency risks, especially among small and medium enterprises (SMEs), which are vastly overrepresented in hard-hit sectors. Without government intervention, even firms that are viable a priori could end up being liquidated—particularly in sectors characterized by labor-intensive technologies, threatening both macroeconomic and social stability…

“Solvency support should be complemented by an effective set of insolvency and debt restructuring tools, including dedicated out-of-court restructuring mechanisms, hybrid restructuring, and stronger insolvency procedures—including simplified reorganization for smaller firms, to raise the system’s capacity. Because liquidations of a priori viable firms may occur even under adequate insolvency procedures, government incentives could be considered to tilt the balance toward restructuring.”

The Biden Administration announced another very large ($2.25 trillion) stimulus program (the “American Jobs Plan”) focused on “infrastructure investment.” However, a closer examination shows that the term “infrastructure” has been stretched beyond all recognition.

As Larry Summers and many others have warned (and I lived through in South American in the 1980s), government borrowing to fund transfer payments and current consumption is a dangerous strategy that eventually self-destructs when investors lose confidence in a country’s willingness and/or ability to repay its debt.

It is therefore critical to ensure that borrowed funds are invested in a way that will increase long-term economic growth, to maintain investors’ confidence in a nation’s ability to service its debt.
Some of the Biden proposals certainly seem to meet that test, including $621billion for highways, ports, bridges, rail and mass transit; $100 billion to upgrade the nation’s electrical grid; $100 billion to increase access to broadband; and $56 billion to upgrade water infrastructure. All in, about 40% of the proposed $2.25 trillion.

Unfortunately, the proposal says nothing about how to control cost overruns and permitting/litigation delays on these projects, which will very likely blunt a significant part of their impact (e.g., see, “For Infrastructure Projects to Succeed, Think Slow and Act Fast” by Flyvbjerg and Gardner, and Edward Glaeser’s 2016 classic, “If You Build It: Myths And Realities About America’s Infrastructure Spending”).

The impact of the remaining 60% of the proposed spending on long term economic growth is much more questionable (e.g., see, “Measuring Infrastructure in the BEA’s National Economic Accounts”, by Bennett et al).

This includes $174 billion to boost the electric vehicle market; $213 billion for retrofitting buildings and building affordable housing (and, presumably, legal fees for zoning fights); $590 billion for R&D and job training initiatives and support for domestic manufacturing; and $400 billion “to expand home care services and provide additional support for care workers”, including higher wages and an easier route to unionization.

As we’ve written before, we think it is quite a stretch to believe that large number of men who have lost their jobs (to automation our outsourcing) in traditionally “male” industries will easily transition to traditionally caring “female” industries.

“Covid Relief Bill Gives $86 Billion Bailout to Failing Union Pension Plans”, by Greg Iacurci, CNBC

SURPRISE

This sets a very dangerous precedent, and potentially opens the door to federal bailouts of underfunded state and local government defined benefit pension plans.

At the end of 2018, the Federal Reserve estimated that the underfunded liabilities of these plans amounted to $4.6 trillion. Unfunded post-employment healthcare liabilities for state and local government employees added a further $1.2 trillion (see: “Survey Of State And Local Government Other Postemployment Benefit Liabilities” by Marc Joffe).

The political fight over any proposal for a federal bailout of these state and local plans (as opposed to closing their funding gaps though a combination of benefit cuts, spending cuts, and/or higher taxes) is sure to be intensely divisive.
For example, in “UK Universities Face Big Rise In Pension Contributions”, the Financial Times’ Josephine Cumbo observes that, “Universities are likely to face the threat of further industrial action, as a funding hole in the sector’s pension scheme increased to more than £14bn, leaving staff and employers facing ‘unaffordable’ rises in contributions…

“The Universities Superannuation Scheme said on Wednesday that contributions paid by 200,000 active members and 350 university employers would need to rise from a combined 30.7 per cent of payroll to as much as 56.2 per cent to plug a shortfall in the pension fund estimated at between £14.9bn and £17.9bn.”

On CNBC, Iacurci noted that, “the $1.9 trillion COVID relief package passed by the Senate on Saturday offers $86 billion in funding to failing pension plans.

“The American Rescue Plan would let certain pensions apply for federal grant funding, which would be used to help pay retirement benefits to workers.

“The provision applies to multi-employer pensions. These plans pay benefits to union workers in industries such as construction, manufacturing, mining, retail transportation and entertainment.

“There are roughly 1,400 such plans in the U.S., covering 10 million people. However, 124 multi-employer pensions are in “critical and declining” status, according to the Pension Benefit Guaranty Corporation. They’re projected to have insufficient funds to pay full retirement benefits within the next 20 years. About 1 million workers are in such plans, according to the American Academy of Actuaries.”

“The U.S. Economy Is Leaving Midsize Companies Behind”, by Govindarajan et al

SURPRISE

“When the Covid-19 pandemic hit, a record number of companies, many of which had survived for more than 50 or even 100 years, had no other option but to file for bankruptcy. Recent trends don’t bode well for midsize companies that are the bedrock of any nation’s economy…

“Data suggests that a perfect storm has been brewing for midsize companies over the past 50 years. In every successive decade since 1970–79, the annual growth rates of assets, sales, and profits have been declining for midsize companies, which are increasingly struggling to earn profits”…

“Despite its low interest rates and stable economic environment, the most recent decade witnessed the slowest growth among midsize companies and a continual deterioration of their financial performance. As shown by bankruptcy filings, pandemic shock made this trend even worse… The booming stock market is not an accurate reflection of the on-the-ground reality for most American corporations.”

“US Policymakers Lose Faith In Official Unemployment Rate”, by Politiand Rogers in the Financial Times

“The rapid decline in the US jobless rate has so far exceeded the forecasts of private sector economists and Fed officials alike… But the headline figure has obscured far less encouraging trends in America’s labour market, and is now considered an incomplete and unreliable guide to the trajectory of the US recovery… most importantly, it has been distorted by the plummeting number of Americans participating in the labour force…

“Published unemployment rates during Covid have dramatically understated the deterioration in the labour market,” Jay Powell, the Federal Reserve chair, said during a speech last month.”

“The Inflation Risk From Joe Biden’s Stimulus Plan Is Exaggerated”, by Chen Zhao

Zhao presents a well-reasoned, evidence-based argument for why the current enthusiasm for “the reflation trade” is very likely overdone.

“About $1tn will meanwhile be used for direct income subsidies to households in the forms of rebate cheques, child tax credits and higher unemployment benefits. There is also $150bn of financial aid for vulnerable businesses. Overall, household and business subsidies total $1.15 trillion…

Such subsidies are quite different from public sector investment. The former is identical to income tax cuts; the latter feeds directly into GDP growth. They also have very different economic multipliers. Recent experience — for example, that of Australia after the 2008 financial crisis — is that the impact of income subsidies on growth is often negligible. This is because businesses and consumers behave rationally. If a tax cut is one off or transitory, the windfall is usually saved rather than spent.

“A case in point is the roughly $3tn stimulus package, passed between March and May 2020. This had a limited effect in boosting growth as consumers not only saved their income subsidies, they saved more of any other income they received. US personal disposable income shot up by $2.4tn between March and May last year. But personal savings soared by more than $5tn.

“Similarly, it is far from certain how much of the Biden package’s $1.15tn in consumer and business subsidies will be spent…

“By comparison, Donald Trump’s 2017 tax cuts were worth about $1.5tn, similar in size to Biden’s proposed income subsidies. Although these tax cuts were “permanent” and aimed at boosting corporate investment and consumer spending, they did little to lift long-term GDP or inflation.

“They did lift corporate earnings and stock buybacks and helped to create a stock market boom. But they did not boost corporate capital expenditure.

“As for household disposable incomes, they did rise as personal tax rates came down. Consumer saving rates also rose by 2 percentage points to 9 per cent of disposal income.

“But consumer spending growth stayed virtually flat. Trump’s tax cuts suggest it is unlikely that Biden’s income subsidies will boost demand by much, or be inflationary.”

Former Treasury Secretary Larry Summers raised objections to the size of the Biden administration’s proposed $1.9 trillion stimulus package. The core of his argument is that it is too large because of the anticipated rate at which the economy is expected to recover.

As such, and in light of the reduction in supply capacity in some sectors of the economy due COVID-induced business closures, a stimulus of this size could increase inflation. This was what you saw in the headlines.

Less mentioned, however, was the risk that increased inflation would almost certainly lead to higher interest rates, which could trigger the rapid deflation of the current bubbles in the debt and equity markets.

And practically absent from the headlines was this equally critical warning from Summers: “If the stimulus proposal is enacted, Congress will have committed 13 percent of GDP [Trump’s $900 billion plus the proposed $1.9 trillion] with essentially no increase in public investment to face the fundamental problems of economic justice, slow, growth and inadequate investment in everything from infrastructure to preschool education to renewable energy [that are] at the heart of Biden’s emphasis on building back better…After resolving the coronavirus crisis, how will political and economic space be found for the public investments shat should be the nation’s highest priority?”

By far the best analyses we have seen are “Supply And Demand Shocks In The COVID-19 Pandemic: An Industry And Occupation Perspective, by del Rio-Chaona et al; “Firms, Failures, and Fluctuations: The Macroeconomics of Supply Chain Disruptions”, by Acemoglu and Tahbaz-Salehi; and “In And Out Of Lockdown: Propagation Of Supply And Demand Shocks In A Dynamic Input-Output Model”, by Pichler et al.

Using a sophisticated dynamic sectoral model of supply and demand shocks that incorporates pandemic induced changes in consumer preferences, the latter paper finds that, “the shocks to on-site consumption industries are more long lasting, and savings from the lack of consumption of specific goods and services during lockdown are only partially reallocated to other expenses.”

Indeed, there is evidence that the inflationary effects of supply capacity cuts are already beginning to appear (e.g., see “Supply Chain Costs Are Mounting In All Sorts Of Ways”, by Claire Jones in the Financial Times).

The bottom line is that Summer’s concerns about inflation and its potential to pop our current credit and equity bubbles (again with unpredictable cascading consequences) are well founded, all else being equal (which it may very well not be – see the next evidence note).

Equally important is Summers concern with the balance in the proposed $1.9 billion stimulus between transfer payments to maintain consumption versus investment spending to raise future growth. Borrowing to sustain consumption rather than to increase production to repay the debt is a recipe for eventual insolvency. At the very least, the current structure of the Biden plan will, to some extent, raise the probability of a future US sovereign debt crisis, which should lead rational investors to demand higher compensation to bear this risk – which in turn increases the likelihood that the debt and equity bubbles will burst, which will substantially depress economic demand (and thus worsen the insolvency crisis, what could become a vicious cycle).

Summers’ objections to Biden’s proposed stimulus plan are based on a critical unspoken assumption – that economic conditions won’t worsen.

That brings to mind the time British Prime Minister Harold Macmillan was once reportedly asked what had been the greatest influence on his administration. “Events, dear boy, events”, he supposedly replied.

One way to think of this is as the compound probability that a series of potential events with substantial negative consequences won’t occur over the next three years. I’ve listed seven of them in the next column.

Let’s very optimistically estimate that there is a 95% probability that each of these seven potential crises will NOT occur over the next 12 months. Let’s also optimistically assume they are independent (which some of them probably aren’t).

Mathematically, this means that there is a 70% joint probability (95% to the 7th power) that none of them will occur over the next year. Looked at differently, it means that there is a 30% probability that one will.

But what happens when we extend the time frame to three years. If there is a 70% probability that none of these crises will occur in the first year, there is only a 34% chance that none of them will occur over the next three years (70% to the third power)– and therefore a 66% chance that at least one will.

As Macmillan said, “events, dear boy, events.”

If one or more of these potential crises occurs, the direct negative shock to demand (and quite possibly supply too) and the indirect (and likely longer lasting) negative shock to uncertainty will very likely be substantial.

In this scenario, the extra stimulus provided by Biden’s $1.9 trillion stimulus may very well be critical to preventing an even worse economic collapse. So from this perspective, Biden’s approach appears to be a prudent response to multiple downside risks.

Those are all big “ifs”. But that’s the world we’re living in today, much as many people don’t want to admit it and confront its implications.

Consider these possible “events” that the Biden administration could confront:

• An increase in inflation, and the popping credit and equity market bubbles rising rates would very likely trigger;

• A US sovereign debt and/or dollar crisis (though the latter would also require a more attractive new currency home for investors fleeing the dollar, which at this point seems unlikely);

• An LDC debt crisis, due to heavy corporate borrowing in foreign currency;

• A Eurozone sovereign debt crisis, most likely triggered by Italy;

• A severe private sector solvency crisis, as the government support that enabled many companies to survive during the pandemic is withdrawn but the economy remains weak;

• SARS-CoV-2 mutations that significantly reduce vaccine efficacy, forcing another return to lockdowns (as we have recently seen in the UK and EU);

• A violent conflict between the US and China (most likely over Taiwan), or between the US and/or Israel and Iran (e.g., see the recent column by the FT’s John Dizard, who recently observed that, “War risk is consistently underestimated by money people… Wall Street, the City of London and their counterparts appear to believe that once vaccines are distributed to most of the developed world’s population, the problem ends. The 1990s assumptions of peace and free financial flows will work once again.”

As Dizard notes, “The market volatility caused by sudden conflict in an over leveraged world would lead to the mother of all un-meet-able margin calls.”

In “Tapping into Talent: Coupling Education and Innovation Policies for Economic Growth”, Akcigit et al show the critical relationship between improving education and the wider diffusion of advanced technologies.

See also: “Costs of Lost Schooling Could Amount to Hundreds of Billions in the Long Run” by the UK Institute for Fiscal Studies; “Pandemic Boosts Automation and Robotics”, “Dani Rodrik: ‘We Are In A Chronic State Of Shortage of Good Jobs’”, and “Why I Was Wrong to Be Optimistic About Robots”, all in the Financial Times; “How Robots Will Break Politics” and “The Pandemic is Replacing People with Tech – Threatening the Jobs Rebound”, both in Politico.

All of these are further evidence of the hypothesis advanced by Acemoglu and Restrepo in 2019, in their paper, “The Wrong Kind of AI: Artificial Intelligence and the Future of Labor Demand”, that for a range of reasons (e.g., the tax code; human capital quality; potential returns), companies are investing in more labor substituting rather than labor augmenting technology to a degree that is neither economically nor socially optimal.

SURPRISE

Looking beyond the short-term, we see two very disturbing developments.

First, as the pandemic has continued, students’ learning losses have continued to accumulate. Unless they are recovered (which seems unlikely, given the interest group rigidities in many K12 education systems, especially in the US) they will have a long-term negative impact on labor productivity growth.

Second, there is accumulating evidence that due to multiple factors (including uncertainty about labor force quality, the differential taxation of labor and capital, profit pressures, health concerns, etc.), employers are increasing their investment in labor substituting automation technologies (e.g., robotics and artificial intelligence).

If not slowed or altered (e.g., to encourage more investment in labor augmenting AI), this will have grim consequences, including worsening inequality, more pressure on governments’ social safety net budgets, increasing social problems, and, almost certainly, increasingly polarized, conflict-ridden, and populist politics.

Two new research papers reported findings along these lines.
In “Artificial Intelligence, Globalization, and Strategies for Economic Development”, Korinek and Stiglitz conclude that, “Progress in artificial intelligence and related forms of automation technologies threatens to reverse the gains that developing countries and emerging markets have experienced from integrating into the world economy over the past half century, aggravating poverty and inequality.”

In “Pandemics and Automation: Will the Lost Jobs Come Back?” Sedik and Yoo from the IMF observe that, “COVID-19 has exacerbated concerns about the rise of the robots and other automation technologies… raising concerns about a jobless recovery.”

They note that these concerns are well founded: “A recent survey of business leaders and human resource strategists of large companies from around the world shows that over 80 percent are accelerating the digitalization of their work processes and expanding their use of remote work, and 50 percent indicate that they will accelerate the automation of jobs in their companies.”

Sedik and Yoo conclude that, “the distributional effects of COVID-19 could be sizeable through an acceleration of robotization:

"Looking forward, a corollary of our results is that as automation and robotization are accelerating from still low levels, they are expected to become even more important drivers of inequality in the future.”

“A Growth Model of the Data Economy”, by Faboodi and Veldkamp

SURPRISE

In this thought-provoking new paper, the authors note that, “The rise of information technology and big data analytics has given rise to ‘the new economy.’ But are its economics new? This article constructs a growth model where firms accumulate data, instead of capital.

"We incorporate three key features of data: 1) Data is a by-product of economic activity; 2) data is information used for prediction, and 3) uncertainty reduction enhances firm profitability.”

While the authors find that the dynamics of this economy differ from those in the traditional, in the long run there are diminishing returns from accumulating data, just as there are from accumulating capital.
Intuitively, this makes sense. A company’s first applications of data to improve prediction will be those that generate the highest returns; returns from the 100th application will likely be lower.

A limitation of the paper is that it glosses over the new economy skill shortages that other authors address. These have limited the diffusion of advanced AI technologies across companies, and thus contributed to the “superstar firm” and “winner-take-all” effects that have led to worsening inequality.

The paper also doesn’t mention other negative aspects of the new digital economy that are covered at length by Shoshana Zuboff in her book, “The Age of Surveillance Capitalism.”

“Zombies at Large? Corporate Debt Overhang and the Macroeconomy”, by Jorda et al from the Federal Reserve Bank of New York

“Jenga-Like Structure Builds In Credit Markets”, by Joe Rennison in the Financial Times

Jorda et al find, “With business leverage at record levels, the effects of corporate debt overhang on growth and investment have become a prominent concern. In this paper, we study the effects of corporate debt overhang based on long-run cross-country data covering the near-universe of modern business cycles. We show that business credit booms typically do not leave a lasting imprint on the macroeconomy. Local projections indicate that business credit booms do not affect the economy’s tail risks either.

“Yet in line with theory, we find that the economic costs of corporate debt booms rise when inefficient debt restructuring and liquidation impede the resolution of corporate financial distress and make it more likely that corporate zombies creep along.”

Regarding that all-important last paragraph, Rennison reports that, “corporate bond market are starting to look unnerving. Matt Mish, who heads up UBS’s credit strategy team, likens the current state of the market to a tower of Jenga blocks. At the moment, crucial support is being provided by central bank buying across the globe, holding borrowing costs low and providing a backstop if investor demand falls. As that support is removed piece by piece, the tower could begin to wobble.”

In contrast to the US, the UK has squarely faced the challenge to demand recovery posed by high levels of debt that small and medium enterprises (SMEs) have taken on to survive the COVID downturn.

In many countries the bankruptcy system forces such companies into liquidation, with debt restructuring and conversion to equity usually open only to large companies. Hence a report from TheCityUK recommends that the government launch new programs to recapitalize such businesses, for example via SME debt forgiveness, a new government entity that could purchase SME loans from lenders and convert them to equity, or by issuing grants and/or making new equity investments (“Supporting Uk Economic Recovery Recapitalising Businesses Post Covid-19”).

“Swaths Of European Firms Risk Collapse Despite Subsidies, ECB Warns”, by Martin Arnold in the Financial Times

“Companies at risk of collapse are defined as having negative working capital and high debt levels” …

“Fourteen percent of Spanish workers are in businesses at risk of collapse, according to new research by the European Central Bank, excluding those who work for financial companies…This is the highest rate of all large Eurozone economies, and comes despite the country’s national furlough scheme.

“It compares with about 8 per cent of employees in Germany and France and 10 per cent in Italy, also taking into account the use of subsidies to keep people in work, the ECB found.

“Stress Testing U.S. Leveraged Corporates in a COVID-19 World”, by Caceres et al from the IMF

This paper analyzes a group of 755 firms, with aggregate indebtedness of US$6.2 trillion, to assess the solvency risks and liquidity needs facing the U.S. corporate sector based on projections of net income, availability and cost of funding, and debt servicing flows under different stress test scenarios.

The paper finds that “leveraged corporates account for most of the potential losses arising from the macroeconomic stresses associated with the COVID-19 crisis, with a concentration of these losses in the oil and gas, auto, and capital and durable goods manufacturing sectors.

“However, potential losses from corporate debt write-downs appear to be a fraction of banks’ capital buffers and, given the size of the leveraged segment and the relatively long duration of that sector’s debt, the near-term liquidity needs of these corporates appear modest.

“Corporate stresses could, however, amplify the current economic downturn—as firms cut investment spending and reduce employment—potentially giving rise to significant indirect losses for the financial system”.

“Digital Capital and Superstar Firms”, by Tambe et al

SURPRISE

This paper provides further evidence of how talent shortages (caused by AI and other technologies improving faster than the education and reskilling systems are producing graduates who can use them) is reinforcing the “superstar firm” effect, and in so doing contributing to rising income inequality.

“General purpose technologies like information technology typically require complementary firm specific investments [e.g. in new organizational processes, systems, and skills] to create value. These complementary investments produce a form of capital, which is typically intangible and which we call digital capital.”

“We create an extended firm-level panel on IT labor investments (1990-2016) using data from LinkedIn…

“We find that 1) digital capital prices vary significantly over time, peaking around the dot-com boom in 2000; 2) significant digital capital quantities have accumulated since the 1990s, with digital capital accounting for at least 25% of firms’ assets by the end of our panel; 3) that digital capital has disproportionately accumulated in a small subset of “superstar” firms and its concentration is much greater than the concentration of other assets; and 4) that digital capital accumulation predicts firm-level productivity about three years in the future”…

“Moreover, per-capita digital capital stocks are substantially greater in firms with more educated workers. These findings are consistent with the emphasis that technology-intensive firms place on making investments in training and skills”…
“Inequality in digital capital among firms is growing as the top firms pull further away from the rest.”

“Impact of COVID-19 on Productivity”, by Bloom et al

Given a declining working age population, this paper's conclusion — that COVID will reduce productivity growth — implies lower medium term economic growth rates, which will worsen debt servicing problems, and make it more difficult to reduce inequality. If these conditions prevail, the net result is very likely to be an increase in social and political conflict and uncertainty.

“We analyze the impact of Covid-19 on productivity in the United Kingdom using data derived from a large monthly firm panel survey.

Our estimates suggest that Covid-19 will reduce Total Factor Productivity in the private sector by up to 5% in 2020 Q4, falling back to a 1% reduction in the medium term.

“Firms anticipate a large reduction in ‘within-firm’ productivity, primarily because measures to contain Covid-19 are expected to increase intermediate costs. The negative ‘within-firm’ effect is partially offset by a positive ‘between-firm’ effect as low productivity sectors, and the least productive firms among them, are disproportionately affected by Covid-19 and consequently make a smaller contribution to the economy”.

“In the longer run, productivity growth is likely to be reduced by diminished R&D expenditure and diverted senior management time spent on dealing with the pandemic.”

“A Reconsideration of Fiscal Policy in the Era of Low Interest Rates”, by Furman and Summers

SURPRISE

In this important paper, the authors argue that, “while the future is unknowable and the precise reasons for the decline in real interest rates are not entirely clear, declining real rates reflect structural changes in the economy that require changes in thinking about fiscal policy and macroeconomic policy more generally that are as profound as those that occurred in the wake of the inflation of the 1970s”…

“We note that with massive increases in budget deficits and government debt, expansions in social insurance, and sharp reductions in capital tax rates, one would have expected to see increasing real rates if private sector behavior had remained constant. We suggest that changes in the supply of saving associated with lengthening life expectancy, rising uncertainty and increased inequality along with reductions in the demand for capital associated with demographic changes, demassification of the economy, and perhaps changes in corporate behavior have driven real interest rates down” …

“We discuss three implications for fiscal policy that follow from low interest rates:
“First, fiscal policy must play a crucial role in stabilization policy in a world where monetary policy can counteract financial instability but otherwise is largely “pushing on a string” when it comes to accelerating economic growth….

“Second, we reconsider traditional views about the dangers of debt and deficits. We note that in a world of unused capacity and very low interest rates and costs of capital, concerns about crowding out of desirable private investment that were warranted a generation ago have much less force today.

“We argue that debt-to-GDP ratios are a misleading metric of fiscal sustainability that do not reflect the fact that both the present value of GDP has risen and debt service costs have fallen as interest rates have fallen. Instead we propose that it is more appropriate to compare interest rate flows with GDP flows…

“Third, we consider the issue of borrowing in the context of how the borrowed funds are used.
“We highlight that traditional notions of financial responsibility for households and businesses hold that borrowing in order to invest in assets that have a return well in excess of the cost of borrowing increases creditworthiness and benefits future stakeholders…We argue that borrowing to finance appropriate categories of Federal expenditure pays for itself in Federal budgetary terms on reasonable assumptions…

“We conclude with thoughts on appropriate guidelines for U.S. fiscal policy. We reject traditional ideas of a cyclically balanced budget on the grounds that it would likely lead to inadequate growth and excessive financial instability.

“We set the goal that fiscal policy should advance economic growth and financial stability. Achieving this goal depends on both improving responses to downturns and expanding and improving public investment. As a new guidepost, we propose that fiscal policy focus on supporting economic growth while preventing real debt service from being projected to rise quickly or to rise above 2 percent of GDP over the forthcoming decade.”

“Global Economic Prospects”, World Bank Report

“Although the global economy is emerging from the collapse triggered by the pandemic, the recovery is projected to be subdued. Global economic output is expected to expand 4 percent in 2021 but still remain more than 5 percent below its pre-pandemic trend.

“Moreover, there is a material risk that setbacks in containing the pandemic or other adverse events derail the recovery…

“The pandemic has exacerbated the risks associated with a decade-long wave of global debt accumulation. Debt levels have reached historic highs, making the global economy particularly vulnerable to financial market stress…

“With weak fiscal positions severely constraining government support measures in many countries, an emphasis on ambitious reforms is needed to rekindle robust, sustainable and equitable growth.”

“ECB warns banks are ‘all over the place’ on bad loan preparations”, by Arnold and Vincent in the Financial Times

SURPRISE

“Europe’s top banking supervisor is writing to the region’s biggest lenders to warn that many of them are failing to do enough to prepare for a likely increase in bad loans due to the fallout from the coronavirus pandemic.”

And that doesn’t include the extent to which they are prepared for another Eurozone sovereign debt crisis, especially one involving Italy, whose government bonds are owned by many banks, and which carry no capital requirement (because they are in theory “riskless”).

Note too that holdings of Italian government bonds now amount to more than 11% of Italian banks’ total assets, and that by the end of the year, Italy’s debt/GDP ratio is projected to reach 160% (e.g., see, “Italy Debt Could Spin Out of Control Unless Growth Picks Up” by Albanese and Follain).

For an in-depth discussion of the many challenges facing the Italian economy, see “Will Italy Recover?” by Papadimitriou et al.

In “Why economics needs to wake up to aging populations”, the FT’s Diane Coyle reviewed a new book, The Great Demographic Reversal, by Goodhart and Pradhan

Coyle begins with an observation with which we strongly agree:

“Economics generally pays surprisingly little attention to demography, even though the ageing and shrinking of the population in so many parts of the world is a striking and new phenomenon in human history.

“Take Italy. Last year the country recorded the smallest annual number of births since the Risorgimento of the mid-19th century and nearly a third of its population is over 60. There has been an absolute decline in the number of people in Italy since 2015, even accounting for net inward migration. It is an extreme case, but the rest of the west, most of eastern Europe and China will follow.

“Yet in economics, humans are abstracted as “labour input”, substitutable by machines, while demographic trends occur beyond the time horizon of macroeconomic models” …

If a nation wants to both service its debt and provide a rising standard of living to its residents, a declining working age population leaves it with three choices: (1) Increase the rate of workforce participation; (2) Increase immigration; and/or (3) Increase labor force productivity. None of these is easy.

Coyle notes that Goodhart and Pradhan “make some strong predictions: The old, at their late stage in the life cycle, don’t save, but spend, so savings “gluts” of the kind thought to have paved the way for today’s low interest rates will vanish as populations age. Nominal interest rates will rise and so will inflation — mainly because of labour shortages and wage pressures.”

However, Coyle also notes that the authors “don’t engage much with the scope for a turnaround in productivity growth, or with the deflationary tendencies clearly associated with technologies as they bring down prices of many goods and services.”

“Evidence of Accelerating Mismeasurement of Growth and Inflation in the U.S. in the 21st Century”, by Leonard Nakamura from the Federal Reserve Bank of Philadelphia

SURPRISE

In this fascinating paper, the author notes that, “a central problem that we face in measuring the economy is the rising economic importance of knowledge and creativity, as the economy focuses on intangible assets, and that these are increasingly digitizable due to the Internet. Once in digital form, reproduction of many products is virtually costless. In a modeled economy in which prices represent marginal resource costs, such goods have zero prices and disappear from GDP. In practice, new business models that accommodate these products make the quantification of consumer welfare and productivity more difficult.”

This means that, “increasingly, economic progress is taking forms that are not readily measured in the U.S. gross domestic product (GDP) accounts. Consequently, Nakaumura “seeks to explore the possibility that economic growth in the U.S. is substantially faster in the 21st century than currently measured in U.S. national income accounts data, and that inflation is substantially slower, indeed, that the U.S. has generally been deflating since the Great Recession”, in the manner of the “healthy” productivity and supply growth led “good deflations” of the 19th century.

He “points to evidence across many product areas that rapid progress is occurring. This raises the possibility that not only did U.S. growth and productivity accelerate after 1995, they have possibly continued strongly after 2005 and there has been no secular stagnation.”

Multiple articles have noted the challenges facing economies after the temporary support programs put in place for COVID run out.

For many companies, already high debt loads have further increased (e.g., see, “Global Waves of Debt” by the World Bank, and “Pandemic Fuels Global Debt Tsunami” by Jonathan Wheatley in the Financial Times).

Many businesses have already closed and jobs have been permanently lost. In the case of small businesses, the owner’s equity – often reflecting their lifetime savings – has been wiped out. In the absence of grant or equity funding (e.g., from a government investment bank), they lack the funds to reopen.

If their abandoned locations are taken over by larger companies that obtained government supports, there will be political hell to pay.

There is also growing evidence that constraints in the current institutional process for restructuring debt could lead to increasing disorder, as the insolvency crisis grows (e.g., see, “Sizing up Corporate Restructuring in the COVID Crisis”, by Greenwood et al).

Many employees who have lost their jobs will need reskilling to remain employable in a rapidly evolving economy.

Yet in most places, these programs are woefully undeveloped and/or ineffective. Too often I read policy reports claiming that more reskilling, retraining, and liftetime learning are critical to maintaining many people’s “employability” in an age of rapid technological improvement.

But I see few that get into the weeds about how hard this has been do to on the ground, where different organizations fiercely protect their turf, while ignoring the larger consequences of their actions. This does not bode well for delivering the education and productivity improvements that are critical to avoiding both deflation and high inflation.

“The Future of Work: Building Better Jobs in the Age of Intelligent Machines”, Final Report of the MIT Future of Work Project

“Global survey: The State of AI in 2020”, by McKinsey & Co.

“The Future of Work: Meaningful Integration or Jobless Future?” INET Webinar with Daron Acemoglu

SURPRISE

A growing number of analyses are focusing on the implications of the gap between the rate at which AI and automation technologies are improving, and the rate at which employees’ and students’ knowledge and skills are growing.

Acemoglu notes that historically the introduction of new technology has not only displaced workers, but also created new jobs requiring new knowledge and skills (what he calls “reinstatement”). He observes that historically, job displacement and reinstatement balanced out, sometimes with a time lag.

However, since 1980, this process has broken down, with displacements exceeding reinstatements. Acemoglu notes that this has coincided with slower productivity growth and increasing inequality.

He also highlighted how the current US tax system makes it cheaper for companies (on an after tax basis) to invest in capital (e.g., automation) rather than labor. Similarly, he noted how increasing automation may lead to increasing strife in emerging markets, where low cost, labor intensive manufacturing has been a traditional source of employment and socio-economic mobility.

The final report from MIT’s Future of Work project, covers issues raised by Acemoglu (and others) in much more depth.

One of its key conclusions is that “enabling workers to remain productive in a continuously evolving workplace requires empowering them with excellent skills programs at all stages of life: in primary and secondary schools, in vocational and college programs, and in ongoing adult training programs.” But MIT also concludes, that, “the distinctive U.S. system for worker training has many shortcomings.”

If you’ve spent anytime trying to deal with this system that will almost certainly strike you as a gross understatement of the challenges we face with respect to continually improving labor force knowledge and skills.

The good news in the MIT report is that “momentous impacts of technological change are unfolding gradually.” This was also highlighted by McKinsey, in its most recent overview of the state of AI is that deployment of advance technologies is still happening relatively slowly, because of the time it takes to change organizations to realize their full benefits.

In theory, this creates the time we need to increase the rate of job reinstatement by accelerating the acquisition of requisite knowledge and skills by current and future workers, if (and it’s a big if) the challenges that entails can be overcome.

On the other hand, McKinsey also found that companies at the leading edge of deploying advanced technologies are pulling away from their competitors, creating another source of inequality.

The IMF released its semi-annual World Economic Outlook (along with its Fiscal Monitor and Global Financial Stability Report)

The WEO painted a sobering picture.

“The medium-term projections also assume that economies will experience scarring from the depth of the recession and the need for structural change, entailing persistent effects on potential output.

“These effects include adjustment costs and productivity impacts for surviving firms as they upgrade workplace safety, the amplification of the shock via firm bankruptcies, costly resource reallocation across sectors, and discouraged workers’ exit from the workforce.

“The scarring is expected to compound forces that dragged productivity growth lower across many economies in the years leading up to the pandemic— relatively slow investment growth weighing on physical capital accumulation, more modest improvements in human capital, and slower efficiency gains in combining technology with factors of production.”

Far more revealing than the careful language in the official reports were interviews with top officials from the World Bank and IMF

In “Many Businesses Are In Sectors That Aren’t Going To Recover” by Hulsen and Bidder from Der Spiegel, Carmen Reinhart, the World Bank’s chief economist, discussed why she considers rapid economic recovery to be an illusion.

“The longer the lockdowns, the uncertainties, the more damage done to the balance sheets of governments, households and firms. That is where this crisis begins to compare to historical ones.

“The issue of financial fragility and bankruptcies becomes much more compelling. People who lose their jobs and do not quickly regain employment will have difficulty servicing their debts. Many businesses are in sectors like entertainment, restaurants and retail that are not going to recover”…

“Right now, we’re in a state of suspension. So many countries have either directly by government decree or through the initiative of the banks given grace periods to firms and households. But that will eventually be over, and that is a source of concern when I look at the next year…

“I'm talking about a period of high non-performing loans that require more recapitalization from governments that also make institutions very leery about new lending, so that we'll have a credit crunch. That environment can occur without drama and can last a long time...

“Historically, in the last 160 years, the average time it took to really recover - meaning you get back to the pre-crisis level of income per capita – is eight years…

“The key lesson in terms of policy for countries is: The earlier you tackle the restructuring of private debt, the earlier you start the recognition of non-performing loans, the need for write-offs, the quicker you can clean the balance sheet for banks, and the quicker the banks can start moving toward new lending.”

“Global Liquidity Trap Requires A Big Fiscal Response”, by Gita Gopinath, Chief Economist of the IMF, in the Financial Times

“Now we are in a global liquidity trap where monetary policy has limited effect… Solvency risks now predominate... The ascent back from what I have called “the great lockdown” will be long and fiscal policy will need to be the main game in town…

“Before the pandemic, there was a worrying consensus that low-for-long interest rates had promoted excessive risk-taking that heightened financial stability risks. The striking disconnect of financial markets from real activity in the recovery from the Covid-19 crisis reinforces these notions…

“The importance of fiscal stimulus has probably never been greater because the spending multiplier — the pay-off in economic growth from an increase in public investment — is much larger in a prolonged liquidity trap.”

“The Fiscal Multiplier of Public Investment: The Role of Corporate Balance Sheet”, by Espinoza et al from the IMF

SURPRISE
While Gopinath is correct about the need for large, coordinated fiscal stimulus by governments, this new paper highlights that the multiplier impact of this spending will be constrained by high private sector debt levels.

“This paper explores whether public investment crowds out or crowds in private investment. To this aim, we build a database of about half a million firms from 49 countries. We find that the effect of public investment on corporate investment depends both on leverage and financial constraints. Public investment boosts private investment for firms with low leverage. However, for firms with high leverage, private investment does not react to an increase in public investment… the effect of public investment on corporate investment is much weaker for firms that are financially constrained.”

“Intangible Investment and Low Inflation: A Framework and Some Evidence”, by Lall and Zeng from the IMF

SURPRISE
The increasing importance of investment in intangible as opposed to fiscal assets in the digitalizing (or “dematerializing”) economy may also constrain the price (inflation) impact of more fiscal and monetary stimulus.

The IMF finds that, “the rise of intangible investment across advanced—and increasingly emerging—economies can plausibly explain many macroeconomic relationships observed over the past decade...

“The underlying structural changes that intangible investments embody, while in train since at least the 1990s, are still at an early stage of transforming economies…

Its distinguishing characteristics are generally greater scalability and lower marginal costs than tangible investment…This may have contributed to more elastic aggregate supply in recent years, which is consistent with lower inflation and a flattening of the Phillips curve. This framework highlights the channels through which technological change, a large constituent of intangible investment, may be leading to wage stagnation and greater market concentration.

In Europe and the United States, there has been an accelerating surge of new COVID infections.

This will almost certainly prolong and worsen the economic downturn, and very likely lead to more severe social and political consequences in the absence of better policy responses than seem likely today.

Various post-COVID bailout programs for private sector companies run the risk of increasing the number of “zombie” firms in the economy, with negative consequences for employment, investment, and productivity growth (as was seen for years after the beginning of Japan’s financial crisis in 1991).

The risks posed by “zombie companies” have been increasingly recognized in the media (e.g., “What To Do About Zombie Firms”, The Economist; and “Pandemic Debt Binge Creates New Generation Of ‘Zombie’ Companies”, Financial Times)

Growth in the number of zombie companies is another channel of likely economic harm resulting from COVID-19 that will almost certainly prolong the downturn.

In “Corporate Zombies: Anatomy and Lifecycle”, Banerjee and Hoffman from the Bank for International Settlements (BIS) “use data on listed non-financial companies in 14 advanced economies, to document a rise in the share of zombie firms, defined as unprofitable firms with low stock market valuation, from 4% in the late 1980s to 15% in 2017.”

“These zombie firms are smaller, less productive, more leveraged and invest less in physical and intangible capital… The literature has so far focused largely on the causes and the consequences of the rise of these firms for other firms and for aggregate productivity. But little is known about the zombies themselves, except that they are commonly found to be less productive than their non-zombie peers.”

The authors find that zombies’ “performance deteriorates several years before zombification and remains significantly poorer than that of non-zombie firms in subsequent years. Over time, some 25% of zombie companies exited the market, while 60% exited from zombie status”…

However, “recovered zombie firms however remain weak and fragile. Their productivity, profitability, investment and employment growth remain well below those of non-zombies. Reflecting this weak performance, they face a high probability of relapsing into zombie state. By 2017, the probability of becoming a zombie firm in the subsequent year was, at 17%, three times higher for a recovered zombie compared to a firm that has never been a zombie firm. This relapse probability of recovered zombies has increased more than threefold over the past decade.”

Writing in the Financial Times, Martin Sandbu concludes that, “a big recapitalisation plan is the only way to address the serious damage that has been done to companies” (“The Corporate Zombies Stalking Europe”).

“The Economic Impact of Learning Losses” by Hanushek and Woessman for the OECD

See also, “Tapping into Talent: Coupling Education and Innovation Policies for Economic Growth” by Akcigit

Large and very likely unrecovered COVID-19 learning losses for elementary and secondary students is another channel through which the pandemic will negatively affect economic growth, and lead to negative social and political effects.

“The worldwide school closures in early 2020 led to losses in learning that will not easily be made up for even if schools quickly return to their prior performance levels. These losses will have lasting economic impacts both on the affected students and on each nation unless they are effectively remediated.

“While the precise learning losses are not yet known, existing research suggests that the students in grades 1-12 affected by the closures might expect some 3 percent lower income over their entire lifetimes. For nations, the lower long-term growth related to such losses might yield an average of 1.5 percent lower annual GDP for the remainder of the century.”

"These economic losses would grow if schools are unable to re-start quickly. The economic losses will be more deeply felt by disadvantaged students. All indications are that students whose families are less able to support out-of-school learning will face larger learning losses than their more advantaged peers, which in turn will translate into deeper losses of lifetime earnings.”

“Demographic Origins of the Decline in Labor's Share” [of National Income in the United States], by Glover and Short.

SURPRISE
In the absence of an effective policy response, this represents another channel through which demographic forces will likely slow economic growth and worsen inequality, thus very likely leading to more severe social and political consequences.

“An aging workforce has contributed to the decline in labor's share. We formalize this hypothesis in an on-the-job search model, in which employers of older workers may have substantial monopsony power due to the decline in labor market dynamism that accompanies age. This manifests as a rising wedge between a worker's earnings and marginal product over the life-cycle…We find that a sixty-year-old worker receives half of her marginal product relative to when she was twenty, which, together with recent demographic trends, can account for 59% of the recent decline in the US labor share.”

Joshua Rauh, one of the leading public finance economists in the US, proposed that, “Municipal Bond Investors Have to Share the Burden in State Bailouts.”

“When Greece had its government debt crisis a decade ago, it received several rounds for bailout funding from the European Commission, the European Central Bank, and the International Monetary Fund. Key to the negotiations were not only the extent to which Greece would reform its public finances, but also how much the existing owners of its debt would have to suffer losses before the country received the bailout funding.

“The private investors in Greek bonds ultimately took haircuts that reduced the value of their positions by 59 percent in 2012.

“Now in the United States, many are calling on the federal government to provide massive transfers for bailouts of state and local governments as they face their own debt crisis… Absent among these requests has been any mention of the existing bond holders, the creditors who voluntarily loaned nearly $4 trillion to state and local governments in the municipal bond market.” Other research has found that, because municipal bond income is exempt from federal taxes, 42% of municipal bonds (by value) are held by the top 0.5% of the income distribution.”

SURPRISE
That Rauh’s proposal was published by The Hill (a widely read publication in Washington DC) marks a watershed in the development of the worsening state and local financial crisis in the United States.

However the fact that Rauh failed to also ask for reductions in unfunded public sector pension plan liabilities (via cuts in retiree benefits) indicates the ugly nature of the conflict that lies ahead.

In the Federal Reserve’s most recent release, these liabilities were estimated to be $4 trillion at the end of 2017. Since then, they have undoubtedly increased.

There is no way that municipal bondholders and state and local taxpayers will accept a deal that provides more federal money and cuts muni bond payments in order to reduce unfunded public pension liabilities.

In the US, analyses have criticized the design and results of the first COVID fiscal stimulus package (e.g., “Doomed To Fail’: Why a $4 Trillion Bailout Couldn’t Revive The American Economy: An avalanche of U.S. grants and loans helped the wealthy and companies that laid off workers. Individuals received about one-fifth of the aid”, by Whoriskey et al in the Washington Post).

Similar criticisms have already been made of the yet to be disbursed EU fiscal stimulus package. For example, in the Financial Times, Wolfgang Munchau writes that, “Last week, the European Commission produced an important document that set out guidelines to EU governments on how to spend the money and how to prevent it from ending up in a pork barrel. It is not a bad list, although I think the priorities are too diffuse. The bigger problem, though, is that member states will almost certainly not follow these guidelines… National political pressures will divert money from truly worthwhile projects” (“Beware Of Smoke And Mirrors In The EU’s Recovery Fund”).

Faced with an unprecedented collapse in global demand, governments have dithered in putting together and the implementing often poorly-designed fiscal stimulus packages.

In the meantime, central banks have been left to do what they can to keep the economy (barely) afloat with the limited monetary tools they have available at the zero lower interest rate bound. Unfortunately, while central banks can effectively resolve liquidity issues, resolving solvency issues requires effective fiscal and structural policy.

In their absence, insolvencies will rise, forcing many more people out of work. In the US, much of this increase in unemployment, at least at first, will likely fall on people in the lower three quintiles of household income, which account for almost 40% of consumption expenditure (the top four quintiles account for 61%), in an economy where private consumption accounts for almost 70% of GDP.

People in the highest quintile cannot remain unscathed for much longer if the collapse of employment (in the US, U6 – the broadest measure of unemployment – was at nearly 13% at the end of September) and consumption beneath them continues for much longer (e.g., “Harvard’s Chetty Finds Economic Carnage in Wealthiest ZIP Codes” on Bloomberg).

Unfortunately, discussion of serious structural policy actions – the need for which was abundantly clear as the economy weakened in 2019 before COVID arrived – is thus far wholly absent.
The last thing the world needs right now is more wasted fiscal stimulus. But that increasingly looks like what we’re going to get, if (in the US at least), a polarized Congress ever reaches agreement on the shape of the next stimulus package.
The resulting sputtering, staggering, and weak economic recovery (driven by rising insolvencies) will almost certainly increase social and political conflict.

It is therefore no surprise that, as Pew Research found, “Views of The Economy Have Turned Sharply Negative In Many Countries Amid COVID-19”.

This year’s Federal Reserve Bank of Kansas City’s Jackson Hole Symposium for central bankers featured two important papers.

We featured one of them in last month’s evidence file: “Scarring Body and Mind: The Long-Term Belief Scarring Effects of COVID-19”, by Kozlowski, Veldkamp, and Venkateswaran. Its key finding is that the psychological effects of a pandemic can depress confidence, consumption and investment spending, and GDP growth rates for years.

The second paper was “What Happened to U.S. Business Dynamism?” by Ufuk Akcigit and Sina Ates. Their key finding is that reduction in knowledge diffusion across firms between 1980 and 2010 has been a critical root cause of multiple effects, from low productivity growth to rising inequality.

A long commentary I wrote about these papers can be found here.

The key point is that the global economy is facing structural headwinds that cannot be overcome with monetary and fiscal stimulus. Much more difficult reforms are needed, and it is not at all clear that our political systems can successfully meet this challenge.

In “Replace the Federal Student Loan System with an Income Share Agreement Program”, AEI’s Beth Akers shows why student loan forgiveness programs are prohibitively expensive and risk increasing inequality.

She reiterates a call (first made during the Clinton administration) for the replacement of student loans with income share agreements, under which in exchange for funding, students would pay to the government (via the tax system) a fixed share of their income for a fixed number of years.

In effect, this would convert the funding of higher education (and skills training) from a debt to an equity-based system.

See also: “The Next “Big Short”: Covid-19, Student Loan Discharge In Bankruptcy, And The Slabs Market”, by Samantha Roy and Christopher Ryan, Jr. This paper highlights changes in the bankruptcy treatment of student loan debt that may increase lender enthusiasm for conversion to equity.

SURPRISE
As student debt outstanding has exponentially increased in recent years, there has been a parallel growth in research on the negative impact it has on economic growth.

As Herbert Stein famously observed, “if something cannot go on forever, it will stop.”

Even if Joe Biden is elected in November, outright forgiveness seems to be a political bridge too far, because of the inequitable distribution of its benefits.

This makes conversion of the debt into a form of equity (and creation of a program to let workers seeking to advance their skills also have access to this financing) a much more likely scenario.

Moreover, this would not just be very likely to produce an increase in economic growth; it could also lead to the creation of a new asset class – human capital – if the government chose to resell these equity claims to investors.

Evidence continued to accumulate about growing distress in the real economy.

The Financial Times noted that, “Small and medium-sized US companies suffered a complete wipeout in profits in the second quarter because of the Covid-19 crisis, in sharp contrast to large multinationals that emerged from the most intense phase of the pandemic in better shape.

“As the earnings season draws to a close, companies within the Russell 2000 stock index — the small-cap benchmark — have reported an aggregate loss of $1.1bn, compared to profits of almost $18bn a year earlier, according to data provider FactSet.
“Meantime, the much bigger companies within the benchmark S&P 500 index have posted a 34 per cent aggregate drop in earnings, to $233bn” (“Coronavirus makes for a brutal quarter for smaller US companies”).

In both Europe and the United States there were growing concerns that extended government support and loan forbearance would create, as it did in Japan, a growing number of large “zombie” companies that survive without investing, growing, and improving productivity and profits.

But at the same time, there was widespread concern about the unpredictable consequences of increasing bankruptcies, business closures, and unemployment when current support programs expire, especially among medium and small companies.

Elsewhere, Chetty et al find that many of these support programs have been highly inefficient, and that money “would have been better spent directly mitigating financial hardship through social insurance” (“Real-Time Economics: A New Public Platform to Analyze the Impacts of COVID-19 and Macroeconomic Policies Using Private Sector Data”).

Finally, in “Two Tales of Debt”, Kermani and Ma find that because of the increasing specialization of firms and supply chains, and the growing percentage of intangible assets on company balance sheets, the average liquidation value of firms is only 23% of their book assets. Hence losses to lenders (and impairment to their capital and ability to provide credit in the future) resulting from an extended period of financial distress are likely to be large.

SURPRISE
In the early days of the COVID pandemic, many people failed to recognize the danger it posed.

Partly this was due to the many distractions they faced, including the Trump impeachment trial, Brexit, and the Democratic Party primaries in the United States.

It was also due to many people’s lack of a mental model for making sense of the information they noticed about the spread of SARS-CoV-2.

The same pattern is also very likely at work once again with respect to timely and accurate assessment of the continuing deterioration of the global economy.

Once again, distractions abound, including a technology stock boom, riots and an increasingly acrimonious election campaign in the United States, intensification of the US-China conflict, street demonstrations following an apparently fraudulent election in Belarus, the apparent breakdown of UK-EU trade treaty talks, and a resurgence in COVID cases in Europe and the United States.

As Megan Greene put it in the Financial Times, “The US Economy is Having a Wile E. Coyote Moment”. “US consumers and businesses have just run straight off a cash cliff, now that extra federal assistance to small companies and unemployed workers has ended. The US economy is now suspended in mid-air.”

The nations of the European Union finally reached a compromise and agreed a 750 billion Euro stimulus plan. However, the plan still must be approved by the European Parliament, which could force further changes in it.

While the north/south tensions that delayed agreement still remain, and there are concerns that southern nations will receive a disproportionate share of the bailout funds, the agreement led to a significant increase in the Euro XR versus the US dollar (which was also helped by a worsening COVID situation and political stalemate over another federal fiscal support bill in the US).

Funds will be allocated on the basis of the relative economic harm COVID is estimated to have caused different countries. Critically, receipt of these funds will be linked to a country’s commitment to enact policy reforms. Funding may be blocked if a national government objects that another government is not implementing these reforms (with the EU Commission having the final say).

Reflecting concern about eroding democracy in Hungary and Poland, a weighted majority of governments can also block disbursement of funds to nations not following “rule of law principles”.

Over a longer time horizon, the issuance of 750 billion Euro in EU debt will accelerate the development of Euro capital market, and make it a more viable competitor to the US dollar.

On the other hand, the weak provisions for countries’ obligations to contribute to repayment of these new EU bonds will, we expect, gradually be recognized, and cause investors to demand a relatively higher yield on them than they would on US Treasuries. Increasing economic problems in Italy in Spain, including any difficulties they have at rolling over their outstanding government debts will hasten this recognition.

In the United States, even as Congressional Democrats and Republicans remained deadlocked over the contents of a second fiscal package to support the economy, concerns continued to be voiced about the sustainability of mounting fiscal deficits that are largely being monetized by the Federal Reserve.

The essence of the problem is that a substantial increase in productivity is needed for the US to service a much higher level of debt without requiring some combination of extended (and politically destabilizing) austerity, inflation, and/or extensive debt restructuring.

However a sustained increase in productivity will have to overcome many headwinds.

In the short term, a number of factors will likely depress the size of the fiscal multiplier – the amount of GDP growth produced by each dollar of government deficit spending. These include high levels of inequality and private sector indebtedness, as well as an aging population.

In the medium term, barriers to higher productivity growth include aging population and poorly performing education system, that fails to produce enough talent to support the diffusion of new technologies (e.g., robotics and artificial intelligence) beyond a limited number of increasingly dominant superstar firms in many industries.

The extensive learning losses that many of America’s 57 million K-12 students have experienced due to COVID will only make this worse. Unfortunately, if the past ten years are any guide, most students will fail to make them up (for base case data see, “Catching Up to College and Career Readiness” by ACT Inc.).

Uncertainties about America’s future growth potential has led to rising concerns about the possibility of a substantial increase in inflation at some point in the future.

The price of gold continued to increase in July.

Lacking increased gold demand for jewelry or industrial uses, this price increase logically reflected a combination of negative rates on US Treasury and other high quality sovereign debt, rising fears about future inflation, and growing concern about key currencies (the Euro and especially the US Dollar) as safe haven assets.

Negative yields on sovereign debt are unattractive because the holder is guaranteed to lose money if the bond is held to maturity, and will lose even more if interest rates rise (which would cause bond prices to fall). Bank deposits still offer a small positive return, and gold has upside potential if uncertainty increases (which would likely cause US Treasury yields to become even more negative).

With respect to inflation, we continue to believe that (as you can see in this month’s regime forecast) a sharp increase is not likely over the next 12 months.

That leaves rising demand for gold driven by increasing uncertainty about the political stability in the United States, which is not unfounded, given the street rioting investors have watched, still rising rates of COVID infection, and growing concerns about whether President Trump may attempt to disrupt the November election or leave office if he is defeated.

In July, further evidence emerged about the structural changes underway in the economy.

SURPRISE
In “US small-business recovery after the COVID-19 crisis”, McKinsey finds that, “After the 2008 recession, larger companies recovered to their pre-crisis contribution to GDP in an average of four years, while smaller ones took an average of six…[After the COVID shock], across all businesses, recovery could take five years or longer under two scenarios that McKinsey Global Institute and Oxford Economics have modeled and that more than half of global executives surveyed see as the most likely to unfold Among small businesses, recovery is again likely to take even longer. Many may never reopen.”

In just one sector, Sharpe and Querolo from Bloomberg forecast that “One-Third of U.S. Restaurants Face Permanent Closure This Year”…” showing how the Covid-19 pandemic is decimating an industry that employs millions of Americans.”

In “The Great Acceleration”, McKinsey notes that, “The fault lines between industries and business models that we understood intellectually before the COVID-19 crisis have now become giant fissures, separating the old reality from the new one. Just as an earthquake produces a sudden release of pent-up force, the economic shock set off by the pandemic has accelerated and intensified trends that were already underway. The result is a dramatic widening of the gap between those at the top and the bottom of the power curve of economic profit — the winners and losers in the global corporate performance race.”

Similarly, in “The “New Normal” Is a Myth. The Future Won’t Be Normal at All”, Bain & Company observes that, “The lessons companies learned in the months after the outbreak were profound. Virtual, digital and automation initiatives, for both customer interactions and internal operations, accelerated at astonishing speed. Supply chains ruptured across the globe, signaling that companies have for too long sacrificed resilience for efficiency… Digital roadmaps once measured in years accelerated rapidly in days and quickly proved their worth… A recent Bain survey of IT buyers shows that more than 80% of companies are accelerating their automation initiatives in response to Covid-19.”

The implications of this trend for future levels of social and political conflict are an important cause for concern, including David Autor and Elizabeth Reynolds’ warning in their paper, “The Nature of Work after the COVID Crisis: Too Few Low-Wage Jobs.”

They note that, “the COVID crisis has shaken our core confidence that the U.S. labor market, caught between the demographic pincers of a swelling retiree population and a flagging fertility rate, would almost inevitably experience structurally tight labor markets for many years to come.”

“No one foresaw that a global pandemic would spur an overnight revolution in telepresence that may upend commuting patterns and business travel, and hence dent demand in rapidly growing—though never highly paid—personal service occupations… As to whether these developments mean that the U.S. labor market will continue to deliver negligible—or perhaps as to whether these developments mean that the U.S. labor market will continue to deliver negligible— or perhaps negative—earnings gains for the typical U.S. worker… On its current trajectory, the unfortunate answer is likely yes.”

Evidence is accumulating that a substantial increase in debt restructurings lies ahead.

In the Financial Times, John Dizard warned that, “Hope Will Not Save US Commercial Properties.” “Commercial real estate will have to be entirely restructured in the US…The problem is most obvious for retailers, joined by the hoteliers. And in just a few more months, we will find out how many offices will be cut back by the work from home phenomenon. Will the offices be 80 per cent occupied? Or 50 per cent?”

Writing elsewhere in the FT, Mohamed El-Erian, warned that, “Investors Must Prepare Portfolios for COVID-19 Debt Crunch.” “The financial stress caused by Covid-19 is far from over. Investors should brace for non-payments to spread far beyond the most vulnerable corporate and sovereign borrowers, in a reckoning that threatens to drag prices lower”…

“There are already plenty of worrying signs: a record-breaking pace for corporate bankruptcies; job losses moving from small and medium-sized firms to larger ones; lengthening delays in commercial real estate payments; more households falling behind on rents and continuing to defer credit card payments; and a handful of developing countries delaying debt payments.”

Finally, in “Firms, Failures, and Fluctuations: The Macroeconomics of Supply Chain Disruptions”, Acegmolu and Tahbaz-Salehi show how in today’s economy extended supply chains can amplify the negative aggregate impact of individual firm failures.

The prospective impact of a rapid increase in bankruptcies on future social and political conflict is a matter for serious concern, particularly if they are handled poorly – which in this case likely means the same way they have always been handled.

I have clearly in mind a prophetic 2012 article by Matt Stoller, “The Housing Crash and the End of American Citizenship.” He noted that, “much as divorce became a culturally common activity in the 1960s, [after the 2008 crash] the rise of a foreclosure epidemic has made the loss of a home a searing but familiar experience for tens of millions of Americans.”

Stoller’s thesis was that, “this wave of foreclosures signals the end of an older social contract and the beginning of a period of deep political and economic instability. The crash of the housing market radically altered the wealth and power distribution mechanisms for the American political order.”

This was written four years before Donald Trump’s election in 2016. A similar wipeout of America’s small businesses could have a similar, and similarly unpredictable, effect.

While the US is reporting increases in COVID-19 cases, and Europe’s economy appears to be recovering, the FT’s Jamil Anderlini reports that “Behind the Recovery, China’s Economy is Wobbling.”

Thus far, China’s economic rebound has only been “achieved with Herculean effort from an interventionist state falling back on the same tools it has relied on since the financial crisis of 2008.

“Even before the first virus cases were discovered in Wuhan, the economy was struggling with massive over-investment, particularly in redundant real estate projects, mounting bad debt, growing dominance of inefficient state enterprises and chronic under-consumption.

“The government’s response to the collapse of growth in the first quarter has exacerbated all these problems.

“Financial regulators are warning of a flood of new bad loans and a surge in unregulated shadow banking even as Beijing opens the credit floodgates to get the economy moving again.

“The build-up of debt in the economy in the aftermath of the 2008 crisis was the fastest and biggest in history and the pace has accelerated to record highs since the start of the pandemic.

“Despite years of official rhetoric on the need to create a consumer economy and reduce reliance on investment as the main driver of growth, China’s household consumption as a percentage of gross domestic product remains extraordinarily low — less than 40 per cent…

“That has prompted Beijing to boost growth through debt-fuelled investment, as it did in the wake of the global financial crisis. Once again, the drive has been led by investment in infrastructure and real estate, and it has been dominated by the sclerotic state-owned sector…

“As the virus continues to rage across much of the world and as relations with the US and other important trade partners worsen dramatically, China’s leaders have clearly decided to revive the old strategy of debt-fuelled, state-dominated investment.

“A decade ago, some economists liked to describe the Chinese economy as a bicycle that needed to maintain a certain speed or it would tip over and crash.

Today it is more like a bicycle laden with enormous boxes of debt, ridden by a drunk and with strategic competitors such as the US trying to knock it over.”

“The Future of Work in Europe” by Smit et al from the McKinsey Global Institute

“The COVID-19 crisis has strongly affected Europe’s labor markets, and it may take years for employment to return to its pre-crisis levels. But the pandemic will not be the only trend shaping the future of work on the continent. This research takes an in-depth look at almost 1,100 local economies across the 27 EU countries plus the United Kingdom and Switzerland. We assess how automation and AI may reshape the mix of occupations, the skills required to work, and the transitions workers face.

“In the aftermath of the pandemic, emerging evidence from companies suggests that technology adoption and other workforce shifts could accelerate…

“Among our key findings: Once the economy recovers, Europe may have a shortage of skilled workers, despite a growing wave of automation. A key reason is the declining supply of labor: Europe’s working-age population will likely shrink by 13.5 million (or 4 percent) due to aging by 2030.

“The trend of shorter workweeks could reduce labor supply by an additional 2 percent…

“More than half of Europe’s workforce will face significant transitions. Automation will require all workers to acquire new skills. About 94 million workers may not need to change occupations but will especially need retraining, as technology handles 20 percent of their current activities…

“While some workers in declining occupations may be able to find similar types of work, 21 million may need to change occupations by 2030. Most of them lack tertiary education. Newly created jobs will require more sophisticated skills that are already scarce today

“Overcoming labor market mismatches in a post-COVID world will be a key challenge…Four broad imperatives stand out: (1) addressing skills shortages; (2) improving access to jobs in dynamic growth hubs, potentially through an increase in remote working; (3) revitalizing and supporting shrinking labor markets (since 40 percent of Europeans will live in regions where jobs are declining over the coming decade); and (4) increasing labor force participation.”

“An Analysis of Joe Biden’s Tax Proposals”, by Pomerleau et al from AEI

The authors “estimate that Joe Biden’s proposal would raise federal revenue by $3.8 trillion over the next decade (2021–30). They would increase taxes, on average, for households at every income level and make the federal tax code more progressive. His tax increases would primarily fall on the top 1 percent of income earners…

“Biden’s proposals would reduce gross domestic product (GDP) by (0.06) percent over the next decade, slightly increase GDP the second decade by 0.07 percent, and result in a small reduction in GDP in the long run (0.2 percent)…

“Although his proposals would raise significant revenue, they would not significantly affect the federal government’s short-run and long-run debt burden.”

“A Crash in the Dollar is Coming” by Stephen Roach

While we don’t agree with Roach’s conclusions, especially in the short term, it is important to present analyses that differ from the conclusions we have reached.

“The era of the U.S. dollar’s ‘exorbitant privilege’ as the world’s primary reserve currency is coming to an end…
"Already stressed by the impact of the Covid-19 pandemic, U.S. living standards are about to be squeezed as never before. At the same time, the world is having serious doubts about the once widely accepted presumption of American exceptionalism.

“Currencies set the equilibrium between these two forces — domestic economic fundamentals and foreign perceptions of a nation’s strength or weakness. The balance is shifting, and a crash in the dollar could well be in the offing.”

“The coming collapse in saving points to a sharp widening of the current account deficit, likely taking it well beyond the prior record of -6.3% of GDP that it reached in late 2005. Reserve currency or not, the dollar will not be spared under these circumstances. The key question is what will spark the decline? …

“The collapse in the dollar will be inflationary — a welcome short-term buffer against deflation but, in conjunction with what is likely to be a weak post-Covid economic recovery, yet another reason to worry about an onset of stagflation — the tough combination of weak economic growth and rising inflation that wreaks havoc on financial markets.”

“The Debt Collection Pandemic” by Foohey et al

see also:

“Income, Liquidity, And The Consumption Response To The COVID-19 Pandemic And Economic Stimulus Payments” by Baker et al

“The coronavirus pandemic is set to metastasize into a debt collection pandemic. The federal government can and should do something to put a halt to debt collection until people can get back to work and earn money to pay their debts. Yet it has done nothing to help people deal with their debts.

“Instead, states have tried to solve issues with debt collection in a myriad of patchwork and inconsistent ways. These efforts help some people and are worthwhile. But more efficient and comprehensive solutions exist.”

“Because American families’ finances are unlikely to recover as soon as the crisis ends, debt collection brought by the COVID-19 crisis also will not dissipate anytime soon. Even after the crisis ends, the need to implement comprehensive, longer-lasting solutions will remain…

“These solutions largely fall on the shoulders of the federal government, though state attorneys general have the necessary power to help people effectively. If the government continues on its present course, a debt collection pandemic will follow the coronavirus pandemic.”

Baker et al find that, “After a steep decline in spending, US households responded rapidly to the receipt of COVID-19 stimulus payments. Still, relative to similar programs in 2001 and 2008, spending on durables decreased…
“Larger increases were observed in spending on food and payments – from credit cards to rents and mortgages – that reflect a short-term debt overhang, which suggests that direct payments failed to stimulate aggregate consumption.”

“The Long Run Consequences of Pandemics”, by Jorda et al from the Federal Reserve Bank of San Francisco

Also:

“Scarring Body and Mind: The Long-Term Belief Scarring Effects of COVID-19”, by Kozlowski et al

SURPRISE

“What are the medium- to long-term effects of pandemics? How do they differ from other economic disasters? We study major pandemics using the rates of return on assets stretching back to the 14th century.

“Significant macroeconomic after-effects of pandemics persist for decades, with real rates of return substantially depressed, in stark contrast to what happens after wars.

“Our findings are consistent with the neoclassical growth model: capital is destroyed in wars, but not in pandemics; pandemics instead may induce relative labor scarcity and/or a shift to greater precautionary savings.”

In “Scarring Body and Mind: The Long-Term Belief Scarring Effects of COVID-19”, Kozlowski et al describe one driver of these long term consequences:

“The largest economic cost of the COVID-19 pandemic could arise from changes in behavior long after the immediate health crisis is resolved. A potential source of such a long-lived change is scarring of beliefs, a persistent change in the perceived probability of an extreme, negative shock in the future…

“We find that the long-run costs for the U.S. economy from this channel is many times higher than the estimates of the short-run losses in output. This suggests that, even if a vaccine cures everyone in a year, the Covid-19 crisis will leave its mark on the US economy for many years to come.”

A number of new papers this month focused on potential implications of the sharply increased pressure on US state and local government budgets and pension plans triggered by the pandemic

In “Muni Bond Investors Could Lose Out as Pension Crisis Cripples Many US Cities”, Pozen and Rauh note how the size of their pension liabilities is artificially deflated by the use of discount rates that are arguably too high (we strongly agree with this view). They also note how in the municipal bankruptcies of Detroit and Stockton (CA), bondholders took far greater losses than pension beneficiaries.

In “States Continue to Face Large Shortfalls Due to COVID-19 Effects”, McNichol and Leachman note that heavy budget cuts include reduced contributions to public pension funds (see also, “The Crisis’s Impact on Budgets”, by Steve Malanga).

In “State Bankruptcy Revisited”, David Skeel argues that the combination of (a) increasing demands for a federal bailout of state and local pension plans, and (b) increasing pressures on the federal budget and borrowing capacity could lead to the enactment of a new chapter of the bankruptcy code that would enable states to reorganize their debts and pension obligations via this process.

“Economic Uncertainty Before And During The Covid-19 Pandemic”, by Altig et al

“Fed Chairman Jerome Powell aptly summarized the level of uncertainty in his May 21st speech noting, “We are now experiencing a whole new level of uncertainty, as questions only the virus can answer the complicated the outlook”.

"Indeed, there is massive uncertainty about almost every aspect of the COVID-19 crisis, including the infectiousness and lethality of the virus; the time needed to develop and deploy vaccines; whether a second wave of the pandemic will emerge; the duration and effectiveness of social distancing; the near-term economic impact of the pandemic and policy responses; the speed of economic recovery as the pandemic recedes; whether “temporary” government interventions will become permanent; the extent to which pandemic induced shifts in consumer spending patterns, business travel, and working from home will persist; and the impact on business formation, and research and development.”

The authors find that, “first, all indicators we track show huge uncertainty jumps in reaction to the pandemic and its economic fallout. Indeed, most indicators reach their highest values on record.

“Second, peak amplitudes differ greatly – from a rise of around 100% (relative to January 2020) in two-year implied volatility on the S&P 500 and subjective uncertainty around year-ahead sales for UK firms to a 20-fold rise in forecaster disagreement about UK growth.

“Third, time paths also differ: Implied volatility rose rapidly from late February, peaked in mid-March, and fell back by late March as stock prices began to recover. In contrast, broader measures of uncertainty peaked later and then plateaued, as job losses mounted, highlighting the difference in uncertainty measures between Wall Street and Main Street.”

“The Second Great Depression”, by Annie Lowrey

“At least four major factors are terrifying economists and weighing on the recovery: the household fiscal cliff, the great business die-off, the state and local budget shortfall, and the lingering health crisis. (See also: “Global Macroeconomic Scenarios of the COVID-19 Pandemic” by McKibbin and Fernando)

“Uncertainty and Growth Disasters” by Jovanovic and Ma from the Federal Reserve Board

This paper documents several stylized facts on the real effects of economic uncertainty. The authors find that, “the marginal effects of higher uncertainty are to significantly increase growth downside risk…

"Higher uncertainty could lead to an abrupt economic decline whereas lower uncertainty does not necessarily rebound the economy from the recession… Higher asset volatility magnifies the negative impact of uncertainty on growth.”

“Assessment of U.S. COVID-19 Situation Increasingly Bleak”, by Jeffery Jones from Gallup

SURPRISE

“Published on 2 July, Gallup found that, “As coronavirus infections are spiking in U.S. states that previously had not been hard-hit, a new high of 65% of U.S. adults say the coronavirus situation is getting worse.

“The percentage of Americans who believe the situation is getting worse has increased from 48% the preceding week, and from 37% two weeks prior…

“Gallup first asked Americans in early April to say whether they thought the coronavirus situation was getting better or worse. At that time, 56% said it was getting worse and 28% better, the most negative assessment prior to the latest reading…

“Americans' greater pessimism is also apparent in the 74% who expect the level of disruption to travel, school, work and public events in the U.S. to persist through the end of this year (37%) or beyond that (37%). This represents a 10-point increase from the prior week in the percentage of U.S. adults who think the coronavirus situation will last at least until the end of the year. In early May, less than half of Americans expected the situation to last that long.”

“Big Data Suggests a Difficult Recovery in US Jobs Market”, by Gavyn Davies in the Financial Times

SURPRISE

“It now seems increasingly improbable, especially in the US, that this structural damage to the labour market will be reversed quickly. Assuming that the Covid-19 effects persist into 2021, the concentration of employment losses among unskilled workers in specific locations, with many permanently failed businesses, will become increasingly difficult to correct. The serious concerns about a deep-rooted scarring of the labour market, forcibly expressed by many Federal Reserve officials, would then be entirely justified.”

“Working Parents are the Key to COVID-19 Recovery”, by Nicole Bateman from Brookings

SURPRISE

As this Brookings analysis shows, reopening schools is critical to restarting national economies. Yet with depressing predictability, in the US this decision (like wearing masks) has become politicized and polarized.

Perhaps with an eye to worsening economic conditions in the run-up to the November election, teachers unions are increasingly refusing to cooperate in school reopening on anything other than a fully remote basis. They’re also demanding a huge amount of new funding for a system that has shown essentially no improvement in its poor results over the past decade, despite the critical importance of those results to productivity improvement.

Brookings notes, “the school year may be over, but the pandemic is not. After forcing closures of schools and child care programs—along with much of the economy—COVID-19 cases are rising in a majority of states. This trend does not bode well for the reopening of those programs and schools, which typically welcome students back within the next eight weeks…

“For working parents, the uncertainty surrounding child care and in-person instruction for school-aged children is unprecedented, with a cascading set of consequences on family life, education, and earnings…

“Moreover, in the event that child care and schools do fully reopen, some parents may not be confident in the safety of those environments and opt to keep their children home.

“Even parents who have thus far avoided layoffs and been able to work from home are performing a nearly impossible balancing act every day, keeping up with their own work while caring for and teaching their children. Many others have been laid off, left their jobs to care for their children, or been forced to cobble together temporary child care arrangements as they continue to report for work at essential jobs, such as nursing and grocery work.

“Parents with minor children comprise almost one-third of the country’s workforce; any economic recovery will rely on their continued participation or reentry into the labor force. The status of schools and child care programs in the fall will dictate the ability of working parents to fully return to work, and therefore will also largely dictate the speed and robustness of economic recovery.”

“COVID-19 And Non-Performing Loans: Lessons From Past Crises” by Ari et al

Non-performing loans are a crucial policy consideration, especially in times of wider economic crisis. This analysis uses a new database covering 88 banking crises since 1990 to draw lessons for post-COVID-19 resolution of non-performing loans.

The authors find that, “compared to the 2008 crisis, the pandemic poses some different challenges. Despite some respite from the credit-crash of 2008, policymakers today are faced with substantially higher public debt, less profitable banks, and often weaker corporate sector conditions, making resolution of non-performing loans even more challenging.”

“The Wrong Way to Help” by Steven Malanga

The dramatic economic impact of COVID019 will substantially reduce state and local government revenues in the United States.

Malanga raises the important point that many of these governments were run ineffectively and inefficiently before COVID-19 arrived, and that bailing out their bad practices is not a long-term solution to the challenges they face.

“The latest Democratic stimulus plan, the massive, $3 trillion Heroes Act, sets aside about a third of that total sum for aid to state and municipal governments. That’s on top of the hundreds of billions of dollars these governments have already received from the CARES Act and other measures, including money for additional Medicaid costs, mass transit subsidies, and direct aid to budgets”…

“The Republican-controlled Senate has balked at these huge numbers, and with good reason. The amount that officials are seeking is likely well beyond the estimated total cost of the current recession for states and municipalities. The huge funding requests, moreover, essentially assume that the entire recession is a function of the virus and that governments deserve to be made whole for any losses, even though fiscal analysts have warned for years that another recession was coming and many states were unprepared for it…

“Many states face extreme fiscal problems now because they’ve continued with bad budgeting practices for years, refusing to initiate reforms even after the fiscal pressures created by the 2008 recession.”

SURPRISE

“Using new ongoing large-scale surveys of U.S. households much like the ones run by the BLS, we provide some preliminary evidence on the response of labor markets in the U.S. to the current crisis.

“We focus on three key variables typically measured by the BLS: the employment-to-population ratio, the unemployment rate, and the labor force participation rate.

“Historically, the employment-to-population ratio and the unemployment rate are near reverse images of one another during recessions as workers move out of employment and into unemployment (or workers in unemployment find it harder to move into employment).

“More severe recessions also sometimes lead to a phenomenon of “discouraged workers,” in which some unemployed workers stop looking for work. This leads them to be reclassified as “out of the labor force” by the BLS definitions, so the unemployment rate can decline along with the labor force participation rate while the employment-to-population ratio shows little recovery, not because the unemployed are finding work but rather because they stop trying to find it.

“Jointly, these three metrics therefore provide a succinct and informative summary of the state of labor markets…
The authors “use a repeated large-scale survey of households in the Nielsen Homescan panel to characterize how labor markets are being affected by the covid-19 pandemic” and document several facts.

“First, job loss has been significantly larger than implied by new unemployment claims: we estimate 20 million lost jobs by April 8th, far more than jobs lost over the entire Great Recession.

“Second, many of those losing jobs are not actively looking to find new ones. As a result, we estimate the rise in the unemployment rate over the corresponding period to be surprisingly small, only about 2 percentage points.

“Third, participation in the labor force has declined by 7 percentage points, an unparalleled fall that dwarfs the three percentage point cumulative decline that occurred from 2008 to 2016.”

“Why Has the US Economy Recovered So Consistently from Every Recession in the Past 70 Years?” by Hall and Kulyak

SURPRISE

“It is a remarkable fact about the historical US business cycle that, after unemployment reached its peak in a recession, and a recovery began, the annual reduction in the unemployment rate was stable at around 0.55 percentage points per year [i.e., just over half a percent per year].

“The economy seems to have had an irresistible force toward restoring full employment. There was high variation in monetary and social policy, and in productivity and labor-force growth, but little variation in the rate of decline of unemployment.”

If the .55% per year recovery rates holds after the COVID-19 induced recession, the recovery of employment will be very slow, which will accentuate pre-existing social and political tensions.

“Production networks and epidemic spreading: How to restart the UK economy?” by Pichler et al

See also, “Socioeconomic Network Heterogeneity and Pandemic Policy Response” by Akbarpour et al for a similar analysis based on US metropolitan areas

SURPRISE

This is the best analysis of the challenges of reopening the economy and how they might be met that we have read.

“The shocks to the economy caused by social distancing are highly industry specific. Some industries are nearly entirely shut down by lack of demand, others are restricted by lack of labor, and many are largely unaffected. Feedback effects amplify the initial shocks. The lack of demand for final goods such as restaurants or transportation propagates upstream, reducing demand for the intermediate goods that supply these industries.

“Supply constraints due to lack of labor under social distancing propagate downstream, by creating input scarcity that can limit production even in cases where the availability of labor and demand would not have been an issue.

“The resulting supply and demand constraints interact to create bottlenecks in production. The resulting decreases in production may lead to unemployment, decreasing consumption and causing additional amplification of shocks that further decrease final demand…

“The social distancing measures imposed to combat the COVID-19 pandemic have created severe disruptions to economic output. Governments throughout the world are contemplating or implementing measures to ease social distancing and reopen the economy, which may involve a tradeoff between increasing economic output vs. increasing the expected number of deaths due to the pandemic. Here we investigate several scenarios for the phased reopening of the economy”…

“At one extreme, we find that reopening only a very limited number of industries can create supply chain mis-coordination problems that in some cases might actually decrease aggregate output. In contrast, reopening all industries would most likely increase R0 [COVID-19’s Basic Reproduction Number] above 1 [and cause virus infections to once again exponentially increase].

“We find a good scenario in-between these extremes: reopening a large part of the upstream industries, while consumer-facing industries stay closed, schools are open only for workers who need childcare, and everyone who can work from home continues to work from home…[This] limits supply chain mis-coordination while providing a large boost to output and a relatively small increase in infection rates.

“Who Will Pay for the Government Spending?” by Rana Foroohar in the Financial Times

Writing before George Floyd’s death and subsequent riots, Foroohar observed that she “thought former Clinton labour secretary Robert Reich got it pretty much right a few days ago when he wrote about four new classes of workers born out of the Covid-19 era — the remotes, the essentials, the unpaid and the forgotten.

“The first two categories will have work; the last two won’t, which roughly squares with the numbers in the NBER paper I flagged last week [as did we in our last issue, “COVID019 is Also a Reallocation Shock”, by Barrero et al], predicting that 42 per cent of -those being laid off won’t have jobs to come back to.

“The big question: what to do about this? The answer — bigger government — seems obvious. These people will have to be retrained for new types of work, and in the meantime, provided with longer term unemployment benefits, given some form of free healthcare, and so forth” …

“The idea that those people simply have to go it alone isn’t sustainable from either an economic or a social stability standpoint.

So, if we assume a bigger government, we must ask: how is it paid for?...Do we print money, tax wealth, or do some combination of both?”

In the same column, Rana’s colleague, Ed Luce replied that he didn’t “think the answer needs to be very complicated. Washington should equalise capital gains and dividend tax with the income tax rate, remove tax deferrals for leverage, purge loopholes in the corporate tax code and impose an escalating carbon tax.

“Some of this would raise revenue. Other reforms, such as swapping a carbon tax for the employer-paid social security tax, would be fiscally neutral but highly efficient. We should tax “bads”, such as carbon, and remove taxes on “goods”, such as jobs…

“The basic equation is simple. Coronavirus will deepen the secular stagnation malaise that Larry Summers has written about. In the absence of private sector demand, the public sector must fill the gap. Whether politics will permit common sense to prevail is another matter.”

Two new articles focused on the potential dangers to the financial system posed by deteriorating leveraged loans that have been packaged and resold in Collateralized Loan Obligation investment structures.

SURPRISE

In “CLOs: Ground Zero for the Next Stage of the Financial Crisis?” the FT’s Rennison and Smith note that “the close cousin of collateralised debt obligations, the pools of mortgage-backed securities that became notorious during the subprime meltdown over a decade ago, CLOs package up risky corporate loans into a group of new securities that have cascading exposure to default by any of the underlying borrowers.

“To the outsider, they can appear to perform some of the alchemy that was evident in the run-up to the financial crisis, transforming risky credits into securities where the largest tranche is awarded a triple A rating…

The US CLO market — by far the biggest — has expanded from $327bn in 2007 to $691bn at the end of 2019, according to data from JPMorgan, rising in lockstep with the underlying leveraged loan market which has doubled from $554bn to nearly $1.2tn, according to data from S&P Global…

“The worry is that further corporate downgrades and escalating defaults could start to unravel sections of the CLO market, in turn prompting a much deeper sell-off that magnifies the broader impact to the economy.
Although proponents of CLOs say the shock absorbers built into their structures.”

In “The Looming Bank Collapse”, Frank Partnoy presents a worst case, but not impossible, scenario, along with an excellent description of CLO mechanics.

Partnoy notes that, “A CLO walks and talks like a CDO, but in place of loans made to home buyers are loans made to businesses— specifically, troubled businesses. CLOs bundle together so-called leveraged loans, the subprime mortgages of the corporate world.”

Partnoy goes on to observe that, “The Bank for International Settlements estimates that, across the globe, banks held at least $250 billion worth of CLOs at the end of 2018… A more complete picture is hard to come by, in part because banks have been inconsistent about reporting their CLO holdings.

“The Financial Stability Board, which monitors the global financial system, warned in December that 14 percent of CLOs—more than $100 billion worth—are unaccounted for.”

In the same report, the FSB “estimated that, for the 30 “global systemically important banks,” the average exposure to leveraged loans and CLOs was roughly 60 percent of capital on hand.”

In the case of CDO’s, analysts believed them to be relatively low risk investments because there had never been a highly correlated fall in housing market prices across the United States. We know how that turned out.

The bad news is that the same assumption underlies the belief in the low risk of various CLO tranches – there has never been a steep, correlated fall in the value of loans made to companies across multiple industry sectors. Until COVID-19 arrived…

Finally, CLO losses won’t be the only ones banks will likely be writing off against their capital bases. They also have their own direct business and consumer loans, many of which have deteriorating credit quality.

For example, consider this recent grim assessment by McKinsey: “Unless the accounting rules regarding how losses must be recognized are amended, all signs point to a wave of losses crashing over the US retail-lending landscape over the next nine to 36 months.

In the short term (three to six months), according to loss forecasts by McKinsey, the current stock of medium- and late-stage delinquent accounts is likely to charge off almost in its entirety, leading to losses of $15 billion to $25 billion. Longer term, the impact of an up to 20 percent unemployment rate will render those customers already struggling to manage their revolving debt largely incapable to do so and will spark an extended period of elevated losses, which could total an excess of $130 billion over the next two years” (“What’s Next for US Credit Card Debt?”).

In sum, these articles make it painfully clear that continued deterioration in corporate credit and household quality could eventually trigger a banking crisis.

“Modern Private Equity and the End of Creative Destruction” by Sebastien Canderle

The author notes that the large number of loans made in recent years with very few covenants (i.e., “covlite” loans), often to private equity backed companies, will very likely produce drawn out loan restructurings during the post-COVID19 downturn, and the creation of many more “zombie” companies that exert a deflationary effect on the economy.

“Zombie Credit and Inflation: Evidence from Europe” by Acharya et al

Based on a study of European evidence, the authors show how providing cheap credit to keep distressed firms from closing has a number of deflationary effects.

“In the cross-section of industries and countries, we find that a rise of zombie credit is associated with a decrease in firm defaults and entries, firm markups and product prices; lower productivity; and, an increase in aggregate sales as well as material and labor cost. These results hold at the firm-level, where we document spillover effects to healthy firms in markets with high zombie credit.”

The authors conclude that “without a rise in zombie credit post 2012, annual inflation in Europe during 2012-2016 would have been 0.45 percentage points higher.”

“Monopsony and Outside Options”, by Stansbury et al

SURPRISE

This paper supports the hypothesis that increasing corporate concentration has depressed real wages.
“In imperfectly competitive labor markets, the value of workers’ outside option matters for their wage. But which jobs comprise workers’ outside option, and to what extent do they matter?”

The authors “split outside options into two components: within-occupation options, proxied by employer concentration, and outside-occupation options, identified using new occupational mobility data.”

They find that, “moving from the 75th to the 95th percentile of employer concentration (across workers) reduces wages by 5%. Differential employer concentration can explain 21% of the interquartile wage variation within a given occupation across cities.”

They also find that the “differential availability of outside-occupation options can explain a further 13% of within-occupation wage variation across cities. Moreover, the two interact: the effect of concentration on wages is three times as high for occupations with the lowest outward mobility as for those with the highest.”

“Investment, Productivity, and the Bonus Culture” by Andrew Smithers

For years, Andrew Smithers has been one of the most acute, if underappreciated (outside the UK) observers of the way business and financial services culture interact in financial markets and the real economy. His latest essay is no exception.

He begins with an often overlooked point: “Weak growth is far and away the most important economic problem facing the United States. This problem is not simply the result of the financial crisis or the severe recession that followed. Rather, it is the result of a much earlier reduction in business investment.”

His thesis is that, “While short–term growth depends on demand, it is rising supply—the ability of the economy to increase output—that determines economic success over time. America’s problem is the slow growth of its potential to supply goods and services caused by two decades of underinvestment” …

“Although commentators have blamed this weakness on various issues, the data show that the major cause has been a change in the way company managements are paid. The 1990s saw the arrival of the bonus culture, which massively shifted management incentives and thus changed management behavior. Sadly, the change did immense damage to the economy.

“Managements were encouraged to invest less and, with lower investment, growth faltered… Had the U.S. economy continued to grow as rapidly over the past dozen years as it had before, the incomes of Americans—as well as spending on schools, law enforcement, and public health—could be 20 percent higher than they are today, without any increase in tax rates or public debt. Not only would there be more prosperity and less poverty, there would also be more resources available to address other problems.

“Restoring growth should therefore be the major priority for the United States, and that will require higher levels of investment.” To which we would add that, in many cases higher investment in new technologies will not produce a broad increase in labor productivity unless it is matched by changes that dramatically improve the performance of America’s primary and secondary education systems.

The dramatic fall in aggregate demand and aggregate supply caused by COVID19 has forced out of the headlines a critical point: Before the pandemic arrived, the global economy was already facing five strengthening (and interacting) headwinds, all of which were contributing to weakening aggregate demand and strengthening secular stagnation.

(1) An ageing population; (2) increasing corporate concentration and declining labor share of GDP; (3) increasing inequality in the division of that declining share; (4) low labor productivity growth; and (5) high levels of debt (including unfunded public pension liabilities).

COVID19 has not made them disappear.

However, in the short-term some are easier to attack than others. High taxes can reduce inequality and debt can be restructured (e.g., written off or converted to equity). Productivity and labor share of GDP have deeper root causes that will require more extensive structural reforms to reverse.

It is clear that the massive uncertainty shock that accompanied COVID19’s gale force arrival is not dissipating.

In “COVID-induced economic uncertainty and its consequences” Scott Baker, Nicholas Bloom, and Steven Davis, Stephen Terry “feed various measures of the COVID uncertainty shock into a model of disaster effects predicts a year-on-year contraction in US real GDP of nearly 11% as of 2020 Q4.

Most people forget how dependent the US economy is on consumption spending, and especially consumption of services, demand for which has been hard hit by COVID19

In the fourth quarter of 2019 US GDP amounted to $21.7 billion in current dollars, at an annualized rate.

Personal Consumption accounted for 68% of US GDP. Services alone accounted for 47%.
Gross Domestic Fixed Investment accounted for a further 17% (Non Residential 13%, and Residential 3%).

Net Exports accounted for a negative 3% (Exports 11% and Imports 14%).

Government accounted for 18% of GDP. Federal spending accounted for 7% (Defense 4% and NonDefense 3%), and State and Local Government 11%.

Even after quarantines are lifted, until a vaccine is developed and deployed people are likely to voluntarily avoid what Japan calls “the Three Cs”: Closed spaces with poor ventilation; Crowded Places; and Close contact settings. This will continue to put very strong downward demand pressure on many service businesses.

There is increasing evidence of the size of the supply shock caused by COVID19.

Leisure and Hospitality was particularly hard hit. In the US alone, more than 8 million employees lost their jobs between February and April.

In “COVID019 is Also a Reallocation Shock”, Barrero et al estimate that across the US economy, 42 percent of recent layoffs will result in permanent job loss.

The United States has seen 2 straight months of declines in the Consumer Price Index as deflationary forces take hold.

In March, the US CPI declined by (0.4)%.

In April, it declined by (0.8)%. Energy (8% weight in the index) was down (10.0)%. Food (16% weight) was up 1.5%. Shelter (31% weight) was flat, at 0%. Other goods less food and energy (20% weight) were down (0.7)%

In the face of a sharp decline in global demand, and large amounts of dollar denominated debt, a substantial increase in emerging market debt restructurings is certain.

In the 1980s Latin American debt crisis, these restructurings caused a “lost decade” of economic growth. Whether this will trigger increased migration flows from emerging to developed market countries remains to be seen. If it does, given high levels of unemployment in the target countries, and their continuing concerns about a second wave of COVID19, increased conflict at regional borders will almost certainly occur.

Sovereign debt problems in developed countries could also have underestimated negative effects

The biggest concern is Italy, which even before COVID19 had a weak economy and high government debt/GDP ratio. An Italian debt crisis could quickly trigger a European banking crisis, as many European banks have invested in sovereign bonds from Eurozone countries because they are deemed to be “risk free” assets with no associated capital requirement.

In the United States, COVID19’s effects on financial markets has substantially worsened the existing public pension fund crisis, and for the first time triggered calls for both a federal bailout and allowing states to declare bankruptcy.

US states must run balanced budgets. In the face of a sharp spike in their social safety net costs, contributions to defined benefit pension plans are being cut back, just as those plans have seen the value of their investments plunge. In a much lower growth economy, pension funds will very likely not be saved by much higher future returns on their investments.

In Illinois, Senate President Don Harmon (D-Chicago) sent a letter to all members of the Illinois Congressional Delegation, seeking $41.6 billion in federal money for the state of Illinois, including $10 billion specifically for state pension funds (a drop in the bucket, really, compared to the state’s $158b in unfunded pension liabilities) Harmon also asked for another $9.6b for underfunded local pension funds.

At the same time, US Senate Majority Leader Mitch McConnell suggested states should be able to declare that bankruptcy (currently, only lower levels of government can, under Chapter 9 of the US Bankruptcy Code), as an alternative to “blue state bailouts” of their pension plans. Many governors immediately rejected the idea.

Even if bankruptcy were possible, it is an uncertain solution, as in some recent municipal bankruptcies judges have decided that (in an apparent contradiction to statutory law) pension fund members clams to current and future benefits were senior to the claims of holders of the municipality’s general obligation (“full faith and credit”) bonds.

It remains very likely that the eventual resolution of the United States’ public pension problems will involve bitter political conflicts between public sector workers and private sector employers and taxpayers, along with a substantial increase in municipal bond market uncertainty.

The Financial Times’ Gillian Tett brought back memories of LDC debt crisis when she recently observed that too many investors seemed to be confusing liquidity problems with solvency problems.

SUPRRISE

While the temporary injection of large amounts of liquidity into financial markets by central banks stemmed the immediate liquidity crisis triggered by COVID19, it did nothing to address the deeper and more dangerous solvency problem created by the collapse of demand in a highly leveraged economy.

This has led observers in multiple countries to call for reforms to their respective bankruptcy processes to reduce the economic disruption from the wave of defaults that lie ahead.

In “Bankruptcy and the Coronavirus” David Skeel, from the University of Pennsylvania, observes that, “the [US] bankruptcy system has three major limitations of great importance in the current environment: it has proven much more effective at reorganizing large corporations than small and medium sized businesses; it functions very differently when the bankruptcy courts are congested; and Chapter 11 [restructuring, versus a Chapter 7 liquidation] depends on the debtor having financing during the bankruptcy case. It is essential that the Federal Reserve and Treasury anticipate these limitations and consider creative solutions to the problems that are likely to arise.”

In, “Unintended effects of loan guarantees during the Covid-19 crisis” Giorgio Gobbi, Francesco Palazzo, Anatoli Segura observe that, “most governments have introduced temporary credit guarantees to ensure banks can provide the liquidity needed by firms during the Covid-19 crisis.” They argue that, “ these policies create incentives for bank to foreclose guaranteed loans maturing close to the expiration date of the guarantee scheme. This hidden effect is worse for firms whose debt is set to substantially increase during the pandemic. To avoid foreclosure ‘waves’ on the eve of the public guarantee termination, complementary measures that reduce firms’ debt burden should also be adopted.”

The insurance industry has also been thrown into turmoil by COVID19, as a result of claims made under existing policies, and pandemic exclusions under new policies that may expose insureds (like companies and schools) to potential liabilities that are unacceptably high.

This is a further underestimated source of potential supply shocks, if businesses (and perhaps schools) can’t obtain the insurance they need to reopen.

SURPRISE

“Insurers braced for claims from Covid-19 legal action”, Financial Times

“Insurers are bracing themselves for billions of dollars of claims because of legal action over the coronavirus pandemic. Industry experts say that shareholders and creditors in the US and other countries will soon start suing company managers over the way they have handled the crisis, and that insurance policies will bear much of the brunt.

And this comes on top of already record setting claims: “Coronavirus to cost insurers more than $200bn” Financial Times. “Just over half of the $203bn estimated loss relates to claims, with insurers expecting to pay out for events cancellation, business interruption and trade credit cover. Another $96bn comes from investment losses, where turmoil in financial markets has hit the assets insurers hold to fund claims. ‘This is a loss of a magnitude that none of us have seen in our lifetime,’ said John Neal, Lloyd’s chief executive.”

“US business groups seek protection from coronavirus lawsuits”, Financial Times

SURPRISE

The uncertain outlook for COVID19-related liability and litigation risk is a critical uncertain that could slow the recovery of the US economy.

As the FT notes, “US business groups are calling on the federal government to shield companies from litigation if they expose employees to Covid-19 infection by calling them back to work before the pandemic abates.
“Even as they do so, however, they face accusations that they are exaggerating the threat of being sued to weaken hard-fought employee protections.”

“While the solution to this remains clear – a government backed high risk insurance pool, as in the case of terrorism and flood insurance – it will very likely take a long time to put in place, resulting in the permanent closure of more businesses and a slower return of economic activity.”

The changes in the price of the US dollar versus other currencies and gold since the equity market high on 19 February have been interesting. As the magnitude of the COVID19 crisis became clear, there was an initial strengthening of the USD against most other currencies. But by the end of April, exchange rates had largely returned to their 19Feb levels.

There were two interesting exceptions. The Japanese Yen strengthened versus the USD and remained there at 30April. The Canadian Dollar weakened and did not snap back.

Between 19Feb and 17Mar, gold lost (8.6%) versus the USD. But between then and 30Apr, it gained 16.6%.

In the past, the argument has been made that continued monetization of growing structural government deficits in the US would eventually trigger a flight from the USD, which would increase inflation via import prices.

There were always three counterarguments: In Japan, twenty years of monetizing fiscal deficits has not produced inflation (in fact, the country has continued to struggle with deflation). And even if investors wanted to flee the USD, where would they go, given the limited breadth and depth of other financial markets (e.g., “Why Is the Euro Punching Below Its Weight?”, by Ilzetzki, Reinhart, and Rogoff).

Finally, there is potential for resistance to currency appreciation in nations – e.g., Switzerland -- that depend on exports for a substantial part of their aggregate demand).

However, there remained the argument that, if investors began to lose confidence in all fiat currencies, the price of gold would rise (as might the price of directly owned property in Europe, where it has historically been a hedge against extremely hard times).

“The Saving Glut of the Rich and the Rise of household Debt” by Mian et al

SURPRISE

As noted above, the world economy was already facing intensifying headwinds before COVID19 arrived. Most of these problems have complex root causes and have thus far have proven impossible to solve at an acceptable economic, social, and political cost. This paper provides another example.

“Rising income inequality since the 1980s in the United States has generated a substantial increase in saving by the top of the income distribution, which we call the saving glut of the rich. The saving glut of the rich has been as large as the global saving glut, and it has not been associated with an increase in investment. Instead, the saving glut of the rich has been linked to the substantial dissaving and large accumulation of debt by the non-rich.

“Analysis using variation across states shows that the rise in top income shares can explain almost all of the accumulation of household debt held as a financial asset by the household sector. Since the Great Recession, the saving glut of the rich has been financing government deficits to a greater degree”.

“Secular Stagnation or Technological Lull?” by Valerie Ramey

SURPRISE

“The slow recovery of the economy from the Great Recession and the lingering low real interest rates have led to fears of “secular stagnation” and calls for government aggregate demand stimulus to lift the growth rate of the economy.”

Ramey aims to “present evidence that the current state of the U.S. economy does not satisfy the conditions for secular stagnation, as originally defined by Alvin Hansen (1939). Instead, the U.S. is experiencing a period of low productivity growth… Long intervals of sluggish productivity growth may be natural in an economy whose growth is driven by technological revolutions that are large, infrequent, and randomly-timed.

“If this is the case, then the best description of the recent experience of the U.S. economy is a technological lull. In this situation, traditional government aggregate demand stimulus policies are not the appropriate response. Instead policies that can increase the rate of innovation and its diffusion may be more appropriate.”

This is a hypothesis that needs to be seriously considered; every month we present technological indicators and surprises that show what appears to be accelerating progress in multiple automation and artificial intelligence technologies that have the potential to generate a substantial increase in productivity.

However, the extent to which this increase also depends on a substantial improvement in education system performance remains debatable. More important, it seems unlikely that a sustained improvement in productivity, on its own, will be sufficient to offset the demand side factors that are contributing to secular stagnation.

“The Productivity J-Curve” by Brynjolfsson et al

SURPRISE

This paper complements Ramey’s, discussed above. The authors argue that, “General purpose technologies (GPTs) such as AI enable and require significant complementary investments, including co-invention of new processes, products, business models and human capital. These complementary investments are often intangible and poorly measured in the national accounts, even when they create valuable assets for the firm.”

I certainly agree, having lived through the 80s/90s ITC investment cycle, where the full benefits of new technologies were not realized for a surprisingly long time, due not only to the slow maturing of the technologies themselves, but even more so because of the slow pace at which companies reorganizes their processes, structures, and staff skills to take maximum advantage of the new technologies’ capabilities (a process you can still see underway today in the education and health care sectors).

The authors claim that this delay “leads to an underestimation of productivity growth in the early years of a new GPT, and how later, when the benefits of intangible investments are harvested, productivity growth will be overestimated.” Their model “generates a Productivity J-Curve that can explain the productivity slowdowns often accompanying the advent of GPTs, as well as the increase in productivity later.”

They also “assess how AI-related intangible capital may be currently affecting measured productivity and find the effects are small but growing.”

Again, as we commented about Ramey’s paper, the authors argument makes sense. That said, however, productivity improvement alone is a necessary but insufficient solution to the forces driving the secular stagnation we faced before the arrival of COVID19.

With the sharp increase in government fiscal deficits triggered by COVID19, there have been a growing number of articles on whether this increase is sustainable.

SURPRISE

One frequently sees references to this equation: “r
But these arguments miss a critical point. In the case of the Latin American debt crisis, governments had lost access to international credit markets; as a result, they were forced into a prolonged period of fiscal austerity during which the amount of outstanding debt remained relatively constant, and sustaining “r
But that is not the case today in many developed countries, where, even before COVID19 arrived, deficits and debt levels were projected to INCREASE because of a political decision to hold down tax rates while various pressures combined to substantially increase various forms of social spending (e.g., pensions, healthcare, etc.).
So the long-term sustainability of the rapid and substantial increases in government debt that are taking place in reaction to the COVID19 shock remains very much uncertain.

Before the COVID19 pandemic exploded, former GE CEO Jack Welch died on 1Mar20.

Welch was GE’s CEO from 1981 to 2001. Thanks to age and experience, I have a very keen view of his legacy. Reg Jones’ leadership of GE was based on a bureaucratic, planning based model that began to break down in the late 70s. Welch brought a more agile approach that in many ways was appropriate for the more dynamic environment he faced in the 80s and 90s.

He was also one of the leading figures in the “financialization” of US (and then global) capitalism during these decades. At the beginning, there was, indeed, a lot of corporate waste, and rooting it out – through LBOs or more aggressive GE style management – made sense. So too did Welch’s attempt to shake up a GE culture that had become overly bureaucratic. Innovations like GE’s Crotonville education center really did add a lot of value. But as always, initially successful ideas were taken too far.

By the time Welch handed the reins of GE to Jeff Immelt in 2001, those excesses were already apparent, far beyond GE (as we wrote then in The Index Investor). Things got even worse in the 2000s and 2010s, and global democratic capitalist systems are paying the price today, just as Jeff Immelt did at GE.

As is often the case, Welch’s legacy is mixed, and again reminds us that successful ideas too often lead to hubris, which inevitably leads to nemesis.

Unfortunately, we never seem to learn this lesson. Today, calls for “stakeholder” instead of “shareholder” capitalism abound, as the cycle begins yet again (e.g., see, “The Illusory Promise of Stakeholder Governance” by Bebchuk and Tallarita)

“Coronavirus and Macroeconomics”, by Fornaro and Wolf

“The consensus is that the coronavirus will cause a negative supply shock to the world economy, by forcing factories to shut down and disrupting global supply chains. But how deep and persistent is this supply disruption going to be?”

“In a traditional Keynesian approach, employment and output are determined by aggregate demand In turn, aggregate demand depends positively on productivity growth. The reason for this is that faster productivity growth boosts agents’ expectations of future income, inducing them to spend more in the present. This effect gives rise to a positive relationship between productivity growth and employment…

“In reality, productivity growth is at least in part driven by firms’ investment. In turn, investment decisions depend on aggregate demand – when demand is strong, the return from investment tends to be high; weak aggregate demand, conversely, depresses firms’ incentives to invest. This effect gives rise to a positive relationship between productivity growth and aggregate demand…

“The supply-demand doom loop: the initial negative supply shock depresses aggregate demand. But now, lower demand induces firms to cut back on their investment, which generates an endogenous drop in productivity growth. Lower productivity growth, in turn, causes a further cut in demand, which again lowers productivity growth. This vicious spiral, or supply-demand doom loop, amplifies the impact of the initial supply shock on employment and productivity growth.”

Monetary and fiscal policy interventions are intended to avoid this doom loop by stimulating aggregate demand, including investment, which should in turn raise productivity, and trigger a virtuous economic recovery loop. Yet the effectiveness of monetary policy is now constrained by very low interest rates (i.e., the zero lower bound liquidity trap).

That leaves fiscal and structural policy to ride to the economy’s rescue.
But there are catches here too. If fiscal policy doesn’t stimulate employment and consumption growth, investment spending is unlikely to recover. Moreover, productivity growth is also constrained not just by the level of investment, but also by other factors such as poorly performing education systems.

Finally, productivity growth is unlikely to trigger higher spending if there is no expectation on the part of workers that it will translate into higher wages. Unfortunately, this is just what has been happening in recent years, as the labor share of GDP has been falling, and real wages have stagnated while labor productivity has increased, albeit far more slowly than in the past.

There were many stories noting that COVID19 could not have arrived at a worse time, given high debt levels (relative to GDP) around the world and the increasing drag they have imposed on aggregate demand growth (e.g., see, “Indebted Demand” by Mian et al)

See, for example, “The Seeds of the Next Debt Crisis”, by John Plender, FT, 3Mar20, and “Coronavirus and Debt: A Toxic Mix”, by Ung Tran, FT, 11Mar20.

As we noted in our August 2019 feature article (“The Next Downturn: How Different? How Deep? How Long?”, and our December 2019 feature (“What Do We Know About Escaping the Persistent Deflation Regime?”), and as William White, former head of the BIS’ Monetary and Economic Department has also emphasized, there are only four ways out of the debt crisis we face.

Ideally, a company or country can grow its way out. That seems highly unlikely after a global shock of unprecedented magnitude. Moreover, before COVID19 arrived, many economies were already facing increasing headwinds that were depressing growth rates. These included ageing populations, declining labor shares of GDP, worsening inequality, weak productivity growth, and those heavy debt loads.

Debts can also be repaid by imposing painful austerity that cuts spending on goods and services for an extended period of time (e.g., the “lost decade” in Latin America after that region’s debt crisis in the 1980s). Today, this approach would be counterproductive economically and almost certainly politically suicidal.

A third option is reducing the real value of debt through high inflation. However, that assumes that (a) the debt explicitly carries a nominal, not real interest rate; (b) it is denominated in the currency experiencing high inflation; and (c) it has a sufficiently long maturity to realize substantial benefits from prolonged inflation. For a substantial portion of the world’s debt, these conditions don’t apply.

That leaves the last option, widespread write-downs, write offs, and/or conversion of debt into equity. It has happened before (e.g., the London Debt Agreement of 1953, which cut West. Germany’s post-war debt by 46%, and limited future debt service payments to no more than 3% of export earnings). It is almost certain that these will be needed again.

As was done in the case of the Latin American debt crisis, such write downs may be facilitated by government issuance to creditors of very long term zero coupon bonds and waivers of mark to market accounting rules.

See also, “Corporate debt burdens threaten economic recovery after COVID-19: Planning for debt restructuring should start now”, by Becker et al

“Public spending at the effective lower bound: The significance of sustainability risks”, by Battistini and Callegari

In this post on VoxEU, the authors summarize a paper they wrote in April 2019 for the European Central Bank (“Dynamic Fiscal Limits and Monetary-Fiscal Policy Interactions”). As global governments undertake unprecedented debt financed fiscal stimulus to counteract demand collapse triggered by the COVID19 pandemic, the sustainability of sovereign debt has never been more important.

The authors note that in their model, “a government honours its obligations if it is able to do so. In other words, public debt is sustainable whenever it is below the government’s maximum ability to repay. This is its fiscal limit. Technically, the fiscal limit is computed as the present discounted value of all current and future maximum primary surpluses” [current government revenue less current expenses, not including interest or debt repayment].

For this reason, for any given forecast for future primary surpluses, declining real interest rates increase the amount of debt they can support without triggering investor fears about sustainability and the likelihood of restructuring or default. On the other hand, rising real rates (as would be the case in a deflation) would have the opposite effect.

However, “there is no such thing as one fiscal limit; stochastic shocks instead create a distribution of fiscal limits that is state-contingent because new shocks arrive every period and, therefore, the distribution shifts every period.”

As a result of COVID19, it is now almost certain that the US (and other nations) will face a public pension funding crisis that is much broader, much deeper, and will arrive much sooner than previously forecast.

Major investment losses and an extended period of low interest rates (which increase the discounted present value of future benefit liabilities) have decimated defined benefit plans’ funding ratios.

Eventually, this will very likely lead to what will almost certainly be a protracted and bitter political conflict between four unpalatable alternatives:

(1) Much higher taxes to pay promised benefits while rebuilding plan assets;

(2) Instead of increased taxes, deep cuts in other public spending to allow for much higher employer pension contributions;

(3) A federal bailout of plans across the nation that would likely cost close to $1 trillion; or

(4) widespread municipal bankruptcies that, based on recent court decisions, if not previous law, sacrifice the theoretically senior claims of municipal bond investors in order to facilitate higher pension plan contributions by public sector employers.

Before COVID19 arrived, the Chinese economy was already facing increasing headwinds because of ageing, falling productivity (because of years of capital misallocation to lower return investments – e.g., funding the property bubble and excess industrial capacity), rising debt levels, and a worsening trade conflict with the United States.

The coronavirus pandemic, especially if it drags on, will create further problems for China, and knock on negative impacts in other countries. For example, COVID19 will accelerate the restructuring of global supply chains away from China.

It will also almost certainly reduce China’s imports of commodities, and, in the absence of new swap lines with the US Federal Reserve, very likely lead to sales of China’s stock of US Treasuries to obtain the dollars needed by local companies to repay dollar borrowings in the face of a rapidly strengthening US dollar exchange rate.

Of course, this also means that defaults on foreign and domestic debts are very likely to increase, which runs the risk of triggering a classic debt deflation.

In the wake of the global COVID19 shock, two factors could lead to a prolonged period of weak economic demand.

SURPRISE

The first is extended uncertainty that depresses the willingness of consumers and businesses to spend (e.g., see “The Uncertainty Channel of the Coronavirus” by Leduc and Liu, “COVID-Induced Economic Uncertainty” by Baker et al, and “Understanding and Predicting Uncertainty Shocks” by The Index Investor).

Prolonged social distancing (and perhaps isolation, in the case of an even deadlier second wave of coronavirus infections in the northern hemisphere this fall) while the world waits for a coronavirus vaccine is just the most obvious source of uncertainty. Headline grabbing increases in unemployment benefits filings are another uncertainty shock, and they are now appearing, particularly in the United States.

Political developments could also further increase uncertainty (e.g., death of a leader, increased social conflict, cancellation of elections, intensifying international conflicts beyond the current oil price war etc.).
Yet another uncertainty shock would be supply chain failures that lead to visible shortages of critical goods, possibly accompanies by sharp increases in their price. The impact of any such shortages are sure to be amplified by social media.
Still another shock would be further sharp price declines across a range of asset classes, and/or an accelerating rise in the price of gold.

Perhaps the most dangerous source of increased uncertainty could be the psychological shock and horror that will result if and when the uncontrolled growth of COVID19 infections leads to mass suffering and casualties in developing nations that are far in excess of what the world has seen thus far.
With respect to willingness to spend, the greatest challenge is very likely to be how to overcome the very low esteem in which various institutions and elites were held before the COVID19 pandemic arrived – our deficit of authentic, inspiring leadership, if you will.

The second factor is an extended lack of capacity to spend on the part of consumers and businesses, leading to widespread debt servicing problems, increasing threats by creditors, and a steady increase in bankruptcy filings, which would further reinforce uncertainty.

In this regard, policy design is critical. For example, many businesses may balk at taking on more debt to survive a bit longer, without any confidence such loans can be repaid, or eventually will be forgiven. As a number of observers have noted, direct cash grants, to both individuals and businesses (provided the latter use them to maintain employment, and not repay debts) will almost certainly be more effective at supporting continued spending in the short term. So too would very clear policies that suspended rent, mortgage, credit card and other debt payments for the duration of the COVID19 emergency.

Unfortunately, and perhaps fatally, the previously noted lack of leadership, and still elevated levels of partisan bickering (even in the face of an existential crisis), may prevent the most effective spending capacity policies from being enacted and implemented in the United States, if not in other countries.

At a slightly longer time horizon, expanding direct government employment and/or programs to purchase a wider variety of products and services from private sector businesses will very likely be needed to support spending capacity as the economy slowly recovers from the pandemic.

“Can the World Afford Fiscal and Monetary Stimulus on This Scale?” by Gavyn Davies, FT, 29Mar20

SURPRISE
Davies notes that, “The fiscal and monetary stimulus announced by the world’s major economies over the past month is a global policy event without precedent in peacetime…It would not be surprising if the Fed’s balance sheet increased by $2tn-$3tn this year, up from $4.2tn at the end of 2019. That is similar to the cumulative increase over the entire decade that followed the financial crash”…

“Many investors — and, privately, some policymakers — wonder if this degree of stimulus by the US and most other big economies is “affordable”, and whether it will cause government debt crises and a subsequent rise in inflation. If the answer to either of these questions is “yes”, markets could lose confidence in the ability of the authorities to cope with the coming recession. The results for asset prices would be gruesome.”

Davies believes the probability of this outcome is low, based on his assumptions that government debt can stay on central bank balance sheets for a long time (as in Japan), and fiscal stimulus will cause real growth to exceed the real interest rate on government debt (which might require the Fed attempting to control rates along the yield curve). At minimum, the latter assumption remains uncertain.

Davies also offers a pre-mortem of sorts: “The bad news is that this form of financing can be dangerous if inflation starts to rise. We discovered during the financial crash that increases in central bank money do not automatically cause this. But today there is a complex mix of supply and demand effects at work and, together, they could cause inflation to rise.” For an example of this, see “Mine Closures Bolster Metals Prices As Demand Collapses”, by Neil Hume in the Financial Times, 6Apr20.

“For example, if supply continues to be constrained while consumers simultaneously receive large government transfers [and spending increases after a coronavirus vaccine is deployed], aggregate demand could rise in an inflationary manner. In that case, it would be important for fiscal injections to be eliminated, or reversed quickly.”

“Declining Worker Power and American Economic Performance”, by Stansbury and Summers

and

“Understanding the Present and Future of Work in the Fissured Workplace Context”, by David Weil

SURPRISE
Before the arrival of COVID19, one of the key headwinds that has been depressing aggregate demand growth is the declining labor share of GDP. Whether COVID19 leads to policy reforms that reverse this trend remains to be seen. In the meantime, it is important to better understanding the underlying root causes that have been at work.

Stansbury and Summers weigh the evidence for three hypothesized causes: (1) An increase in companies’ monopoly power in product markets (leading to higher markups and profits); (2) An increase in companies monopsony power in labor markets; and (3) A decrease in employees’ worker power.

The authors find that aggregate level data does not provide strong evidence for one hypothesis over the others. However, industry level data clearly points to declining worker power at the most important root cause.

They ascribe this decline to three factors:

(1) A less favorable policy environment (e.g., the declining real value of the minimum wage);

(2) Increasing shareholder pressure on companies to cut costs, leading to more aggressive wage negotiations and increased use of domestic and international outsourcing; and

(3) Increased competition for workers from improving labor substituting technologies, including automation and artificial intelligence.

Weil is the author of the 2014 book “The Fissured Workplace”, which argued that, “large corporations have shed their role as direct employers of the people responsible for their products, in favor of outsourcing work to small companies that compete fiercely with one another. The result has been declining wages, eroding benefits, inadequate health and safety conditions, and ever-widening income inequality.”

In his new paper, he looks to the future, and argues that fissured workplaces “require different policies for the workplace and labor market than traditional approaches including those regarding worker rights and protections, employment responses to the business cycle, workforce education and training, and job and career mobility.”

His recommendations, and similar ones from others, are likely to get a more serious hearing after the COVID19 pandemic subsides, almost certainly in the UK under Boris Johnson, and in the United States if Joe Biden defeats Donald Trump.

In February, the potential severity of the COVID-19 outbreak gradually became clear.

See this month’s macro forecast and feature article for more commentary on this development.

“The rise of zombie firms: causes and consequences”, by Bamerjee and Hoffman from the Bank for International Settlements

In the wake of the COVID-19 crisis, the issue of zombie firms is poised to increase in importance.

“The rising number of so-called zombie firms, defined as firms that are unable to cover debt servicing costs from current profits over an extended period, has attracted increasing attention in both academic and policy circles. Using firm-level data on listed firms in 14 advanced economies, we document a ratcheting-up in the prevalence of zombies since the late 1980s.

“Our analysis suggests that this increase is linked to reduced financial pressure, which in turn seems to reflect in part the effects of lower interest rates. We further find that zombies weigh on economic performance because they are less productive and because their presence lowers investment in and employment at more productive firms.”

“How Much Money Does the World Owe China?” by Horn et al

SURPRISE
“Over the past two decades, China has become a major global lender, with outstanding claims now exceeding more than 5% of global GDP. Almost all of this lending is official, coming from the government and state-controlled entities.

“Our research, based on a comprehensive new data set, shows that China has extended many more loans to developing countries than previously known. This systematic underreporting of Chinese loans has created a “hidden debt” problem – meaning that debtor countries and international institutions alike have an incomplete picture on how much countries around the world owe to China and under which conditions.

"In total, the Chinese state and its subsidiaries have lent about $1.5 trillion in direct loans and trade credits to more than 150 countries around the globe. This has turned China into the world’s largest official creditor — surpassing traditional, official lenders such as the World Bank, the IMF, or all OECD creditor governments combined…

“Despite the large size of China’s overseas lending boom, no official data exists on the resulting debt flows and stocks. China does not report on its international lending, and Chinese loans literally fall through the cracks of traditional data-gathering institutions."

“Foreign exchange swaps: Hidden debt, lurking Vulnerability”, by Claudio Borio et al, from the Bank for International Settlements

SURPRISE
“Foreign exchange swaps and forwards are a key instrument in the global financial system for hedging, position-taking and short-term funding. They involve the exchange of notional amounts at a future date and, as funding vehicles, they are akin to other forms of collateralised borrowing (e.g. repo). The amounts involved are huge, but the instruments remain mysterious in some ways: because of an accounting peculiarity, they are treated very differently from other forms of collateralised debt”…

The authors “find that non-US residents’ US dollar forward payment obligations arising from foreign exchange swaps and forwards are likely to be even larger than the corresponding on-balance sheet US dollar debt. It also highlights the favourable regulatory treatment that these instruments receive, and argues that they represent a critical pressure point in international financial markets.”

“Europe is out of economic ammunition”, by Desmond Lachman from AEI

“Even before the coronavirus outbreak, troubles have been coming to the European economy not as single spies but in battalions. Worse yet, these troubles have come at a time when the European Central Bank (ECB) is running out of monetary policy ammunition and the German government remains wedded to a balanced budget policy. None of this bodes well for the European economy in the year ahead – or, for that matter, the global economy.

“At the beginning of 2020, all four of the European economy’s largest economies—Germany, France, the United Kingdom, and Italy—were beset by striking economic or political difficulties…

“Unfortunately, with the fallout from the coronavirus epidemic about to hit the global economy, there is little reason to believe that the economic or political difficulties besetting Europe’s main economies will clear up any time soon…With Europe’s economy being approximately the same size as that of the United States, another European economic slowdown would have a major effect on the global economy.”

“Evaluating the mineral commodity supply risk of the U.S. manufacturing sector”, by Nassar et al

“Trade tensions, resource nationalism, and various other factors are increasing concerns regarding the supply reliability of nonfuel mineral commodities. This is especially the case for commodities required for new and emerging technologies ranging from electric vehicles to wind turbines.”

“In this analysis, supply risk is defined as the confluence of three factors: the likelihood of a foreign supply disruption, the dependency of U.S. manufacturers on foreign supplies, and the ability of U.S. manufacturers to withstand a supply disruption. The methodology is applied to 52 commodities for the decade spanning 2007–2016. The results indicate that a subset of 23 commodities, including cobalt, niobium, rare earth elements, and tungsten, pose the greatest supply risk. This supply risk is dynamic, shifting with changes in global market conditions.”

“Unequal gains: American growth and inequality since 1700”, by Lindert and Williamson

“Americans have long debated when the country became the world’s economic leader, when it became so unequal, and how inequality and growth might be linked. Yet those debates have lacked the quantitative evidence needed to choose between competing views.

“This column introduces evidence on American incomes per capita and inequality for two centuries before World War I. American history suggests that inequality is not driven by some fundamental law of capitalist development, but rather by episodic shifts in five basic forces: demography, education policy, trade competition, financial regulation policy, and labour-saving technological change.”

“The Global Financial Resource Curse”, by Benigno et al from the Federal Reserve Bank of New York

SURPRISE
“Since the late 1990s, the global economy has experienced two spectacular trends. First, there has been a surge of capital flows from developing countries - mainly China and other Asian countries - toward the United States. Second, productivity growth in the United States has declined dramatically. Both facts have been the center of academic and policy debates, but have so far been considered independently. In this paper, instead, we argue that these two phenomena might be intimately connected” ...

“The key feature [of our model] is that the tradable sector is the engine of growth of the economy. Capital flows from developing countries to the United States boost demand for U.S. non-tradable goods. This induces a reallocation of U.S. economic activity from the tradable sector to the non-tradable one. In turn, lower profits in the tradable sector lead firms to cut back investment in innovation.

“Since innovation in the United States determines the evolution of the world technological frontier, the result is a drop in global productivity growth. We dub this effect the global financial resource curse.

“The model thus offers a new perspective on the consequences of financial globalization, and on the appropriate policy interventions to manage it.”

“Debt and Financial Crises”, by Koh et al, Centre for Applied Macroeconomics, Australian National University

“Emerging market and developing economies have experienced recurrent episodes of rapid debt accumulation over the past fifty years… This paper reports four main results:"

"First, episodes of debt accumulation are common, with more than 500 episodes occurring since 1970.

"Second, around half of these episodes were associated with financial crises which typically had worse economic outcomes than those without crises— after 8 years output per capita was typically 6-10 percent lower and investment 15-22 percent weaker in crisis episodes.

“Third, a rapid buildup of debt, whether public or private, increased the likelihood of a financial crisis, as did a larger share of short-term external debt, higher debt service, and lower reserves cover.

"Fourth, countries that experienced financial crises frequently employed combinations of unsustainable fiscal, monetary and financial sector policies, and often suffered from structural and institutional weaknesses.”

“The Budget and Economic Outlook: 2020 to 2030” by the Congressional Budget Office

This latest report forecasts continuing large deficit and a sharp rise in the ratio of outstanding US Government debt to GDP. If aggregated demand growth remains weak, it is almost certain that a substantial portion of newly issued debt will be monetized by the Federal Reserve.

A critical uncertainty is whether this can be done without triggering increased inflation. The case of Japan provides evidence that this is possible when underlying deflationary forces are strong. However, whether this would be possible in the case of the world’s dominant reserve currency remains to be seen, particularly if there is no demonstrable progress on critical issues like low productivity growth.

“In CBO’s projections, the federal budget deficit is $1.0 trillion in 2020 and averages $1.3 trillion between 2021 and 2030. Projected deficits rise from 4.6 percent of gross domestic product (GDP) in 2020 to 5.4 percent in 2030.”

“Other than a six-year period during and immediately after World War II, the deficit over the past century has not exceeded 4.0 percent for more than five consecutive years. And during the past 50 years, deficits have averaged 1.5 percent of GDP when the economy was relatively strong (as it is now).”

“Because of the large deficits, federal debt held by the public is projected to grow, from 81 percent of GDP in 2020 to 98 percent in 2030 (its highest percentage since 1946). By 2050, debt would be 180 percent of GDP—far higher than it has ever been.”

“Capital Composition and Declining Labor Share” by Eden and Gaggl

SURPRISE

In a 2019 paper, “How the Wealth Was Won: Factor Shares as Market Fundamentals”, Greenwald et al observed that, “From the beginning of 1989 to the end of 2017, 23 trillion dollars of real equity wealth was created by the non-financial corporate sector. We estimate that 54% of this increase was attributable to a reallocation of [profits from labor compensation to] shareholders in a decelerating economy. Economic growth accounts for just 24%, followed by lower interest rates (11%) and a lower risk premium (11%). From 1952 to 1988 less than half as much wealth was created, but economic growth accounted for 92% of it.”

The critical question is what drove this reallocation of economic profits from labor to capital.
In “Capital Composition and Declining Labor Share”, Eden and Gaggl find that, “Though information and communications (ICT) capital is a small fraction of the capital stock, it is highly substitutable with labor, and its user cost declined sharply over the last few decades. A framework that distinguishes between ICT and non-ICT capital is empirically plausible and suggests that automation accounts for more than one quarter of the global decline in the labor share…In the United States it accounts for 40 percent.”

“Unpacking Skill Bias: Automation and New Tasks”, by Acemoglu and Restrepo

SURPRISE

The authors find that “automation: (i) powerfully impacts inequality; (ii) can reduce real wages; and (iii) can generate realistic changes in inequality with small changes in productivity.”

They also note that, “New tasks, on the other hand, can increase or reduce inequality depending on whether it is skilled or unskilled workers that have a comparative advantage in these new activities. Using industry-level estimates of displacement driven by automation and reinstatement [into the workforce] due to new tasks.”

The authors “show that displacement is associated with significant increases in industry demand for skills both before 1987 and after 1987, while reinstatement reduced the demand for skills before 1987, but generated higher demand for skills after 1987. The combined effects of displacement and reinstatement after 1987 explain a significant part of the shift towards greater demand for skills in the US economy”.

In sum, “a primary reason for the increase in the skill premium (and the decline in the real wages of less skilled workers) has been rapid automation that has replaced tasks previously performed by less skilled workers”.

“Competing with Robots: Firm-Level Evidence from France”, by Acemoglu et al

SUPRRISE

“Consistent with theory, robot adopters experience significant declines in labor share and the share of production workers in employment, and increases in value added and productivity.

“They expand their overall employment as well. However, this expansion comes at the expense of their competitors (as automation reduces their relative costs)...”

“The overall impact of robot adoption on industry employment is negative…the impact of robots on overall labor share is greater than their firm-level effects because robot adopters are larger and grow faster than their competitors”.

“Cyber Risk and the U.S. Financial System: A Pre-Mortem Analysis”, by Eisenbach et al from the Federal Reserve Bank of New York

SURPRISE

“Our analysis demonstrates how cyber attacks on a single large bank, a group of smaller banks or a common service provider can be transmitted through the payments system…

"A cyber attack on any of the most active U.S. banks that impairs any of those banks’ ability to send payments would likely be amplified to affect the liquidity of many other banks in the system. The extent of the amplification would be even greater if banks respond strategically, which they are likely to do if there is uncertainty about the attack...

“The impact on geographies with concentrated banks may be even larger…[There are also] other ways that the system may become impaired that highlight the importance of all banks in the network, not just the largest banks.

“First, if a number of small or midsize banks are connected through a shared vulnerability, such as a significant service provider, this would likely result in the transmission of a shock throughout the network. Similarly, banks with a relatively small amount of assets but large payment flows also have the potential to impair the system…

“While the shock we assume is extreme in some ways — a complete inability to send payments—it is conservative in others. We currently do not model spillovers outside the payment network such as to short term creditors that provide liquidity to impaired banks…

We also focus primarily on the impact that a cyber attack may have within a single day. However, if a cyber attack were to compromise the integrity of banks’ systems, the reconciliation and recuperation process would be an unprecedented task. This could have severe implications on the stability of the broader financial system vis-à-vis spillovers to investors, creditors, and other financial market participants.”

“Systemic Risk in the Broad Economy”, by Welburn et al from RAND

And

“Skewed Business Cycles” by Salgado et al

SURPRISE
“In the years since 2008, “The ability of small, seemingly isolated risks to grow and spread across heavily interconnected systems—a problem summarized by the term systemic risk—has emerged as a central focus for research and policy change.” …

“However, despite the increased attention on systemic risks, surprisingly little attention has spilled over beyond financial networks into systemic risks in the broad economy.”

The authors document “a sparse network of supplier-customer linkages with a dense center composed of heavily interconnected firms with numerous customer and supplier linkages. Using network analysis, [they] explore the distribution of interconnectivity across firms, finding that of the most heavily interconnected firms, many of the most heavily interconnected firms come from several different sectors of the economy. In particular, in addition to financial sector firms, [they find] many firms in technology and telecommunications with high levels of interconnectivity in observed firm networks.”

They then use their network model to “estimate the potential aggregate impact of an isolated shock on each individual firm, exploring the systemic risk of individual firms”…

They conclude that, “growth in the technology sector over the past decade has contributed to new forms of systemic risk. No firm epitomizes the shift in systemic risk more than Amazon and its increasingly widespread cloud computing service, Amazon Web Services (AWS), a point illustrated through the efforts of this report. Amazon’s centrality in traditional production networks was just emerging at the time of the 2008 crisis. Now, its centrality in digital networks underpinning diverse firms and even public institutions provides an example of the potential of systemic risk in the broad economy…

More broadly, “the majority of the most-central firms [in the network] lie outside the financial sector (the traditional focus of systemic risk conversations), and they vary across diverse business sectors…firms posing systemic risk have more heterogeneity than the focus on financial firms has led many to believe. Instead, many of the most central firms—and thereby firms posing the risk of largest aggregate losses following an idiosyncratic shock—are of varying sizes and in varying industries.”

In “Skewed Business Cycles”, Salgado et al describe how these negative network effects and cascades can be triggered.
A small number of firms represent a disproportionate number of the losses incurred during a recession. which they describe as a drop in the “skewness” (asymmetry) with an important number of firms experiencing substantial declines in sales, hiring, and productivity — i.e., an increase in the risk of a disaster at the firm level.

During economic downturns, “a subset of firms does extremely badly, leading to a left tail of large negative outcomes.”

“Why is the Euro Punching Well Below Its Weight?” By Ilzetski, Reinhart, and Rogoff

“On the twentieth anniversary of its inception, the euro has yet to expand its role as an international currency…By some measures, it plays no larger a role than the Deutschemark and French franc that it replaced…

A number of factors have limited the euro’s reach, including lack of financial center, limited geopolitical reach, and US and Chinese dominance in technology research. Most important, in our view, is the comparatively scarce supply of (safe) euro-denominated assets. The European Central Bank’ lack of policy clarity may have also played a role.”

“What if the economists are all wrong on productivity?” By Glenn Hutchins, Financial Times 28Jan20

SURPRISE

“There has been considerable hand-wringing about why productivity growth is anaemic and inflation is stubbornly low. This is important because productivity gains, which allow an economy to grow faster than its population, determine increases in national wealth…

“There is today a ‘dialogue of the deaf’ between Silicon Valley and the economics profession…

Economists point to longitudinal data that shows productivity has been rising at a lethargic pace and say it shows the lack of true technology breakthroughs such as flying cars….

"But the tech industry looks at a world economy that is rapidly transforming from industrial to digital and argues that the changes must be causing productivity to hurtle forward at warp speed, creating widespread financial benefits. Tech leaders also point out that they are on a mission to eradicate costs from everything, everywhere…

"Techies believe we live in an economy with rapid productivity growth, burgeoning output and relentless price drops…

"With that in mind, let’s go back to the question of why the global economy proved allergic to a modest tightening of interest rates. If the traditional economists are right, and real interest rates (actual levels minus inflation) are in fact hovering near zero, history would suggest that rates could have increased materially without a hitch.

“Now consider the view of the techies that we do not live in an economy characterised by little
productivity growth, low inflation and modest increases in gross domestic product. What if they are right?...

“If actual deflation was running at around 2 per cent today, real interest rates would be roughly equal to historic levels and the stubborn resistance of economic activity to increases would be unsurprising. Does this alternative view fit reality better? … That suggests that the negative nominal rates now common in much of the world may be normal and could be with us for a long time.”

“Recession Ahead: An Overview of Our Predicament”, by Gail Tverberg on OurFiniteWorld.com

Gail Tverberg is an actuary who for many years has been writing articles about the complex interactions between energy, economic growth, and debt. As she notes, most economic models don’t take these interactions into account.

Demand growth is driven by some combination of population growth, productivity growth, and increasing debt. It also requires energy. If energy prices are too high, demand gradually declines. There are many ways high energy prices can emerge, including regulatory constraints on supply (e.g., banning some types of fossil fuels in the absence of offsetting falls in the price of other sources of energy, including their delivery to end consumers), increasing marginal costs of production (e.g., due to depleting supply of low cost deposits), or demand growth (driven by population, productivity, and/or debt) that exceeds energy supply growth and/or the rate at which energy efficiency improves (at least in the short term).

However, the opposite can also create problems – slow demand growth caused by declining or aging populations, weak productivity and/or excessive debt can lower energy prices to a level that causes investments in energy supply to fall, potentially causing energy shortages (which have a negative feedback impact on productivity growth, and ultimately the ability of the economy to service its high level of debt).

In other words, economic problems can be caused and exacerbated not only by energy prices that are too high, but also by ones that are too low.

As Tverberg says, “it is a perpetual tug of war between energy prices that are too high to be affordable and too low to be profitable.”

“Germany steps up hunt for migrant workers amid fears for economy”, FT 16Dec19

“Polish companies turn to robots as labour shortage bites”, FT 15Dec19

“Germany is stepping up efforts to attract more migrant workers from outside Europe, as business leaders and politicians warn that the pervasive lack of skilled labour poses a mounting risk to the country’s economy.

“A decade of expansion has left the German labour market with record low unemployment and companies struggling to fill 1.36m vacancies…A survey released on Monday by Germany’s chambers of commerce (DIHK) found that 56 per cent of companies said the lack of skilled labour was the biggest risk to their business…

“The Amica warehouse on the outskirts of Wronki, a small town in western Poland, towers over the surrounding countryside, houses up to 230,000 items, and can process 1,600 of them in an hour. But perhaps the most striking thing about the cavernous grey facility is that it can be run by just one person.

“Instead of workers, huge orange robots driven by algorithms glide between 46m-high bays packed with washing machines and ovens, shuffling them around so they can be dispatched as quickly as possible to customers around the world.

“Opened two years ago, the futuristic warehouse is central to Amica’s expansion plans. But it is also part of the Polish white goods group’s battle against the labour shortages that are constraining one of Europe’s fastest-growing economies.”

“US retailers hit by ‘worst year since 2008’ for discounting”, FT 15Dec19

“US department stores and clothing retailers, trying to weather the continued onslaught of online shopping, are resorting to some of the biggest discounts since the 2008 crisis to woo consumers, heightening concerns of a squeeze in profit margins.”

“The Clash of Capitalisms: The Real Fight for the Global Economy’s Future”, by Branko Milanovic 10Dec19 in Foreign Affairs

Capitalism now has no rival, but two models offer significantly different ways of structuring political and economic power in a society. Political capitalism gives greater autonomy to political elites while promising high growth rates to ordinary people. China’s economic success undermines the West’s claim that there is a necessary link between capitalism and liberal democracy...

“At the same time, China’s government and those of other political capitalist states need to constantly generate economic growth to legitimize their rule, a compulsion that might become harder and harder to fulfill. Political capitalist states must also try to limit corruption, which is inherent to the system, and its complement, galloping inequality. The test of their model will be its ability to restrain a growing capitalist class that often chafes against the overweening power of the state bureaucracy…

“Liberal capitalism has many well-known advantages, the most important being democracy and the rule of law. These two features are virtues in themselves, and both can be credited with encouraging faster economic development by promoting innovation and social mobility. Yet this system faces an enormous challenge: the emergence of a self-perpetuating upper class coupled with growing inequality. This now represents the gravest threat to liberal capitalism’s long-term viability."

De Nederlands Bank (the Central Bank) used an interesting sentence is a recent article about its gold stock that raised a lot of eyebrows.

SURPRISE
“Shares, bonds and other securities are not without risk, and prices can go down. But a bar of gold retains its value, even in times of crisis. That is why central banks, including DNB, have traditionally held considerable amounts of gold. Gold is the perfect piggy bank – it's the anchor of trust for the financial system. If the system collapses, the gold stock can serve as a basis to build it up again. Gold bolsters confidence in the stability of the central bank's balance sheet and creates a sense of security.”

“Inflation Dynamics: Dead, Dormant, or Determined Abroad?” by Kristin Forbes, from MIT

“CPI inflation has become more synchronized around the world since the 2008 crisis, but core and wage inflation have become less synchronized. Global factors (including commodity prices, world slack, exchange rates, and global value chains) are significant drivers of CPI inflation in a cross-section of countries, and their role has increased over the last decade, particularly the role of non-fuel commodity prices. These global factors, however, do less to improve our understanding of core and wage inflation which is still largely a domestic process.”

“Macroeconomic effects of political risk shocks”, by Sinem Hacioglu Hoke, from the Bank of England

The author investigates “the macroeconomic impact of political risk” and concludes that they are distinct from shocks that increase uncertainty about economic policy. Moreover, “the political risk shocks we identify are important drivers of inflation dynamics as well as economic activity. Collectively, these findings point to the medium to long term impact of political risk shocks, which comes with a delay.”

“Global Waves of Debt”, by Kose et al from the World Bank

“The global economy has experienced four waves of broad-based debt accumulation over the past fifty years. In the latest wave, underway since 2010, global debt has grown to an all-time high of 230 percent of GDP in 2018.”

“French strikers angry about pension reform cut power to homes, companies”, Reuters, 17Dec19

Whether the sustained and increasingly painful standoff between the French government and public sector workers over pension reforms is a harbinger of things to come in other developed countries facing similar pension underfunding crises remains to be seen…

“The power cuts, illegal under French law, deepened a sense of chaos in the second week of nationwide strikes that have crippled transport, shut schools and brought more than half a million people onto the street against President Emmanuel Macron’s reform.”

“Eight centuries of global real interest rates, R-G, and the ‘suprasecular’ decline, 1311–2018”, by Paul Schmelzing, from the Bank of England

SURPRISE
This paper points out that for most of economic history, economic growth and real interest rates have been low (see, for example, Angus Maddison’s papers, and “Seven Centuries of European Economic Growth and Decline” by Fouquet and Broadberry).
“
With recourse to archival, printed primary, and secondary sources, this paper reconstructs global real interest rates on an annual basis going back to the 14th century, covering 78% of advanced economy GDP over time.”

The author “shows that across successive monetary and fiscal regimes, and a variety of asset classes, real interest rates have not been ‘stable’, and that since the major monetary upheavals of the late middle ages, a trend decline between 0.6–1.6 basis points per annum has prevailed…

“Against their long‑term context, currently depressed sovereign real rates are in fact converging ‘back to historical trend’ — a trend that makes narratives about a ‘secular stagnation’ environment entirely misleading, and suggests that — irrespective of particular monetary and fiscal responses — real rates could soon enter permanently negative territory.”

“The Value of Government Debt”, by John Cochrane

SURPRISE
“The analysis of government finances, how debt is paid off, grown out of, or inflated away, is a long literature…We live in a time of unusually large peacetime government debt to GDP ratios. How will these debts be resolved – by primary surpluses, by low returns, or by large GDP growth rates? What set of expectations sustains these large debts – and what will happen if those expectations of surpluses, growth, and low returns change? Can we count on growth to exceed returns for the foreseeable future, suggesting a rather painless further expansion of government debt? Or are we primed for a debt crisis?

“We cannot know, of course, but the lessons of history captured by these calculations are illuminating: We can learn how past variation in debt to GDP ratios was resolved, and we can learn how debts are resolved on average…

“I find that about half of the postwar variation in debt to GDP ratios corresponds to variation in expected future surpluses, and about half to expected growth-adjusted discount rates…

“The discount rate contribution comes mostly from nominal returns. Essentially none of the variation in debt to GDP ratios corresponds to changing growth forecasts. In the full sample, going back to 1930, even more of the variation in the debt to GDP ratio comes from discount rates, and less from variation in expected future surpluses…

“About a third of the postwar fall in debt to GDP did come from sustained primary surpluses. The rest came from the larger fall in the cumulative growth-adjusted return r minus g. Nominal returns and inflation largely cancel, with rising GDP contributing the rest.

“Starting in the mid 1970s, sustained primary surpluses turn to repeated large primary deficits, and r minus g turns slightly positive.

Subsequent variation in the value of debt largely corresponds to variation in cumulated primary surpluses and deficits. Variation in rates of return, though large, is not sustained enough to produce much variation in the value of debt. The inflation of the 1970s did little to devalue debt, as debt rolled over faster than unexpected inflation could devalue it. Using the correct return on the entire government debt portfolio, there is little sign of a substantial post-2000 decline in r minus g that might make debt more sustainable.”

“Five market axioms that can no longer be relied upon”, by Mohamed El-Erian, FT, 13Nov19

SURPRISE
In the coming years, “investors will have to grapple with once-unthinkable economic and market trends as they set about fine-tuning their portfolios next year. Where they end up will depend on five factors that are growing less stable by the day…

"First, that globalisation carries on expanding markets and delivering efficiency gains. Second, that" "emerging economies will continue to catch up with their more developed counterparts, led by those" "pursuing reforms.

Third, that robust liquidity will anchor well-functioning markets. Fourth, that "policy effectiveness in developed markets will limit the global economy’s “downside”.

And finally," "that politics and governance will support market-based systems and the global rule of law.”

“Financial Repression is Knocking at the Door, Again. Should We Be Concerned?”, by Jafarov et al from the IMF

SURPRISE
This paper concludes that much higher debt-financed government spending in the future will likely be accompanied by higher rates of financial repression, which in turn is likely to depress GDP growth rates. This is not a good omen if the goal of fiscal stimulus is to escape secular stagnation and deflation.

“Financial repression (legal restrictions on interest rates, credit allocation, capital movements, and other financial operations) was widely used in the past but was largely abandoned in the liberalization wave of the 1990s, as widespread support for interventionist policies gave way to a renewed conception of government as an impartial referee.

“Financial repression has come back on the agenda with the surge in public debt in the wake of the Global Financial Crisis, and some countries have reintroduced administrative ceilings on interest rates. By distorting market incentives and signals, financial repression induces losses from inefficiency and rent-seeking that are not easily quantified. This study attempts to assess some of these losses by estimating the impact of financial repression on growth using an updated index of interest rate controls covering 90 countries over 45 years.

“The results suggest that financial repression poses a significant drag on growth, which could amount to 0.4-0.7 percentage points of GDP.”

“Will debt-fuelled buyout boom end in stagnation?”, by John Dizard, FT 14Nov19

As always, Dizard is very likely right on target.

“Apparently all informed and decent opinion is converging on the certainty that the rise of leveraged private equity will end with a market crash. But what if the result of the debt-powered asset buying is not a shock, but stagnation? It has happened before…

“The outcome of buying assets at high prices with high leverage seems depressingly clear…Private equity companies have directly or implicitly promised more capability to their investors. They are supposed to be hands-on operational managers. When the economy goes south, their names will be on the lay-offs and unpaid contracts, however clever their documentation.”

“Billions needed to fund rising cost of social care, think-tank warns”, FT 10Nov19

SURPRISE
Most discussions of the rising cost of healthcare focus on the effectiveness and efficiency with which countries respond to chronic and acute needs. The rising cost of social care for an aging population (including home care, assisted living, nursing homes, etc.) is quite similar to the rising cost of social security and underfunded public sector defined benefit pension plans – they are grey swans, whose increasing danger is right before our eyes, but that we disregard because its arrival seems so far off.

This article shows that authorities in the UK are far more sensitive to this issue than their counterparts in the United States. “English local authorities will need billions in extra funding during the next parliament to meet the rising cost of adult social care, even if council taxes rise at twice the rate of inflation, according to a prominent think-tank.

“The Institute for Fiscal Studies analysis concludes that councils will struggle even to maintain services at existing levels over the next few years, with election pledges of more generous provision — such as Labour’s plan for free personal care for the over-65s — adding to the pressures. Over the longer term, as the population ages, the challenge will be much greater, and the councils able to raise most revenue from local taxes are unlikely to be those with the highest social care needs.”

OECD Economic Outlook, Nov19

This warning indicator reminded me of similar ones – e.g., by William White of the BIS – that some raised in advance of the 2008 Global Financial Crisis. The juxtaposition of the OECD’s commentary with rising equity and bond markets cannot help but reinforce one’s belief in the short-term focus and momentum-driven nature of today’s financial system.

“For the past two years, global growth outcomes and prospects have steadily deteriorated, amidst persistent policy uncertainty and weak trade and investment flows. We now estimate global GDP growth to have been 2.9% this year and project it to remain around 3% for 2020-21, down from the 3.5% rate projected a year ago and the weakest since the global financial crisis…

“Overall, growth rates are below potential. The mix between monetary and fiscal policies is unbalanced. Central banks have been easing decisively and timely, partly offsetting the negative impacts of trade tensions and helping to prevent a further rapid worsening of the economic outlook…

“However, to date, other than a few countries, fiscal policy has been only marginally supportive, and not especially of investment, while asset prices have been buoyant. The biggest concern, however, is that the deterioration of the outlook continues unabated, reflecting unaddressed structural changes more than any cyclical shock.”

Two major publications ran features this month on underfunded public sector pension plans:
The Economist (“Public Pensions are Woefully Underfunded”) and the FT: (“‘Their house is on fire’: the pension crisis sweeping the world” by Cumbo and Wigglesworth, and “Pension Funds Warn Over QE Damage” by Jennifer Thompson).

Low interest rates have increased the discounted present value of public sector defined benefit pension plans’ future liabilities to beneficiaries, while reducing the returns they earn on their investments. This has worsened already very large funding shortfalls in many plans.

Ray Dalio’s latest essay (see next evidence item) highlights the potentially negative impacts that could – and very likely will – result from more widespread public recognition of the size of government’s off balance sheet pension liabilities and the very painful choices they create for already polarized political systems.

“The World Has Gone Mad, and the System is Broken”, by Ray Dalio from Bridgewater

SURPRISE
In light of rising concerns with pensions (and the underlying government liabilities they represent), it was interesting to see that in his latest essary, Ray Dalio focused on them more than he has before.
In addition to the sharp increase in government deficit spending financed by monetary creation that he expects to see as a result of the protracted downturn he (like us at The Index Investor) expects to commence in the near future, in this essay Dalio also notes that, “pension and healthcare liability payments will increasingly be coming due while many of those who are obligated to pay them don’t have enough money to meet their obligations. Right now many pension funds that have investments that are intended to meet their pension obligations use assumed returns that are agreed to with their regulators. They are typically much higher (around 7%) than the market returns that are built into the pricing and that are likely to be produced. As a result, many of those who have the obligations to deliver the money to pay these pensions are unlikely to have enough money to meet their obligations.

“Those who are recipients of these benefits and expecting these commitments to be adhered to are typically teachers and other government employees who are also being squeezed by budget cuts. They are unlikely to quietly accept having their benefits cut.

“While pension obligations at least have some funding, most government healthcare obligations are funded on a pay-as-you-go basis, and because of the shifting demographics in which fewer earners are having to support a larger population of baby boomers needing healthcare, there isn’t enough money to fund these obligations either.

“Since there isn’t enough money to fund these pension and healthcare obligations, there will likely be an ugly battle to determine how much of the gap will be bridged by 1) cutting benefits, 2) raising taxes, and 3) printing money (which would have to be done at the federal level and pass to those at the state level who need it). This will exacerbate the wealth gap battle.

“While none of these three paths are good, printing money is the easiest path because it is the most hidden way of creating a wealth transfer and it tends to make asset prices rise. After all, debt and other financial obligations that are denominated in the amount of money owed only require the debtors to deliver money; because there are no limitations made on the amounts of money that can be printed or the value of that money, it is the easiest path.

“The big risk of this path is that it threatens the viability of the major world reserve currencies as viable storeholds of wealth. At the same time, if policy makers can’t monetize these obligations, then the rich/poor battle over how much expenses should be cut and how much taxes should be raised will be much worse. As a result rich capitalists will increasingly move to places in which the wealth gaps and conflicts are less severe and government officials in those losing these big tax payers will increasingly try to find ways to trap them.”

“Nonbank Lending”, by Chernenko et al

SURPRISE
This is a very sobering paper especially when you realize that these loans have been made by entities that do not have access to liquidity from the Federal Reserve’s discount window. In the next downturn, these loans will likely contribute to debt deflation.

“We show that nonbank lending in the US is widespread, with 32% of all loans being extended by nonbanks. Nonbank borrowers are less profitable, more levered, and more volatile than bank borrowers. Firms with a small negative EBITDA are 34% more likely to borrow from a nonbank than firms with a small positive EBITDA.

“While nonbank lenders are less likely to monitor by including financial covenants, they are more likely to align incentives through the use of warrants. Controlling for firm and loan characteristics, nonbank loans carry 190 basis points higher interest rates.”

“The 2019 Global Mercantilist Index”, by Foote and Ezell

“In the global race for leadership in the most advanced technology industries, many countries are resorting to “innovation mercantilism” to create unfair advantages for their own industries at the expense of foreign competitors and global innovation progress. Ranking 60 nations on 18 variables such as market access, forced localization, currency manipulation and intellectual property protections, the 2019 Global Mercantilist Index finds that China is the world’s most innovation-mercantilist nation. Others such as India, Indonesia, and Russia have also engaged in innovation mercantilist practices, placing them in the report’s “moderate-high” category.”

“Public Debt and Private Investment”, by Huang et al

SURPRISE
An almost certain consequence of a prolonged economic downturn will be a sharp increase in debt-financed government spending. This paper finds that this will very likely have negative consequences for small firms.

“Establishing the presence of a causal link from public debt to economic growth and investment has proved challenging. This column uses data for nearly 550,000 firms in 69 countries to show that government debt affects corporate investment by tightening the credit constraints faced by private firms. Higher levels of public debt increase the correlation between investment and cashflow for firms that are more likely to be credit constrained – i.e. unlisted, small, and young firms – but appear to have no effect on the correlation between cash and investment of listed, well-established, and large firms.”

“The Global Equilibrium Real Interest Rate: Concepts, Estimates, and Challenges”, by Michael Kiley of the Federal Reserve

SURPRISE
This paper makes the important point that global factors (e.g., increasing secular stagnation around the world) are making a powerful contribution to today’s low real interest rates, and that models that focus only on national drivers are likely to produce erroneous estimates.

“Real interest rates have been persistently below historical norms over the past decade, leading economists and policymakers to view the equilibrium real interest rate as likely to be low for some time. Various definitions and approaches to estimating the equilibrium real interest rate are examined, including approaches based on the term-structure of interest rates and small macroeconomic models.

“The individual-country approaches common in the literature are extended to allow for global trend and cyclical factors. The analysis finds that global factors dominate the downward trend in the equilibrium interest rate across 13 advanced economies. A corollary of this finding is that the U.S. equilibrium rate may be substantially lower than estimated in U.S.-only studies.”

“The Aggregate and Distributional Effects Of Financial Globalization”, by Furceri et al

SURPRISE
This is an important paper that quantifies what many already intuitively believe about the “financialization” of the global economy. The critical implication is that controls on cross-border capital flows – last seen in the 60s and early 70s – are likely to reappear as national politicians seek ways out of the next global economic downturn.

“Free trade has contributed to a great convergence of emerging market countries toward incomes in industrialised nations in recent decades. It is less clear whether free mobility of capital across national boundaries has conferred similar benefits.”

The authors “present evidence suggesting that the gains in average incomes have been – at best – small, while increases in income inequality and the decline in the labour share of income have been significant. Financial globalisation thus poses far more difficult equity-efficiency trade-offs than free trade and should be at the centre of debates about how to make globalisation inclusive.”

This month, the IMF updated its flagship publications about the health and future of the global economy

Global Financial Stability Report: “Key vulnerabilities in the global financial system include: (1) Rising corporate debt burdens; (2) Increasing holdings of riskier and more illiquid assets by institutional investors; and (3) Greater reliance on external borrowing by emerging and frontier market economies”…

“Corporate sector vulnerabilities are already elevated in several systemically important economies as a result of rising debt burdens and weakening debt service capacity. In a material economic slowdown scenario, half as severe as the global financial crisis, corporate debt-at-risk (debt owed by firms that are unable to cover their interest expenses with their earnings) could rise to $19 trillion—or nearly 40 percent of total corporate debt in major economies.”

World Economic Outlook: “The global economy is in a synchronized slowdown, with growth for 2019 downgraded again—to 3 percent—its slowest pace since the global financial crisis. This is a serious climbdown from 3.8 percent in 2017, when the world was in a synchronized upswing. This subdued growth is a consequence of rising trade barriers; elevated uncertainty surrounding trade and geopolitics; idiosyncratic factors causing macroeconomic strain in several emerging market economies; and structural factors, such as low productivity growth and aging demographics in advanced economies”…

“It is important to keep in mind that subdued world growth is occurring at a time when monetary policy has significantly eased almost simultaneously across advanced and emerging markets”…

The global economy is at risk of “an abrupt shift in risk sentiment [that would ] expose financial vulnerabilities built up over years of low interest rates.”

The IMF meetings were accompanied by many media commentaries, all of which shared a pessimistic outlook about what lies ahead.

In the Financial Times, former Larry Summers opined that “The Global Economy is at Risk from a Monetary Policy Black Hole”, noting that “today’s core macroeconomic problem – chronic lack of demand… even with burgeoning government debt and unsustainable lending.” This situation “is profoundly different from the problem any living policymaker has seen before.” In the face of effective fiscal and structural policies, “central banks in Europe and Japan have embraced negative interest rates…[and] the US appears to be one recession away from entering the same black hole.”

Prasad and Wu of the Brookings Institution observed that “the worldwide slowdown is giving way to a synchronized stagnation characterized by weak growth in some major economies and essentially no growth or even mild contraction in others. Fears of an imminent global recession seem premature, but policymakers seem at a loss about how to revive growth, with little appetite for fundamental reforms and limited room for effective macroeconomic stimulus…

“Persistent trade tensions, political instability, geopolitical risks, and concerns about the limited efficacy of monetary stimulus continue to erode business and consumer sentiment, holding back investment and productivity growth” (“October 2019 update to TIGER: Sliding into synchronized stagnation”).

Finally, writing in the FT, Megan Greene said in public what many have been worried about in private: “The politics of fiscal stimulus are problematic”. “There is widespread agreement that central banks do not have the tools needed to address the kind of supply-side shocks the global economy is facing. The world is caught in a liquidity trap, with persistently low interest rates and a glut of savings. Fiscal stimulus would be one way to escape it. But while the economics are sound, the politics are problematic… I wouldn’t hold my breath for significant fiscal stimulus from the world’s largest economies. The real question we should be asking is, what happens when it fails to materialise. There’s an old saying: hope is not a strategy” (The Politics of Fiscal Stimulus are Problematic).

“Economics Needs a Post-Crash Revolution” by Mervyn King on Bloomberg (27Oct19)

Surprise
One hypothesis for why demand is so weak is that spending is being held back by “radical uncertainty”. If this is the case, former Bank of England Governor Mervyn King writes that, “escaping from a low-growth trap sprung by radical uncertainty isn’t like climbing out of a Keynesian downturn, with temporary monetary or fiscal stimulus restoring demand to its trend path. It requires instead a reallocation of resources from one component of demand to another, from one economic sector to another, and from one company to another… The remedy isn’t monetary policy, but measures to support the needed reallocation of resources … Asset values in many places will need to be written down to more realistic levels, and some financial intermediaries will have to be recapitalized.”

We agree with Lord King (and long before him, with Keynes) that radical uncertainty has a larger negative impact on demand than modern economics recognizes. We also appreciate that high uncertainty triggers anxiety and fear in many human beings, which are often accompanied by protective anger, particularly when elites and institutions don’t seem up to the challenge of addressing the underlying root causes.

We believe that at the individual level (and in no small measure thanks to the denser network connections social media has made possible) this has become a key driver of the upsurge in populist anger we observe around the world today. Finally, we suspect that today’s political polarization and the apparent paralysis of traditional approaches to addressing the challenges we face (as both Summers and Greene note above) are creating a feedback loop that will very likely deepen and prolong the inevitable downturn when it finally arrives.

“Vulnerabilities in the International Monetary and Financial System”, speech by Claudio Borio of the Bank for International Settlements

Surprise
Borio zeroes in on an underappreciated risk in the next downturn: The buildup of international US dollar funding liabilities, especially on the balance sheets of foreign banks.

A critical uncertainty is whether, in the face of a global financial crisis the Trump administration would attempt to interfere with the Federal Reserve’s use of the dollar swap lines with foreign central banks that are critical to the latter’s ability to provide dollar liquidity to borrowers in times of financial system crisis.

Borio notes that, “the sharp increase in US dollar borrowing post-crisis is troubling. The corresponding debt has roughly doubled for Emerging Market Economies' non-bank borrowers, to some $3.7 trillion. And this, let me stress, does not include borrowing via FX swaps, which is not covered in the statistics as it is off-balance sheet. That borrowing, according to our estimates, is even larger. Including also advanced economies, the equivalent figure to the on-balance sheet borrowing for EMEs is $11.8 trillion while the one for FX swaps is of the order of $14 trillion or more.

“It would not be surprising, therefore, if the next episode of financial stress had the US dollar segment at its epicentre, just as it was during the Great Financial Crisis in 2008.”

“Tracking the Forces Threatening the World’s Hottest Economies”, by Orlick et al, Bloomberg Business Week, 29Oct19

Surprise
Using the newly launched “New Economy Drivers and Disrupters Index”, the authors survey the world economy. The index “evaluates 114 economies on two sets of metrics. One captures the traditional drivers of development, while the other captures exposure to the disruptive forces creating new risks and opportunities in the new economy. The drivers consist of a composite gauge of productivity, projected growth in the labor force, the scale and quality of investment, and a measure of distance from the development frontier. The disrupters gauge economies' positions in relation to populism, protectionism, automation, digitization and climate change.”

Key findings from the authors’ analysis include:

(1) “When it comes to some of the changes sweeping the global economy, China is less well-placed. Protectionism threatens to hammer trade flows and slow technology catch-up with global leaders. Climate change will compound stresses on a long coastline and a population already threatened with water scarcity. High inequality and limited social mobility pose a medium-term threat to political stability”;

(2) For the U.S., an immigrant-enhanced workforce and trade-boosted gains in productivity could support annual GDP growth at 2.7% in the next decade. Without those drivers, growth could slump to 1.4%”;

(3) For emerging markets, lower wages reduce the incentive to automate. But that doesn’t mean the risk of disruption is low. Automation is rapidly approaching the level at which a substantial share of low value-added work can be done by machines, undermining low-cost advantage of developing markets…[and] blocking their path to prosperity.”

“The Inflexible Structure of Global Supply Chains” by Bayoumi et al from the IMF

Surprise
This new analysis suggests that the uncertainty caused by the long-term conflict between the US and China, as well as other trade conflicts, is going to weigh on the supply side of the global economy for longer than many currently expect.

“The rise of global supply chains has had profound effects on individual economies and the global trading system, thereby complicating standard macroeconomic analyses…test the degree of global-supply-chain flexibility. Our estimates show that, in the short run, the production structure is highly inflexible, and that this rigidity has, if anything, risen over time as supply chains have deepened over time. Indeed, for the 2000-15 period, we cannot reject the hypothesis that supply chains are completely inflexible…

“The finding that global value chains are largely inflexible in the short-term and relatively inflexible in the long-run has important implications. From a business-cycle point of view, it underscores the importance of the international production structure in understanding how shocks to one country may reverberate around the world.”

“Reallocating Public Spending to Reduce Income Inequality: Can It Work?” by Doumbia and Kinda of the IMF

Surprise
The authors, “assess whether and how governments could reduce income inequality by changing the composition of public spending while keeping the total level of expenditure fixed. This question is particularly important for various reasons.

“First, high public debt and limited fiscal space in many advanced economies seem set to remain a lasting legacy of the global economic and financial crisis. Second, in many advanced economies, particularly in Europe, already-high spending levels combined with high taxation constrain the potential to address rising inequalities through additional spending increases. Third, many developing economies face significant challenges in realizing their tax revenue potential, limiting much-needed fiscal space for growth-enhancing and social spending”…

“The results show that reallocating spending toward social protection and infrastructure is associated with lower income inequality, particularly when it is financed through cuts in defense spending. This result is only valid in countries with low risks of conflict and strong institutions. In countries with a high risk of conflict and weak institutions, the analysis does not find evidence that cutting defense spending to finance infrastructure and social outlays improves income distribution.”

“The Return of Geoeconomics”, by Michael Lind

Surprise
Michael Lind is one of the most provocative analysts we know, and in his latest column he does not disappoint, and focuses on the logic that underlies what may be a permanent, rather than a transient, change in the nature of the United States’ relations with other nations.

“For decades, the study of international security has been divorced from the study of international trade and investment, along with domestic economic development”…

“Even before Donald Trump became the first president in living memory to explicitly promote U.S. economic nationalism, the wall that divided the national-security realists and the free-market economists was crumbling—mainly because of the rise of China, which has benefited from a version of statist economics while challenging U.S. military hegemony in Asia. Slowly but inevitably, debates about national security and the global economy are merging into a single dispute about relative national power”…

“In the industrial era, the basis of military power is manufacturing. This still holds true, notwithstanding the current hype surrounding the so-called ‘knowledge economy.’ A country cannot defeat its enemies with cat video apps” …

Any country which hopes to be an independent great power must be able to obtain and maintain its own state-of-the-art manufacturing sector …

From the point of view of national security, industrial interdependence is not a courageous step toward the utopian ideal of a borderless global market and a golden age of perpetual peace. Far from that, it is a dangerous risk that must be minimized.”
“In particular, national strategists must ensure that the supply chains in the country’s defense industrial base are not located in the territory of potential military rivals or in coercible third countries. They must protect the militarily-relevant industries they have and, if necessary, obtain new ones …

The logic of the military-economic security dilemma suggests that a grand strategy of liberal hegemony should be abandoned by a declining hegemon that is losing relative shares of military and industrial capacity to rising powers.”

“The former hegemon need not revert to the infant-industry protectionism of its own earlier catch-up phase. Rather, it should seek to open foreign markets for its exports while preserving its domestic industries from unfair competition by insisting on strict reciprocity in trade. And it should minimize its economic dealings with current and potential military rivals altogether, for fear that its consumers and capitalists will build up the power of enemies…for the last half-century, the United States, like Britain a century earlier, has done the reverse. Mesmerized by a putative liberal world order, Washington has extended its military frontier, taking on more and more imperial commitments, while allowing mercantilist Asian and European trading partners to wipe out much of American manufacturing.”

“Likewise, U.S.-based multinationals have transferred over much of their production capacity to China, Mexico and other countries, where cheaper labor or government subsidies exist in abundance.”

“In my view, the persistence of free trade policies in Britain and the United States, even after they became harmful, is perhaps best explained in terms of domestic political factors. The most important among these is the political influence of finance…The problem is that a politically dominant financial sector may be willing to sacrifice the interest of domestic manufacturers in the service of other goals, like opening trading partners to financial investment.”

“The Behavioral Foundations of New Economic Thinking, by Sanjit Dhami & Eric Beinhocker

This paper is an outstanding review of this critical new direction in economics.

“Growth is taking a dangerous downward turn”, posted on September 19, 2019 on the OECD website by Laurence Boone, OECD Chief Economist

“The events of the last 18 months are not just a passing trend. The proliferation of tariffs and subsidies and the increasing unpredictability of trade policies have destroyed growth in international trade, triggering a sharp slowdown in industrial output and investments. When companies do not know what tomorrow will bring, they exercise their “wait-and-see option”.

Given that an investment is a long-term commitment, they are waiting for this insidious trade war to settle down in order to know where to invest. However, when temporary uncertainty is recurrent and rooted, large amounts of investments are withheld, thereby affecting not just present day demand but also tomorrow’s growth potential and employment…

“The investment gap created by the current situation will have a long-term and structural impact on growth, all the more so as it will take time to clarify the new trade policy environment…There is a danger of growth being bogged down for a long time.”

“The repo markets mystery reminds us that we are flying blind”, by the FT’s Gillian Tett

Surprise
“The development that is sowing shock and confusion is related to the normally arcane matter of financial plumbing. At the start of the week, overnight borrowing rates in the repurchase or repo market, where traders do short-term deals to swap Treasuries for cash, suddenly rose to 10 per cent, up from their normal levels of 2-2.5 per cent…the last time we experienced this scale of gyrations in repo rates was the 2008 financial crisis…

“The fact that a “temporary” cash squeeze created so much drama shows that neither the Fed nor investors completely understand how the cogs of the modern financial machine mesh.”

“Assessing Economic Conditions and Risks to Financial Stability”, by Eric S. Rosengren President & Chief Executive Officer Federal Reserve Bank of Boston

Surprise
Without mentioning WeWork by name, in this speech Rosengren highlighted that maturity mismatch is no less dangerous in commercial real estate as it is in commercial banking.

“Evolving market models, along with low interest rates, are creating a new type of potential financial stability risk in commercial real estate. One such market model is the development of co-working spaces in many major urban office markets…What makes this form of development a potential financial stability risk is two-fold.

“First, co-working companies – which enter into long-term leases with the property owners – have tended to re-lease to smaller-sized and less mature companies on a shorter-term basis. This segment of the economy is likely to be particularly susceptible to an economic downturn, potentially resulting in office vacancies rising more quickly than they have historically. Thus, in a downturn the co-working company would be exposed to the loss of tenant income, which puts both them and the property owner at risk if they cannot make lease" payments to the owner of the building…"

“A second reason for concern is that some companies may utilize bankruptcy-remote special purpose entities, or SPEs, for leases. This structure may allow the co-working company to potentially walk away from unprofitable lease arrangements in an economic downturn without the property owner having recourse to the ultimate parent, the co-working company. Simply put, I am concerned that commercial real estate losses will be larger in the next downturn because of this growing feature of the real estate market, which could ultimately make runs and vacancies more likely due to this new leasing model…”

“Long-Term Firm Growth: An Empirical Analysis of US Manufacturers 1959-2015”, by Dosi et al

Surprise
“Firm growth is an essential feature of market economies, shaping together macroeconomic performance and the evolution of industry structures. As a potential indicator of organizational fitness within a competitive environment, firm growth is also a central concern to both the practice and theory of business strategy.”

“Despite both its theoretical and practical importance, though, growth remains a poorly understood property of firms. While previous studies have documented the highly skewed nature of rm growth rates, we know far less about the persistence of growth rates over long-periods of time…”

The authors find “that growth rate persistence is there and may be even substantial for some firms, but it is rare.” They also find “circumstantial but widespread evidence that heterogeneity across firms correlates with industry dynamism…High growth industries are fueled by underlying industrial dynamics involving highly heterogeneous firms.”

This is an important finding, and supports the hypothesis that increasing concentration and declining competition in many industries has been an important cause in the productivity slowdown.

“Investment Update: How Do Public Plans Value Their Assets?” by Aubry and Wandrei, Center for Retirement Research at Boston College

The funded status of public defined benefit pension plans has become a critical risk in countries around the world. Funded ratios (the value of plan assets to the present value of future plan payment liabilities to pension beneficiaries) have been declining (with the difference often being termed “pension debt”).

The authors note that, “since higher returns reduce the burden of contributions (on plan sponsors, participants and, ultimately, taxpayers), achieving adequate returns is critical…”

Unfortunately, the manner in which plans have pursued these returns may have led to an overly rosy view of their funded ratios.

“Since 2001, in the US plans have incrementally reduced their assumed return from 8.0 percent to 7.2 percent. But, the average annualized return for public plans from 2001-2018 has been only 5.9 percent. Virtually all plans underperformed their assumed return over the period, but some fared much worse than others…

“Starting in 2017, the Governmental Accounting Standards Board (GASB) has required public plans to disclose how the value of their investments is determined. The new standard – GASB 72 – uses the same basic framework as the Financial Accounting Standards Board (FASB), which provides guidance for private sector accounting…

“Both FASB and GASB use the same fair value hierarchy for disclosure purposes: Level 1: Assets with an immediately known, and quoted, market value of redemption (e.g., stocks and Treasury securities). Level 2: Assets without known quoted prices where fair value is modeled using observed, direct or indirect, market values (e.g., corporate and municipal bonds).Level 3: Assets where fair value is determined using unobservable assumptions (e.g., real estate appraisals)…”

The authors’ analysis finds that nearly a quarter of plan assets are valued at Level 3. They conclude that, “since valuation of Level 3 assets is the most subjective of the three levels, this finding suggests that the reported values for a significant portion of plan assets could vary more from the value that plans would receive if they were to liquidate their holdings.”

Global Debt Surges to Highest Level in Peacetime, FT 25Sep19

“The level of government debt around the world has ballooned since the financial crisis, reaching levels never seen before during peacetime…the world’s major economies have debts on average of more than 70 per cent of GDP, the highest level of the past 150 years except for a spike around the second world war — raising profound questions about the sustainability of the global debt pile...

“Unlike earlier eras, when governments typically ran surpluses during peacetime, the pressures of modern democracy and welfare systems have made persistent deficits the norm in many countries.”

What this article leaves out is the critical point that this has occurred at the same time as a range of demand and supply side constraints on faster economic growth have appeared in many countries. To avoid an explosive debt trap (leading to some form of Minsky moment), it is imperative that interest rates on this huge debt burden be kept at or below the economy’s constrained rate of growth.

The History and Future of Debt, by Reid et al from DB Research

Surprise
This thought-provoking analysis should be combined with our forecast of what lies ahead and the ones by Ray Dalio from Bridgewater.

“Common wisdom suggests that the prudent upper threshold for government debt/GDP is in the range of 70-90% for high-income countries, 50-70% for euro area countries and 30-50% for the EM complex. Evidence has suggested that growth slows past these thresholds and thus risks creating an unsustainable and negative debt/GDP cycle. Today many countries are above these levels, with the globe seeing the highest peacetime debt in history, and yet until recently hardly a week went by without fresh record lows in bond yields…”

“Do we have to rethink our view on debt sustainability or is this a big bubble? Much depends on the future interaction between governments and central banks. In a world of stubbornly low growth and low inflation, and with populist governments increasingly looking at reversing prior fiscal consolidation/ austerity, eventually the temptation to use negative/ultra-low rates to borrow to spend will prove too tempting…”

“Ironically, the biggest risk to a plan to borrow at low/negative rates to facilitate fiscal spending might be that it is actually successful. If inflation is generated (as it should be with such policies), then the bonds that are [not held by central banks] may be much more vulnerable than they are today, when markets don't believe inflation is possible…

“The key to a sustainable debt environment over the next decade(s) will be about keeping nominal yields well below nominal GDP. As such, financial repression and aggressive central bank purchases might still be in the early stages…So higher debt, higher inflation, higher nominal GDP, higher yields, and higher central bank balance sheets.”

“Toward Fair and Sustainable Capitalism”, by Leo Strine, Chief Justice, Delaware Supreme Court

Surprise
Along with the Business Roundtable’s recent pronouncement that companies should balance the increasing shareholder value with the pursuit of other goals, Strine’s law review article marks an important turning point in the debate about the relationship between financialized capitalism and the viability of democracy in the face of worsening inequality.

“The incentive system for the governance of American corporations has failed in recent decades to adequately encourage long-term investment, sustainable business practices, and most importantly, fair gainsharing between shareholders and workers. That should not be so. This state of affairs exists in no small part because we have made public companies more and more responsive to the desires of the stock market, as represented by institutional investors with a demand for immediate returns. This has resulted in declines in gainsharing of corporate profits with workers, a large increase in stock buybacks, skyrocketing CEO pay, and growing inequality…

“When looking for the causes of growing inequality and a corporate governance system that does not work for all, the usual subjects of criticism are the CEOs and boards of large companies, but very little is said about those who wield over 75% of shareholder voting power: institutional investors. Most stock today is owned not by mom-and-pop investors who directly hold stock in individual companies, but by institutional investors who control human investors’ capital…

“Corporations will not give more thoughtful consideration to their employees and social responsibility—that is, our corporate governance system and economy will not change—unless the institutional investors who elect corporate boards also support doing so.”

“Has the dollar lost ground as the dominant international currency?” by Eswar Prasad, from Brookings

and

“Are Investors Ready for the ‘Doomsday Dollar’ Scenario?” by Rana Foroohar in the 29Sep19 Financial Times

A sharp fall in confidence in the US dollar and declines in its exchange rate versus other currencies features prominently in Ray Dalio’s scenario for a sharp rise in US inflation in the future. It is therefore important to continue monitoring early warning indicators that Dalio’s forecast is becoming reality.

Prasad concludes that, “the euro has stumbled, the renminbi has stalled, and dollar supremacy remains unchallenged.

In contrast, Foroohar notes that, “shifts in the global reserve system take time…if US companies are perceived as no longer being the most competitive in the world, their share price will fall, as will the dollar. Are we at that point? Not yet. But given the erosion of America’s skills base, its ailing infrastructure and lack of research investment, I wonder if we might be soon…”

The curious case of copper prices

In “Why is nobody buying the copper needed for a greener world?”, the FT’s always interesting John Dizard notes that, “Wind and solar [power generation] require three to fifteen times as much copper per unit of output as fossil fuel generation. This is after decades of technological development and efficiency improvements… Paul Gait and his team of metals mining analysts at Bernstein in London have come up with estimates of the copper price levels needed to finance new mines. “We believe copper needs to be priced at $8,800/tonne, or a 40 per cent uplift, to meet the government-agreed 2030 targets for decarbonisation…”

Given this, current copper prices of around $5,500/MT must reflect a very substantial fall in underlying global economic demand that has not yet been fully recognized by investors in other asset classes.

Following Iran’s attack on Saudi oil facilities, oil prices only briefly increased

As Sherlock Holmes notes, sometimes it is the dog that doesn’t bark that provides the most important clue.

It is very important to note that the reaction of oil prices was short-lived, due to increasing supply capacity outside of the Middle East, as well as market fears of a weakening economy and declining petroleum demand. On balance, we conclude that this makes a US and Saudi retaliatory strike against Iranian Republican Guard Corps assets more likely if another violent provocation occurs in response to the United States’ imposition of tighter sanctions on Iran.

Wharton Dean Geoffrey Garrett’s speech to incoming students was a sobering and succinct summary of the challenges we face today.

He noted “three intersecting geo-economic and geo-political trends:

(1) After four decades of ever-increasing engagement between China and the United States, the world’s two leading powers seem increasingly determined to decouple their economies from each other—making a second Cold War a reality and superpower war more likely.

(2) Notwithstanding that past technological revolutions have improved both the quality of life and the world of work, the combination of robots and AI threatens to destroy many more jobs than it creates—undermining the foundations of a good life based on a good job.

(3)While it remains tempting to dismiss the recent rise of anti-establishment politics as an aberration, the roots of populism run much deeper and stronger—weakening the foundations of democracy and increasing the chances of international conflict.”

“In my darkest moments, I fear that 2019 is looking more like 1929. Ninety years ago, economic inequality was at an all-time high in America and Europe. The seeds of authoritarian nationalism were sprouting in Asia, Europe and Latin America. World War I had destabilized the old global order without creating a new one. Against this backdrop, the stock market crash of October 1929 then ignited the horrendous cascade of depression, fascism and World War II—arguably the worst 15 years in history.”

“The notion that we could even remotely be near such a global paroxysm may seem unthinkable today. But I bet that is how everybody living the life of The Great Gatsby and Downton Abbey in the late 1920s felt, too.”

Coverage of the Federal Reserve Bank of Kansas City’s annual conference at Jackson Hole, Wyoming focused on the growing belief that, as the FT put it, “central banks are out of ammo” with sovereign yields turning negative and the next downturn looming.

As Adair Turner noted in his FT column of the same title, “central banks have lost much of their clout…It has been clear since the 2008 global financial crisis that when short and long-term interest rates are already very low, further cuts make little difference to real economic activity.”

Clearly, fiscal policy (and structural reform) should play a much larger role when the next downturn occurs. Yet whether the political will exists for this to happen remains unclear. For example, this month the US Congressional Budget Office stated that in the face of rapidly growing deficits, US government debt is on an “unsustainable course.”

Moreover, as Turner notes, “large fiscal deficits and forms of monetary finance are already major drivers of global growth...Triggered by the Trump administration’s 2017 tax cuts, the US fiscal deficit has risen to today’s 4.5 per cent of gross domestic product. China’s fiscal deficit has grown from 2.8 per cent of GDP in 2015 to 6 per cent in 2019, with some of this financed by People’s Bank of China lending to state owned banks to buy public bonds. Japan has run large deficits for a decade, fully matched by Bank of Japan purchases of government bonds, which will never be sold back to the private sector. And while Germany has stuck to the path of fiscal rectitude, its growth has relied on exports to these profligate rule breakers.”

These stories, and many more like them, reflect a growing fear that political leaders are either unwilling or unable to reverse the “secular stagnation” and “Japanification” that are descending upon the developed world, which may culminate in a deflationary trap that once entered will extremely difficult to escape.

“The Three Big Issues and the 1930s Analogue” by Ray Dalio

Dalio asserts that the three most important forces now at work in the world political economy are: (1) the end of the long-term debt cycle (or supercycle, as some have called it); (2) the large wealth gap and political polarization; and (3) a rising world power (China) challenging the existing world power (United States). Together, these have created dangerous conditions reminiscent of the 1930s.

Dalio’s concern, repeated here again, is that these conditions will lead to a sharp increase in deficit spending and debt monetization that will eventually lead to a sharp increase in inflation.

The critical uncertainty is whether this may be delayed for a long time by the emergence of a Japan-style deflationary trap, or perhaps avoided through various forms of debt writedowns.

“Inflation Dynamics: Dead, Dormant, or Determined Abroad?” by Kristin Forbes

“Over the last decade, the performance of standard models used to understand and forecast inflation has deteriorated. When growth collapsed during the 2008 Global Financial Crisis (GFC), inflation in most countries fell less than expected. Since then, as economies have largely recovered and unemployment fallen—even to record lows in some countries—inflation has not picked up as expected. A burgeoning literature has proposed a range of possible explanations for these puzzles…”

Forbes concludes that global factors including, “higher commodity prices, higher oil prices, exchange rate depreciations, less world slack, and weaker global value chains are all associated with higher CPI inflation, and the role of this set of variables—particularly commodity prices—has increased.”

“Expectation Error” by Xia Zhang of the University of Chicago

The author, “backcasts expectation errors of credit spreads via machine learning. I use newspapers over the past century to construct text-based expectations of credit spreads and study the relationship between expectation errors and business cycles. The main result is that over-optimism about future credit spreads predicts lower GDP growth and higher unemployment over the medium run, even after controlling for past and prevailing credit spreads. This finding suggests credit-market sentiment is an important driver of economic fluctuations.”

“US retailers quicken exit from malls as online shopping bites”, FT 21Jul19

“Retailers vacated US shopping centres at the fastest pace in at least nine years in the second quarter as the relentless rise of online shopping and collapse of debt-laden chains begin to hit the commercial property market.

More than 7,400 store closures have been announced this year, with Sears, Victoria’s Secret and Charlotte Russe among a raft of household names to shut outlets in malls across the country.”

“German manufacturing companies report industry in freefall”, FT 25Jul19

“Ifo manufacturing business climate index slumped to minus 4.3 in July from positive 1.3 the previous month. The reading was the lowest in more than 9 years.”

“Confidence Collapse in a Multi-Household, Self-Reflexive DSGE Model”, by Morelli et al

SURPRISE
“Agent Based Models (ABMs) provide a promising alternative framework to think about macroeconomic phenomena. In particular, ABMs easily allow for heterogeneities and interactions. These may generate non-linear effects and unstable self-reflexive loops that are most likely at the heart of the 2008 crisis, while being absent from benchmark DSGE models where only large technology shocks can lead to large output swings.

“Unfortunately, ABMs are still in their infancy and struggle to gain traction in academic and institutional quarters (with some major exceptions, such as the Band of England or the OECD). In order to bridge the gap between DSGE and ABMs and allow interesting non-linear phenomena, such as trust collapse, to occur within DSGE, we replace the representative household by a collection of homogeneous but interacting households. Interaction here is meant to describe the feedback of past aggregate consumption on the sentiment (or confidence) of individual households – i.e. their future consumption propensity…

“We find that such a minimal setup is extremely rich, and leads to a variety of realistic output dynamics: high output with no crises; high output with increased volatility and deep, short lived recessions; alternation of high and low output states where relatively mild drop in economic conditions can lead to a temporary confidence collapse and steep decline in economic activity.

“The crisis probability depends exponentially on the parameters of the model, which means that markets cannot efficiently price the associated risk premium [which remains inherently uncertain]. We conclude by stressing that within our framework, narratives become an important monetary policy tool, that can restore trust and help steer the economy back on track.”

“The Future of Work in America” by the McKinsey Global Institute

“Without bold, well-targeted interventions, automation could further concentrate growth and opportunity.” …

“Automation technologies promise to deliver major productivity benefits that are too substantial to ignore. They are also beginning to reshape the American workplace, and this evolution will become more pronounced in the next decade. Some occupations will shrink, others will grow, and the tasks and time allocation associated with every job will be subject to change. The challenge will be equipping people with the skills that will serve them well, helping them move into new roles, and addressing local mismatches…

“Local economies across the country have been on diverging trajectories for years, and they are entering the automation age from different starting points…Our analysis of 315 cities and more than 3,000 counties shows that the United States is a mosaic of local economies with widening gaps between them…

“The next wave of automation will affect occupations across the country, displacing many office support, food service, transportation and logistics, and customer service roles. At the same time, the economy will continue to create jobs, particularly roles in healthcare, STEM fields, and business services, as well as work requiring personal interaction. While there could be positive net job growth at the national level, new jobs may not appear in the same places, and the occupational mix is changing. The challenge will be in addressing local mismatches and help workers gain new skills…

“Communities need to prepare for this wave of change, focusing in particular on job matching and mobility, skills and training, economic development and job creation, and support for workers in transition. They can draw on a common toolbox of solutions, but the priorities vary from place to place—from affordable housing in major cities to digital infrastructure that enables remote work in rural counties…”

“Automation and occupational mobility: A data-driven network model” by del Rio-Chanona et al

SURPRISE
“Many existing jobs are prone to automation, but since new technologies also create new jobs it is crucial to understand job transitions. Based on empirical data we construct an occupational mobility network where nodes are occupations and edges represent the likelihood of job transitions. To study the effects of automation we develop a labour market model…

“At the micro level we analyze occupation-specific unemployment in response to an automation-related reallocation of labour demand…. The model’s key prediction is the heterogeneous distribution of unemployment and long-term unemployment rates at the occupation level…

“The network structure plays an important role: workers in occupations with a similar automation level often face different outcomes, both in the short term and in the long term, due to the fact that some occupations offer little opportunity for transition….

“We show that the effects of network structure on aggregate unemployment are substantial, increasing unemployment by roughly 25%, and that changes in the distribution of the labor demand across the network can cause significant shifts in the aggregate unemployment rate even when the total supply and demand of jobs is held constant…

“Our work underscores the importance of directing retraining schemes towards workers in occupations with limited transition possibilities.

“From Good to Bad Concentration: US Industries Over the Past 30 Years” by Covarrubias et al

SURPRISE
“We study the evolution of profits, investment and market shares in US industries over the past 40 years. During the 1990’s, and at low levels of initial concentration, we find evidence of efficient concentration driven by tougher price competition, intangible investment, and increasing productivity of leaders."

"After 2000, however, the evidence suggests inefficient concentration, decreasing competition and increasing barriers to entry, as leaders become more entrenched and concentration is associated with lower investment, higher prices and lower productivity growth.”

“How to Avert a Public Pensions Crisis”, by Josh McGee in National Affairs

We have repeatedly noted that America’s public sector defined benefit pension plan crisis is the proverbial train coming down the tracks. And it will only get worse if the economy ends up in a prolonged period of low growth and low investment returns (see this month’s Feature Article). McGee’s article is an excellent primer on how this crisis developed, and the limited number of painful options that are available to reduce its potential economic impact.

In the UK, the suspension of withdrawals from Neil Woodford’s Equity Income Fund was both the latest example of a very old plotline, and an indicator of new risks in the global financial system.

SURPRISE

The old plot line is the danger of a fund investing in illiquid assets while promising investors daily access to their money. When banks engage in such “maturity transformation” their liquidity risk is hedged by their access to the central bank’s discount window. But funds without such assess face the choice that confronted Woodford, between selling assets at potentially deep discounts to their value or imposing limitations on investors’ ability to withdraw their funds.

The new risk has been created by the growth in the volume of funds that have been invested in products that offer daily withdrawals, engage in maturity transformation, and lack access to the central bank’s discount window. Examples of this include some credit hedge funds, and ETFs that invest in assets that are hard to value or for which the underlying markets are shallow (e.g., high yield bonds, or emerging markets debt and equities). And with the post-2008 crisis imposition of higher capital requirements on banks (which reduced the profitability of market making), liquidity in many markets has arguably been reduced.

The risk this creates is that a piece of news or sudden change in sentiment that triggers a selloff of these products (e.g., investors attempting to sell their emerging market bond ETFs) could overwhelm the thin market liquidity for the underlying assets, triggering a sharp fall in their prices, and thus the prices of the ETFs that track them, setting off a powerful feedback loop that could quickly spread to other assets.

In light of the above, Robin Wigglesworth’s 19Jun Financial Times column “Are Markets Somehow Broken?” was particularly timely and on target.

SUPRISE
Wigglesworth noted that, “Fears over economic growth are spreading, and investors are pricing in the Federal Reserve cutting interest rates three times this year, beginning next month. And yet, various measures of market volatility are surprisingly subdued.”

These measures included a range of indexes that were created after the 2008 crisis and are meant to provide early warning of potential downturns, including the Office of Financial Research’s “Financial Stress Index”, the St. Louis Federal Reserve Bank’s “Financial Stress Index”, and the Bank of America “Global Financial Stress Index”, in addition to the more well-known equity market volatility indices like the VIX.

Wigglesworth contrasted the relative calm presented by these indices with two more worrisome indicators, including increases in the “Economic Uncertainty Index” (which we also track), and the number of negative surprises tracked by Citibank’s “Economic Surprise Index”, which measures the gap between actual versus forecasted outcomes for popular indicators. To this we would add the IMFs recent warning (in this year’s Global Financial Stability Review) of the growing number of vulnerabilities in the global financial system.

In our view, this divergence reflects two key point we have often made: (1) Qualitative, and especially complex information – especially the degree of investor uncertainty and its underlying drivers -- is more slowly incorporated into asset prices than quantitative information (most of which represents lagging indicators); and (2) In the face of rising uncertainty, social copying increases, and the conventional wisdom is likely to strengthen, even as the underlying system becomes more fragile and the potential for a sudden, sharp change increases.

“The Turning Tide: How Vulnerable are Asian Corporates?”, by the IMF.

“Asia’s nonfinancial corporate sector is vulnerable to a tightening of global financial conditions. Higher global interest rates and exchange rate depreciation increase the probability of default of Asian firms. A 30 percent currency depreciation is associated with a two-notch downgrade in the corporate credit rating (e.g., from A to BBB+), resulting in 7 percent of Asian firms falling into bankruptcy.”

The IMF also published “Enabling Deep Negative Rates to Fight Recessions: A Guide”

SURPRISE

The publication of this report very clearly suggests that the IMF is deeply concerned about the possibility that the global economy could shift into the Persistent Deflation Regime.

“The experience of the Great Recession and its aftermath revealed that a lower bound on interest rates can be a serious obstacle for fighting recessions. However, the zero lower bound is not a law of nature; it is a policy choice. The central message of this paper is that with readily available tools a central bank can enable deep negative rates whenever needed—thus maintaining the power of monetary policy in the future to end recessions within a short time.”

There have also been other indicators of increasing concern about the possibility of an extended period of deflation.

In “The Eurozone’s Japanification – More to Come”, ING Economics observes that, “the Eurozone is showing similarities with Japan of the early 1990s. A financial crisis turns into an economic crisis, which then turns into a banking crisis, and finally into an existential crisis”…

“For the Eurozone, the lessons for the future from Japanification are more important than the lessons from the past. The Japanese experiences show that it will be very hard to actually escape a low growth and low inflation environment without reverting to loose fiscal policies and policies aimed at increasing productivity growth.”

See also, “Lost in Deflation: Why Italy’s woes are a warning to the whole Eurozone”, by Servaas Storm of the Institute for New Economic Thinking

In her 27Jun column, “Negative interest rates take investors into surreal territory”, the Financial Times’ Gillian Tett observes that, “the global pile of negative yielding debt has swelled above $12.5tn, breaking the record set in 2016. Even in America, the yield on 10-year Treasuries recently fell below 2 per cent. That might not look dramatic since it is still positive in nominal terms. But when adjusted for core inflation (about 2 per cent) it equates to a near-negative real rate.”

Tett warns that, “There has been extraordinarily little public debate about the record levels of negative yielding debt. Neither politicians — nor many voters — appear to really care. However, it would be a profound mistake for investors to ignore what is now under way or simply presume that they have seen it before.”

In a 24Jun speech, Robert Kaplan, president of the Federal Reserve Bank of Dallas noted that, “there are two key elements of inflation: the cyclical and the structural. Dallas Fed economists believe these two forces are currently working in opposing fashion.”

“Cyclical inflationary forces are building. These cyclical forces are driven primarily by a tightening labor market and continuing wage gains. Historically, economists would have expected a tightening labor market to contribute to greater price pressures. This connection between labor market slack, wages and prices is sometimes referred to as the ‘Phillips curve.’

“Given these cyclical factors, why hasn’t inflation been more apparent? Why have we spent most of the past seven years—and particularly the past two years, when the unemployment rate has been below most estimates of the natural rate of unemployment—with a headline Personal Consumption Expenditure inflation rate below the Fed’s 2 percent objective?

“Our view at the Dallas Fed is that the structural forces of technology, technology-enabled disruption and, to some lesser extent, globalization are muting the relationship between labor market tightening and wage gains, and are even further muting the connection between wage gains and prices.

“Technology advancements such as artificial intelligence are allowing businesses to replace people with technology. In addition, new business models, often technology enabled and aided by the proliferation of mobile computing power, are disrupting old business models and allowing consumers to have more power in choosing the lowest price at a high level of convenience. Think Amazon, Uber, Lyft, Airbnb and so on…”

“It is our view that as cyclical forces build, which lead to increased costs, these cost increases are just as likely to lead to business margin erosion as they are higher prices.

“In a historically tight labor market, cyclical inflationary pressures will likely remain elevated. The question is whether they are strong enough to offset the structural forces that are muting inflation. Time will tell, but we are watching this dynamic very carefully at the Dallas Fed.”

Another new IMF paper highlights the mix of deflationary forces that are at work in the economy

“The Price of Capital Goods: A Driver of Investment Under Threat” notes that, “over the past three decades, the price of machinery and equipment fell dramatically relative to other prices in advanced and emerging market and developing economies…The broad-based decline in the relative price of machinery and equipment, in turn, was driven by the faster productivity growth in the capital goods producing sectors relative to the rest of the economy, and deeper trade integration, which induced domestic producers to lower prices and increase their efficiency.”

On the one hand, this is an example of so-called “good deflation”, which is driven by increasing supply relative to demand. However, the fall in relative capital goods prices also reflected relative weakness in demand; had demand been stronger, substantial productivity increases would have produced greater wage increases, instead of falling prices and rising shareholder returns.

There were also second order effects (i.e., feedback loops), as falling capital goods prices led to increased substitution of capital for labor, which contributed to wage stagnation, which further weakened demand, and quite possibly led to higher borrowing which made the economy even more vulnerable to so-called “bad deflation” that increases the real cost of debt service and can lead to a cascading collapse in economic activity.

Bloomberg’s Noah Smith published a well researched and thought provoking critique of the current economy that highlights the challenges that governments will face in the next downturn, which may well be quite severe and characterized by stubborn deflation.

SURPRISE
In “Too Many Companies Drain Value from the Economy”, he describes the decline of competition in many industries, and the rise of rent extraction that shifts economic value from labor to capital. Smith notes the different forces that have produced this outcome, from growing regulation to increasing scale economies and winner-takes-all dynamics in more industries.

A new report from Pew focused on the continued worsening of the public sector pensions crisis in the United States.

“After nine years of revenue growth and strong investment performance, the pension funding gap—the difference between a retirement system’s assets and its liabilities—for all 50 states remains more than $1 trillion, and the disparity between well-funded public pension systems and those that are fiscally strained has never been greater…”

“Strong investment performance in 2017 was due to [many plans’] high allocations of assets to stocks and alternative investments such as private equity, hedge funds, and real estate. Although these vehicles can produce high returns, they also expose plans to increased risk and volatility.

“Based on investment returns posted since 2017, Pew estimates a deficit of approximately $1.5 trillion as of December 2018.

“Ongoing declines in pension funding levels increase the pressure on state and local budgets as the cost of pension debt rises. Employer contributions to state pension systems have grown faster than state revenue since 2007, accounting for nearly $180 billion in additional spending that otherwise could have funded other programs and services.”

“The Global Economy Hit by Higher Uncertainty” by Ahir et al

The authors find that increased in uncertainty, as measured by World Uncertainty Index, could reduce global GDP growth by up to 0.5% in 2019

“Evolution or Revolution: An Afterward” by Blanchard and Summers

The authors begin by observing that, “the changes in macroeconomic thinking prompted by the Great Depression and the Great Inflation of the 1970s were much more dramatic than have yet occurred in response to the events of the last decade. “

They forecast that “this gap is likely to close in the next few years as a combination of low neutral rates, the reemergence of fiscal policy as a primary stabilisation tool, difficulties in hitting inflation targets [i.e., the rising threat of deflation], and the financial ramifications of a low rate environment lead to important changes in our understanding of the macroeconomy and in policy judgments about how to achieve the best performance.”

“The Burden of Debt” by Irwin Stelzer

“The spectre of debt is haunting the world…In America, the government’s outstanding debt tops $22 trillion and is rising at close to $1 trillion per year, soon to exceed even that level. The Congressional Budget Office (CBO) estimates that the federal debt held by the public, now at 78 percent of GDP, will rise to 92 percent in 2029. And that statistic assumes that Congress, in an unusual display of fiscal responsibility and political heroism, does not extend the Trump tax cuts that are due to expire in 2025. More likely, tax cutters will be on as thin on the ground in 2025 as they are now, and government debt will exceed 100 percent of GDP.

“Harvard economists Kenneth Rogoff and Carmen Reinhart studied data on the relation of growth to debt in 44 countries spanning about 200 years and concluded that when the ratio reaches 90 percent, growth significantly declines.

“America is not alone in choosing profligacy over prudence. Between 2008 and 2017 global financial debt rose from $97 trillion to $169 trillion according to McKinsey & Company. Stephen Jen, CEO of hedge fund Eurison SLJ Capital, believes “the debt load in the world is so high now that it can’t withstand any historically normal size of interest-rate increases anymore.”

“A better way to anticipate downturns” by Tim Koller of McKinsey

“While the savviest executives and investors know better than to get caught up in the short-term fluctuations of the economy, many others, looking for evidence of longer-term trends, still fixate on movements in the equity markets.

“They shouldn’t. The fact is that those markets, well analyzed as they are, don’t predict downturns effectively. Credit markets are a better place to look for signs of impending trouble, in no small part because they have been at the core of most financial crises and recessions for hundreds of years…

“The credit markets are where crises develop—and then filter through to the real economy and drive downturns in the equity markets…Unfortunately, it takes several years for crises to develop, and once the conditions are in place, they are nearly inevitable.”

“Aggregate Implications of Changing Sectoral Trends” by Foerster et al

SURPRISE
“This paper highlights the steady decline in trend GDP growth over the post-war period, 1950 to 2016…The estimates reveal that trends in total factor productivity (TFP) and labor [employment] growth have steadily decreased across a majority of U.S. sectors since 1950…

“Interestingly, more than 2/3 of the secular decline in aggregate TFP growth results from the combination of sector-specific disturbances, thus leaving only an ancillary role for aggregate TFP…

“Construction more than any other sector stands out by a considerable margin for its contribution to the trend decline in GDP growth since 1950, accounting for close to 1/3 of this decline. Structural changes in Professional and Business Services and Nondurable Goods together account for another 25 percent…”

“In addition, the slow process of capital accumulation means that structural changes have endogenously persistent effects. We estimate that trend GDP growth will continue to decline for the next 10 years absent persistent increases in TFP and labor growth.”

“The Economic Effects of the 2017 Tax Revision: Preliminary Observations” by Gravelle and Marples from the Congressional Research Service

“In 2018, gross domestic product (GDP) grew at 2.9%, about the Congressional Budget Office’s (CBO’s) projected rate published in 2017 before the tax cut. On the whole, the growth effects tend to show a relatively small (if any) first-year effect on the economy. Although growth rates cannot indicate the tax cut’s effects on GDP, they tend to rule out very large effects particularly in the short run.

Although investment grew significantly, the growth patterns for different types of assets do not appear to be consistent with the direction and size of the supply-side incentive effects one would expect from the tax changes. This potential outcome may raise questions about how much longer-run growth will result from the tax revision.”

“Can Redistribution Help Build a More Stable Economy?” by Papadimitrious et al from the Levy Economics Institute

For years, I've been a big fan of the Levy Economic Institute’s annual Strategic Analyses of the US economy, and the consistent stock/flow model upon which it is based. Their latest analysis, as usual, packed with insights, and well worth a read.

They note that, “For better or worse, the structural problems in the US economy – with some important exceptions -- have not changed significantly over the last two-and-a-half decades.” They include “(1) weak net export demand; (2) fiscal conservatism; (3) increasing income inequality; and (4) financial fragility… Importantly, the situation on most of these fronts is getting worse.”

The authors conclude that, “for a robust and sustainable economic future, the US economy requires deep structural reforms that deal with the aforementioned problems. There is no single policy that can achieve this.”

In April, the IMF released its biannual World Economic Update and Global Financial Stability Report

The WEO noted that the global expansion was “losing steam” in the face of “high policy uncertainty”, and that “global risks are skewed to the downside.” The deceleration of growth in the Euro area was particularly surprising. The WEO also concluded that, “Sustained excess external imbalances in the world’s key economies and policy actions that threaten to widen such imbalances pose risks to global stability…Over the medium term, widening debtor positions in key economies could constrain global growth and possibly result in sharp and disruptive currency and asset price adjustments.”

The subtitle of the GFSR echoed the WEO’s warning: “Vulnerabilities in a Maturing Credit Cycle.” More specifically, “As the credit cycle matures, corporate sector vulnerabilities—which appear elevated in about 70 percent of systemically important countries (by GDP)— could amplify an economic downturn…”

More specifically, as I’ve seen time and again over a 40 year career that has spanned multiple debt crises, high leverage (financial, operating, or both) makes companies much quicker to start layoffs when a business cycle turns down. And at a time when uncertainty about technology’s impact on future employment is already sky high, high debt levels have set the stage for a non-linear negative reaction when the downturn arrives.

“The Return of the Policy That Shall Not Be Named: Principles of Industrial Policy” by Cherif and Hasanov of the IMF

This is an excellent overview of industrial policy, and provides insightful comparisons between the policies pursued by fast developing Asian countries and other nations that have grown more slowly. The authors conclude that “true industrial policy” amounts to “Trade and Innovation Policy” or “TIP”… Innovation-driven growth is key to sustaining productivity gains and achieving high-income status.”

TIP focuses on “(i) the support of domestic producers in sophisticated industries, beyond the initial comparative advantage; (ii) export orientation; and (iii) the pursuit of fierce competition with strict accountability”… The state has to set the level of ambition of its goal, and then implement the right policies while imposing accountability and being able to adapt fast as conditions change—Ambition, Accountability, and Adaptability (AAA), or a triple A, of the “leading hand of the state”…

Trade and Innovation Policy has been applied with different degrees of intensity, and therefore success. The authors observe that, “The strategy of the Asian miracles’ industrial policy/state intervention can be summed up as follows:

(1) Intervene to create new capabilities in sophisticated industries: Pursue policies to steer the factors of production into technologically sophisticated tradable industries beyond the current capabilities to swiftly catch up with the technological frontier.

(2) Export, export, export: A focus on export orientation as any new industrial product was expected to be exported right away with the use of market signals from the export market as a feedback for accountability. As conditions changed, both the state and the firms adapted fast.

(3) Cutthroat competition (at home and abroad) and strict accountability: No support was given unconditionally although performance assessment was not necessarily based on short-term profits. While specific industries may get support, intense competition among domestic firms was highly encouraged in domestic and international markets.”

Citicorp Briefing on Modern Monetary Theory, by Buiter and Mann

The authors conclude that the case for MMT (more specifically, having the central bank monetize debt issued to finance government deficits) is strongest when monetary policy is at the zero lower bound and private sector demand is weak and contracting. At all other times, large government deficits financed by central bank debt monetization run the risk of substantially increasing inflation.

“Lost in Deflation: Why Italy’s Woes are a Warning to the Whole Eurozone” by Servaas Storm of the Oxford Institute for New Economic Thinking

SURPISE
Lest you think the IMF paper on Industrial Policy is just the theoretical musings of academics economists, this paper focuses on a very practical example that has been much in the news of late: Italy. The author notes, “Lacking political voice, about the only thing the ‘left behinds’ can do is to “send in a wrecking ball to disrupt the system”1—which means voting against the establishment and “having more of the same”, even if it is less clear what exactly one is voting for. ‘Brexit’ and Trump are clear manifestations of such anti-establishment anger, and similar sentiments are building up elsewhere as well.

In Italy, the third largest economy of the Eurozone, the ‘wrecking ball’ came in the form of the anti-establishment, anti-euro and anti-austerity ‘government of change’, as the League‒Five Star Movement coalition prefers to call itself. The two coalition parties surfed a wave of discontent2 with roots deep in Italy’s economic crisis, the origins of which go back almost three decades and the symptoms of which are manifold: a secular stagnation of productivity growth; stagnant real wages, high (youth) unemployment and stalling incomes; a sustained loss of international competitiveness; a crumbling infrastructure suffering from chronic under-investment; a manufacturing industry, made up of mostly small- and medium-scale enterprises, prone to offshoring; and a government and banking system crippled by debts. Promising drastic changes away from austerity and a fundamental break with discredited establishment politics, the Five Star Movement (M5S) and the League (Lega) garnered the votes of more than 16 million of mostly working-class and middle-class people—an increase of six million voters compared to Italy’s 2013 general elections and about 50% of all votes in 2018…”

“Using macroeconomic data for 1960-2018, this paper analyzes the origins of the crisis of the ‘post-Maastricht Treaty order of Italian capitalism’. After 1992, Italy did more than most other Eurozone members to satisfy EMU conditions in terms of self-imposed fiscal consolidation, structural reform and real wage restraint—and the country was undeniably successful in bringing down inflation, moderating wages, running primary fiscal surpluses, reducing unemployment and raising the profit share.

But its adherence to the EMU rulebook asphyxiated Italy’s domestic demand and exports—and resulted not just in economic stagnation and a generalized productivity slowdown, but in relative and absolute decline in many major dimensions of economic activity. Italy’s chronic shortage of demand has clear sources: (a) perpetual fiscal austerity; (b) permanent real wage restraint; and (c) a lack of technological competitiveness which, in combination with an overvalued euro, weakens the ability of Italian firms to maintain their global market shares in the face of increasing competition of low-wage countries. These three causes lower capacity utilization, reduce firm profitability and hurt investment, innovation and diversification.

The EMU rulebook thus locks the Italian economy into economic decline and impoverishment. The analysis points to the need to end austerity and devise public investment and industrial policies to improve Italy’s ‘technological competitiveness’ and stop the structural divergence between the Italian economy and France / Germany. The issue is not just to revive demand in the short run (which is easy), but to create a self-reinforcing process of investment-led and innovation-driven process of long-run growth (which is difficult).”

“What Happened to US Business Dynamism?” by Akcigit and Ates

SURPRISE
This paper explores one aspect of the widening divide between the top tier companies in many industries and all the others. Research has shown that this is a key contributor to worsening inequality. One theory is that the faster adoption of advanced technology by leading firms and its slower adoption by others is due to the former’s ability to recruit and retain the limited number of highly talented graduates of our education system. This paper focuses on these firms’ aggressive use of patents to prevent the diffusion of advanced technology to others.

“In the past several decades, the U.S. economy has witnessed a number of striking trends that indicate a rising market concentration and a slowdown in business dynamism. In this paper, we make an attempt to understand potential common forces behind these empirical regularities through the lens of a micro-founded general equilibrium model of endogenous firm dynamics. Importantly, the theoretical model captures the strategic behavior between competing firms, its effect on their innovation decisions, and the resulting “best versus the rest” dynamics.

“We focus on multiple potential mechanisms that can potentially drive the observed changes and use the calibrated model to assess the relative importance of these channels…Our results highlight the dominant role of a decline in the intensity of knowledge diffusion from the frontier firms to the laggard ones in explaining the observed shifts.

“We conclude by presenting new evidence that corroborates a declining knowledge diffusion in the economy. We document a higher concentration of patenting in the hands of firms with the largest stock and a changing nature of patents, especially in the post-2000 period, which suggests a heavy use of intellectual property protection by market leaders to limit the diffusion of knowledge. These findings present a potential avenue for future research on the drivers of declining knowledge diffusion.”

“Global Declining Competition” by Diez et al from the IMF

Like the previous paper, this analysis focuses on the changing dynamics of competition, and the changes in market power that have contributed to the stagnation of real wages for the middle class, and thus a worsening of inequality and a rise in social and political conflict in many Western nations.

“Using a new firm-level dataset on private and listed firms from 20 countries, we document five stylized facts on market power in global markets. First, competition has declined around the world, measured as a moderate increase in average firm markups during 2000- 2015.

Second, the markup increase is driven by already high-markup firms (top decile of the markup distribution) that charge increasing markups.

Third, markups increased mostly among advanced economies but not in emerging markets.

Fourth, there is a non-monotonic relation between firm size and markups that is first decreasing and then increasing.

Finally, the increase is mostly driven by increases within incumbents and also by market share reallocation towards high-markup entrants.”

The previous paper further supports findings from another paper published last year by Song et al from the Federal Reserve Bank of Minneapolis, “Firming Up Inequality”. The authors “use a massive, matched employer-employee database for the United States to analyze the contribution of firms to the rise in earnings inequality from 1978 to 2013.

They find that, “one-third of the rise in the variance of earnings occurred within firms, whereas two-thirds of the rise occurred between firms. However, this rising between-firm variance is not accounted for by the firms themselves: the firm-related rise in the variance can be decomposed into two roughly equally important forces: a rise in the sorting of high-wage workers into high-wage firms and a rise in the segregation of similar workers between firms…”

“Our main result is that the rise in the dispersion between firms in firm average earnings accounts for the majority of the increase in total earnings inequality.”

“Peak Profit Margins? A Global Perspective” by Jensen et al from Bridgewater Associates

SURPRISE
In its February analysis of US profit margins, Bridgewater concluded that, “Over the last two decades, US corporate profit margins have surged and have contributed more than half of the excess return of equities relative to cash. Without that consistent expansion of margins, US equities would be 40% lower than they are today…Over the last few decades, almost every major driver of profit margins has improved. Labor’s bargaining power fell, corporate taxes fell, tariffs fell, globalization increased, technology allowed for greater scale and lower marginal costs, anti-trust enforcement fell, and interest rates fell. These factors have produced the most pro-corporate environment in history. Many of these drivers of high profit margins are now under threat.”

In this latest report, the Bridgewater team expands its focus to global profit margins. The authors conclude that, “Corporations around the world simultaneously benefited from the broad-based decline in labor’s bargaining power, increased globalization, lower antitrust enforcement, technology allowing for greater scale and lower marginal costs, and lower corporate taxes, interest rates, and tariffs. These factors have produced the most pro-corporate environment in history globally, with the US benefiting the most…

Looking ahead, some of the forces that have supported margins over the last 20 years are unlikely to provide a continued boost. Incentives for offshore production have been reduced as global labor costs have moved closer to equilibrium, with domestic costs and rising trade conflict increasing the risk from offshoring, while the potential tax rate arbitrage from moving abroad is now much smaller.”

US Senator (and presidential candidate) Elizabeth Warren proposed a program to forgive a substantial amount of US college student loan debt.
This is the first salvo in what will likely become a much larger and more painful conversation about the inability of many economies to service the amount of debt they have taken on, given projections for slow demographic and productivity growth, and how unavoidable debt-relief will occur.

SURPRISE
At the beginning of 2019, student loan debt stood at $1.6 trillion, having tripled since 2004, as household earnings stagnated and college costs rose at rates well above inflation. Numerous authors have claimed that this represents a significant drag on economic growth (e.g., “Student Loans are Beginning to Bite the Economy”, Bloomberg, 20Aug18 and “The Student Debt Crisis: Could It Slow the Economy? Knowledge at Wharton, 22Oct18), though others claim the effects are small.

The most thorough analysis we have seen is “The Macroeconomic Effects of Student Debt Cancellation” by Fullwiler et al from the Levy Economics Institute.

The authors conclude that “debt cancellation lifts GDP, decreases the average unemployment rate, and results in little inflationary pressure (all over the 10-year horizon of our simulations), while interest rates increase only modestly. Though the federal budget deficit does increase, state-level budget positions improve as a result of the stronger economy…[Moreover] Research suggests many other positive spillover effects that are not accounted for in these simulations, including increases in small business formation, degree attainment, and household formation, as well as improved access to credit and reduced household vulnerability to business cycle downturns. Thus, our results provide a conservative estimate of the macro effects of student debt liberation.”

Warren’s proposal met with both support and opposition. However, it served the larger purpose of increasing public focus on the potential need for widespread debt forgiveness and restructuring, in a highly leveraged economy that is potentially facing, due to demographic and productivity factors, an extended period of low real growth.

This is a point that has previously been made by William White, former Chief Economist at the Bank for International Settlements, who I have long regarded as one of the most astute observers of the global economy; for example, White was warning about the building negative pressures in the global economy and financial system long before the 2008 crisis exploded.

This month, in a 9Apr19 interview with the Swiss publication “Finanz und Wirtschaft”, (“Central Banks are Biased Towards Loose Policy”), White reiterated his view that to avoid the next economic downturn triggering an uncontrolled debt deflation, policy makers need to plan for a more structured approach to debt reduction, noting that, “You must identify which debt is not serviceable and take steps to make sure that it is written off. The supervisors in the banking system have to force the banks to restructure as opposed to provide support to zombie firms. In the next recession, we should have a combination of fiscal stimulus and a credible longer term debt sustainability target and pay much greater attention to debt restructuring. But nobody likes to talk about this.”

The United States eliminated waivers that had enabled limited sales of Iranian oil to continue.

SURPRISE
The reduction in Iranian oil supply, to say nothing of the heightened risk of violent conflict (which could include Iranian attempts to close the Strait of Hormuz to oil traffic, and/or attacks on Saudi oil facilities) runs the risk of triggering a sharp increase in world oil prices, which would reduce global demand, increase uncertainty, and likely trigger a worldwide recession.

Negotiations between China and the US took a turn for the worse in early May, leading to further increase in US tariffs on Chinese goods, and a promise to respond in kind by China.

This has further ratcheted up uncertainty (whose full impact will only be felt with a lag), which makes the global economy even more susceptible to a sharp downward break.

“World economy lurches from uneven recovery to synchronized slowdown”, Brookings Institution, 7Apr19

Based on the latest update to the Brookings/Financial Times “Tracking Indexes for the Global Economic Recovery (TIGER)” Eswar Prasad of Brookings concludes that, “the drumbeat of warnings about a looming worldwide recession is rising. Although such concerns seem premature, major advanced and emerging market economies are all losing growth momentum. The nature of the slowdown has ominous portents for these economies over the next few years, especially given present constraints on macroeconomic policies that could stimulate growth.”

March saw a rising number of articles that noted indicators of a slowing economy and looming recession.

“Bain Boss Warns Over Private Equity Debt Levels”, FT, 1Apr19

“German 10-year bond yield slips below zero for first time since 2016”, FT, 22Mar19

“Euro and stocks hit after bleak data stokes slowdown fears”, FT, 22Mar19

“Global Debt: When is the Day of Reckoning?”, FT, 16Mar19

“U.S. Debt: Is It the Calm Before the Storm?”, Knowledge@Wharton, 15Mar19

“US Corporate Debt is High, But Not Yet Dangerous” by Gavyn Davies, Financial Times, 25Mar19

Surprise
In contrast to commentators warning about the potential negative consequences of high corporate debt levels, Davies notes that corporate profit margins are still high, and interest rates are still low, which makes the current stock of debt easier to service. That said, he also acknowledges that there are pockets of concern, such as leveraged loans.

“On Falling Neutral Real Rates, Fiscal Policy, and the Risk of Secular Stagnation”, by Lukasz and Summers

“This paper demonstrates that neutral real interest rates would have declined by far more than what has been observed in the industrial world and would in all likelihood be significantly negative but for offsetting fiscal policies over the last generation.”

“We start by arguing that neutral real interest rates are best estimated for the block of all industrial economies given capital mobility between them and relatively limited fluctuations in their collective current account. We show, using standard econometric procedures and looking at direct market indicators of prospective real rates, that neutral real interest rates have declined by at least 300 basis points over the last generation.”

“We argue that these secular movements are in larger part a reflection of changes in saving and investment propensities rather than the safety and liquidity properties of Treasury instruments. We then point out that the movements in the neutral real rate reflect both developments in the private sector and in public policy.”

“We highlight the levels of government debt, the extent of pay-as-you-go old age pensions and the insurance value of government health care programs have all ceteris paribus operated to raise neutral real rates.”

[However], “we suggest that the private sector neutral real rate may have declined by as much as 700 basis points since the 1970s” [due to a wide range of trends, including aging, declining total factor productivity growth, rising inequality, and increasing concentration in many industries].

The authors conclude that their “findings support the idea that, absent offsetting policies, mature industrial economies are prone to secular stagnation [weak demand relative to potential supply]…Policymakers going forward will need to engage in some combination of greater tolerance of budget deficits, unconventional monetary policies and structural measures to promote private investment and absorb private saving if full employment is to be maintained and inflation targets are to be hit.”

“Why markets should get set for QE4” by Michael Howell, 19Feb19

SURPRISE
Minsky would love this paper, as it describes our continued progression towards the “Minsky Moment” when the full nature of the debt crisis we face will become widely appreciated.

“To better understand the risks, we must think of western financial systems as essentially capital redistribution mechanisms that are used to refinance existing positions, rather than capital-raising mechanisms to obtain new money. This refinancing role means that quantity (liquidity) matters more than quality (price, or interest rates). Liquidity derives from balance sheet capacity and, in America, this is closely linked to the size of the Fed’s QE operations.

Liquidity can be measured based on the funds that flow through both the traditional banking system and the wholesale money markets. The latter have taken on huge importance in recent years, eclipsing banks as sources of lending. They have been fueled by vast inflows from institutional cash pools, such as cash-rich companies, asset managers and hedge funds, the cash-collateral business of derivative traders and foreign exchange reserve managers. These pools have outgrown the banking systems, and their size typically exceeds the deposit insurance thresholds for government guarantees.

“It is why these pools need to invest in other secure short-term liquid assets. In the absence of instruments provided by the state — in the form of central bank lending facilities and Treasury bills — the private sector has had to step in. This has happened largely through short-term loans known as repurchase agreements, or repos; and asset-backed commercial paper.

“The credit system increasingly operates through these repo markets, and often with active central bank participation. The repo mechanism bundles together “safe” assets, such as government bonds, foreign exchange and high-grade corporate debt, and uses these as security against which to borrow. While credit risk is to some extent mitigated, the risk of being able to roll or refinance positions remains.

The search forever more collateral encourages the issuance of higher quality private bonds, which, in turn, allows for greater issuance of lower-grade bonds. A deteriorating economic backdrop and tight market liquidity can compromise this poorer quality debt because the heightened risk of default often means that demand dries up and prevents their refinancing.

This kind of shock could reverberate and trigger a rush from investors into high-quality, short-term instruments, such as government-backed Treasury bills, central bank reverse repos and banks’ reserves.

So is another crash coming? Much depends on the central banks. Whereas the global financial crisis was caused by too much private sector leverage, our concern today is a growing shortage of central bank liquidity caused by the deliberate unwinding of the QE policies put in place to replace the private sector funding that evaporated in 2007/08.

The bottom line is that liquidity matters hugely, and modern financial systems cannot function without large central bank balance sheets.
In short, we expect to see another round of central-bank asset purchases — “QE4” — far sooner than many expect.”

“What Anchors for the Natural Rate of Interest?” by Borio et al from the Bank for International Settlements

Similar to the Lukasz and Summers analysis, this paper also takes a critical look at the conceptual and empirical underpinnings of prevailing explanations for low real (inflation-adjusted) interest rates over long horizons and finds them incomplete.

The authors’ perspective “differs from the standard narratives put forward to explain the trend decline in real interest rates. Invariably, the presumption is that an excess of ex ante saving over investment has driven equilibrium real interest rates down. In this narrative, monetary and financial factors play at most only a cursory role, if any. For instance, in his secular stagnation hypothesis, Summers (2015) contends that chronically weak aggregate demand together with the zero lower bound have kept desired saving above investment and pushed the natural rate below market rates…”

“The role of monetary policy, and its interaction with the financial cycle in particular, deserve greater attention. By linking booms and busts, the financial cycle generates important path dependencies that give rise to intertemporal policy trade-offs. Policy today constrains policy tomorrow. Far from being neutral, the policy regime can exert a persistent influence on the economy’s evolution, including on the real interest rate…”

“The interest rate is of immense importance in today’s highly financialised economy. It underpins borrowing and lending, thus acting as a speed regulator for activity…

“There is a growing recognition that the financial cycle exerts a powerful and potentially long-lasting influence on the economy, not least when it implodes. To the extent that monetary policy, which sets the price of leverage, can influence the financial cycle, it too may have a persistent impact on the economy’s long-run path, and hence also on real interest rates…

“The underlying theme is that booms usher in busts. The fragilities that emerge during the bust build up during the preceding boom and cannot be analysed without reference to it. This contrasts with popular approaches that view crises as the result of (exogenous) shocks amplified by financial frictions in the system…

“These features introduce an intertemporal policy trade-off. Easier policy today boosts output in the short run but accommodates the build-up of financial imbalances, which generate large output losses in the long run when they implode. Depending on the monetary policy rule, the economy’s fragility to boom-bust cycles may be high or low, with significant implications for the long-run evolution of output and real interest rates.”

“The Real Effects of Zombie Lending in Europe”, Bank of England Working Paper by Belinda Tracy

“Around 10% of European firms were in receipt of subsidized bank loans following the peak of the European sovereign debt crisis in 2011. To what extent did such forbearance lending contribute to the subsequent low output growth experienced by the euro area? In this paper, we address this question by developing a quantitative model of firm dynamics in which forbearance lending and firm defaults arise endogenously.

The model provides a close approximation to key euro-area firm statistics over the period 2011 to 2014. We evaluate the impact of forbearance lending by considering a counterfactual scenario in which firms no longer have access to loan forbearance.

Our key finding is that aggregate output, investment and total factor productivity are higher in the absence of forbearance lending than in the benchmark scenario that includes forbearance lending. This suggests that forbearance lending practices contributed to the low output growth across the euro area following the onset of the sovereign debt crisis.”

This echoes a similar point made by Raha Foroohar in the FT: “Low interest rates have papered over myriad political and economic problems, not just for 10 years, but for decades.”

“What the Federal Reserve Got Totally Wrong about Inflation and Interest Rate Policy: Getting Real About Rents”, by Daniel Alpert

Surprise
Alpert argues that the Fed “has failed to appreciate the changes to inflation dynamics changes that have persisted over the past 15 years. In particular, the nature of inflation in the housing sector and the extent to which it has dominated the entire subject of price inflation. In short, this is not your father’s inflation.”

He notes that, “since the end of 2013, housing – and, particularly, rents and owners’ equivalent rents of primary residences (Aggregate Rent) – has dominated both the core and all-items measure of CPI in a manner never before experienced (even during the housing bubble of the 2000s) and has distorted both measures considerably…

“The reasons for the vast impact of residential housing rent inflation relate not to the classic demand-push inflation that would be characteristic of a post-recession recovery in employment and economic growth – but are to be found in the dramatic changes in the nature of housing demand, the supply of new housing, and slowed residential mobility since the Great Recession…

“An unprecedented contraction in the inventory of owner-occupied and for sale residential housing, together with a dramatic fall off (especially when adjusted for the number of U.S. households) in the availability and sales of owner-occupied housing, has produced pressures on both residential rents and prices that are not consistent, from a causal perspective, with any period of economic growth in modern U.S. history…

“Fed policy rate and quantitative easing during and for most of the decade since the beginning of the Great Recession sparked growth in owner-occupied home prices that, while not as dramatic of that during the housing bubble of the 2000s is once again inconsistent with the growth in prices of housing construction inputs, meaning that it represents a speculative increase in the price of land itself. [Housing prices] have again risen above the level to which home prices have traditionally been anchored. This is proving to be unsustainable, and housing price growth is decelerating.”

“Why Does Everyone Hate MMT?” by James Montier, from Grantham, Mayo, van Otterloo

Surprise
James Montier is one of the macro commentators whose work I have eagerly read for years. As always, his latest note is thought provoking.

Montier believes that Modern Monetary Theory has been unfairly maligned by many mainstream economists. He notes that “understanding a nation’s monetary environment is vital…Any country that issues debt only in its own currency and has a floating exchange rate can be thought of as being monetarily sovereign, and cannot be forced to default on its debt (i.e., the US, Japan, and UK, but not the Eurozone or most emerging markets)…

“Even in a monetarily sovereign state, private debt matters. The private sector cannot print money to repay its debts. As such, it has the potential to create a systematic vulnerability. Think Minsky’s financial insability hypothesis: stability begets instability…[Rather than excessive money supply growth], hyperinflations are generally characterized by three traits: (1) a large negative supply shock; (2) big debts denominated in foreign currency; and (3) distributive conflicts, which provide an inflationary transmission mechanism via mandated wage increases and/or indexation” [see Montier’s article on “Hyperinflations, Hysteria, and False Memories, as well as “World Hyperinflations” by Hanke and Krus].

“Why ‘Japanification’ Looms For The Sluggish Eurozone”, by John Plender, Financial Times, 12Mar19

“ECB president Mario Draghi described the Eurozone as being in ‘a period of continued weakness and pervasive uncertainty.’”

Plender also reviews the argument for whether the Eurozone is heading for “Japanification” – a prolonged period of population aging and shrinkage, weak demand growth (in absolute, but not necessarily per capita terms), and low inflation or deflation, in which government deficits are critical to maintaining output, and government debt/GDP continues to increase.

Plender concludes that “the eurozone will continue to be overdependent on the rest of the world for demand stimulus; Japanification will become a more familiar word in the European vocabulary; populism will advance; and interest rates may remain lower for much longer than most people now expect.”

“Digital Abundance and Scarce Genius: Implications for Wages, Interest Rates, and Growth”, by Benzell and Brynjolfsson

Surprise
The authors ask, “Why, if emerging technologies are so impressive, are interest rates so low, wage growth so slow and investment rates so flat? And why is total factor productivity growth so lukewarm?...If digital labor and capital can be reproduced much more cheaply than its traditional forms. But if labor and capital are becoming more abundant, what is constraining growth? We posit a third factor, `genius', that cannot be duplicated by digital technologies.”

“Our model can explain why ordinary labor and ordinary capital haven't captured the gains from digitization, while a few superstars have earned immense fortunes. Their contributions, whether due to genius or luck, are both indispensable and impossible to digitize. This puts them in a position to capture the gains from digitization.”

The authors’ definition of “genius” includes not only superstar individuals (estimated to be 3% of all employees), but also digital and organizational assets that are distinct from superstar workers and their creations. These include intellectual property, natural monopolies or oligopolies, and organizational capital, in the form of processes that are hard to understand and imitate, including the creation of cultures that give them an advantage in attracting and retaining superstar employees.

The high returns to genius, and the additional economic growth and reductions in inequality that would result from producing more of it, cast the failure to substantially improve the productivity of the education system in a particularly harsh light.

“The Rise of Corporate Market Power and Its Macroeconomic Effects”, Chapter 2, IMF World Economic Outlook, April 2019

With political opposition to growing concentration in many industries, while at the same time M&A activity continues to increase it, the IMF has entered this debate with a powerful analysis.

“This chapter investigates whether corporate market power has increased and, if so, what the macroeconomic implications are. The three main takeaways from a broad analysis of cross-country firm-level patterns are that (1) market power has increased moderately across advanced economies, as indicated by firms’ price markups over marginal costs rising by close to 8 percent since 2000, but not in emerging market economies;

(2) The increase has been fairly widespread across advanced economies and industries, but within them, it has been concentrated among a small fraction of dynamic—more productive and innovative—firms; and,

(3) Although the overall macroeconomic implications have been modest so far, further increases in the market power of these already-powerful firms could weaken investment, deter innovation, reduce labor income shares, and make it more difficult for monetary policy to stabilize output. Even as rising corporate market power seems, so far, more reflective of “winner-takes-most” by more productive and innovative firms than of weaker pro-competition policies, its challenging macroeconomic implications call for reforms that keep future market competition strong.”

“The Macroeconomic Implications of a Global Trade War”, by Antoine Berthou et al

“Using a multicountry model, this column shows that a global and generalised 10 percentage point increase in tariffs could reduce the level of global GDP by almost 2.0% on impact and up to 3.0% after two years, when all the additional indirect channels materialise.”

Results from the first year of the experiment have been mixed. Reported wellbeing increased (social trust, confidence in one’s future, etc.) vs the control group not receiving a basic income; however, there was no difference in employment between those receiving BI and those who did not. So UBI makes you happier, but not more inclined to work. Who would have guessed?

“Public Debt: Fiscal and Welfare Costs in a Time of Low Interest Rates” by Olivier Blanchard former Economic Counselor to IMF

SURPRISE
Blanchard argues that the fiscal and welfare cost of growing government debt levels may in the short-term be lower than many imagine. Debt service/GDP ratios are still low, and current real borrowing rates are still lower than expected GDP growth.

However, at some point higher levels of debt are very likely to lead to higher interest rates, unless they are used to finance growth increasing investments (e.g., fiscal stimulus in downturn, or infrastructure), rather than transfer and interest payments as they are today.

In fact, the October 2018 IMF Fiscal monitor projects that between 2018 and 2023, the rate of growth of GDP will be less than the interest rate on government debt by the following amounts (2018 government debt/GDP ratio after rate difference):

Australia: (1.2%), 41%
Canada: (0.1%), 87%
France: (1.2%), 97%
Italy: 0.5%, 130%
Japan: (1.1%), 238%
UK: (0.4%), 87%
USA: (1.3%), 106%

If accurate, these projections imply that servicing government debt will put increasing pressure on most nations' budgets over the next five years.

“Public Debt Through the Ages”, by Eichengreen et al (IMF Working Paper) is a fascinating trip through two thousand years of sovereign debt history.

“Sovereign debt is a Janus-faced asset class. In the best of times it relaxes the domestic constraint on savings, smooths consumption, and finances investment. Investors see it as a safe haven, as delivering “alpha,” and as a means of portfolio diversification.

In the worst of times it is associated with debt overhangs, banking collapses, exchange-rate crises and inflationary explosions. Investors see it unenforceable, illiquid and prone to messy debt workouts. In this paper, we use history to analyze both aspects…

“We consider public debt from a long-term historical perspective, showing how the purposes for which governments borrow have evolved over time. Periods when debt-to-GDP ratios rose explosively as a result of wars, depressions and financial crises also have a long history. Many of these episodes resulted in debt-management problems resolved through debasements and restructurings.

“Less widely appreciated are successful debt consolidation episodes, instances in which governments inheriting heavy debts ran primary surpluses for long periods in order to reduce those burdens to sustainable levels…

“Countries have pursued two broad approaches to debt reduction. The orthodox approach relies on growth, primary surpluses, and the privatization of government assets. In turn this encourages long debt duration and non-resident holdings.

Heterodox approaches, in contrast, include restructuring debt contracts, generating inflation, taxing wealth and repressing private finance. This in turn discourages foreigners from holding the government’s obligations and investors from holding long-duration debt.

Today, financial repression is unlikely to be as effective as after World War II. Repression then relied on tight financial regulation, capital controls, and limited investment opportunities. Today a much larger share of advanced economy debt is held by non-residents, and a lower share by banking systems, making it more difficult to maintain a captive investor base that accepts debt offering sub-market returns. In addition, regulatory measures compelling banks to hold domestic government debt and then attempting to inflate it away could threaten financial stability in the financially-competitive low-growth environment of the 21st century.

The value attached to price stability by central banks and retail investors in government bonds in turn limits the political viability of surprise inflation. Higher inflation would also have indirect costs, in the form of a persistent departure from less risky long-duration debt. Governments would be trading off lower short-run debt-servicing costs for higher costs and heightened volatility in the future.”

“Why markets should get set for QE4” by Michael Howell, 19Feb19

SURPRISE
Minsky would love this paper, as it describes our continued progression towards the “Minsky Moment” when the full nature of the debt crisis we face will become widely appreciated.

“To better understand the risks, we must think of western financial systems as essentially capital redistribution mechanisms that are used to refinance existing positions, rather than capital-raising mechanisms to obtain new money. This refinancing role means that quantity (liquidity) matters more than quality (price, or interest rates). Liquidity derives from balance sheet capacity and, in America, this is closely linked to the size of the Fed’s QE operations.

Liquidity can be measured based on the funds that flow through both the traditional banking system and the wholesale money markets. The latter have taken on huge importance in recent years, eclipsing banks as sources of lending. They have been fueled by vast inflows from institutional cash pools, such as cash-rich companies, asset managers and hedge funds, the cash-collateral business of derivative traders and foreign exchange reserve managers. These pools have outgrown the banking systems, and their size typically exceeds the deposit insurance thresholds for government guarantees.

“It is why these pools need to invest in other secure short-term liquid assets. In the absence of instruments provided by the state — in the form of central bank lending facilities and Treasury bills — the private sector has had to step in. This has happened largely through short-term loans known as repurchase agreements, or repos; and asset-backed commercial paper.

“The credit system increasingly operates through these repo markets, and often with active central bank participation. The repo mechanism bundles together “safe” assets, such as government bonds, foreign exchange and high-grade corporate debt, and uses these as security against which to borrow. While credit risk is to some extent mitigated, the risk of being able to roll or refinance positions remains.

The search forever more collateral encourages the issuance of higher quality private bonds, which, in turn, allows for greater issuance of lower-grade bonds. A deteriorating economic backdrop and tight market liquidity can compromise this poorer quality debt because the heightened risk of default often means that demand dries up and prevents their refinancing.

This kind of shock could reverberate and trigger a rush from investors into high-quality, short-term instruments, such as government-backed Treasury bills, central bank reverse repos and banks’ reserves.

So is another crash coming? Much depends on the central banks. Whereas the global financial crisis was caused by too much private sector leverage, our concern today is a growing shortage of central bank liquidity caused by the deliberate unwinding of the QE policies put in place to replace the private sector funding that evaporated in 2007/08.

The bottom line is that liquidity matters hugely, and modern financial systems cannot function without large central bank balance sheets.
In short, we expect to see another round of central-bank asset purchases — “QE4” — far sooner than many expect.”

“Globalization in Transition: The Future of Trade and Value Chains” by the McKinsey Global Institute

“Although trade tensions dominate the headlines, deeper changes in the nature of globalization have gone largely unnoticed

We see that globalization reached a turning point in the mid-2000s, although the changes were obscured by the Great Recession. Among our key findings:

First, goods-producing value chains have become less trade-intensive. Output and trade both continue to grow in absolute terms, but a smaller share of the goods rolling off the world’s assembly lines is now traded across borders. Between 2007 and 2017, exports declined from 28.1 to 22.5 percent of gross output in goods-producing value chains.

Second, cross-border services are growing more than 60 percent faster than trade in goods, and they generate far more economic value than traditional trade statistics capture.

Third, less than 20 percent of goods trade is based on labor-cost arbitrage, and in many value chains, that share has been declining over the last decade.

The fourth and related shift is that global value chains are becoming more knowledge-intensive and reliant on high-skill labor. Across all value chains, investment in intangible assets (such as R&D, brands, and IP) has more than doubled as a share of revenue, from 5.5 to 13.1 percent, since 2000.

Finally, goods-producing value chains (particularly automotive as well as computers and electronics) are becoming more regionally concentrated, especially within Asia and Europe. Companies are increasingly establishing production in proximity to demand while boosting trade in services over the next decade…

Companies face more complex unknowns than ever before, making flexibility and resilience critical…

The challenges are getting steeper for countries that missed out on the last wave of globalization. As automation reduces the importance of labor costs, the window is narrowing for low-income countries to use labor-intensive exports as a development strategy.”

“The Real Effects of Zombie Lending in Europe”, Bank of England Working Paper by Belinda Tracy

“Around 10% of European firms were in receipt of subsidized bank loans following the peak of the European sovereign debt crisis in 2011. To what extent did such forbearance lending contribute to the subsequent low output growth experienced by the euro area? In this paper, we address this question by developing a quantitative model of firm dynamics in which forbearance lending and firm defaults arise endogenously.

The model provides a close approximation to key euro-area firm statistics over the period 2011 to 2014. We evaluate the impact of forbearance lending by considering a counterfactual scenario in which firms no longer have access to loan forbearance.

Our key finding is that aggregate output, investment and total factor productivity are higher in the absence of forbearance lending than in the benchmark scenario that includes forbearance lending. This suggests that forbearance lending practices contributed to the low output growth across the euro area following the onset of the sovereign debt crisis.”

This echoes a similar point made by Raha Foroohar in the FT: “Low interest rates have papered over myriad political and economic problems, not just for 10 years, but for decades.”

“Corporate Bond Markets in a Time of Unconventional Monetary Policy” by Celik et al from the OECD

SURPRISE
This excellent analysis makes depressingly clear the number of threats that have emerged since 2008 in our increasingly complex corporate debt markets.

“Corporate bond markets have become an increasingly important source of financing for nonfinancial companies. The total outstanding debt in the form of corporate bonds reached USD 13 trillion as of end-2018. In real terms, this is twice as much as in 2008. This paper documents a number of elevated risks and vulnerabilities associated with this development and looks at how the quality of today’s outstanding stock of corporate bonds differs from earlier credit cycles…

Since the financial crisis in 2008, non-financial companies have dramatically increased their borrowing in the form of corporate bonds. Between 2008-2018 global corporate bond issuance averaged USD 1.7 trillion per year, compared to an annual average of USD 864 billion during the years leading up to the financial crisis. As a result, the global outstanding debt in the form of corporate bonds issued by non-financial companies reached almost USD 13 trillion at the end of 2018. This is twice the amount in real terms that was outstanding in 2008.

Any developments in these areas will come at a time when non-financial companies in the next three years will have to pay back or refinance about USD 4 trillion worth of corporate bonds.

This is close to the total balance sheet of the US Federal Reserve.

Moreover, global net issuance of corporate bonds in 2018 decreased by 41% compared to 2017, reaching its lowest volume since 2008. Importantly, net issuance of non-investment grade bonds turned negative in 2018 indicating a reduced risk appetite among investors. The only other year that this happened over the last two decades was in 2008.

By taking into account similar intra-category changes in ratings also within the non-investment grade category, our “global corporate bond rating index” reveals a clear downward trend in overall bond ratings since 1980. This global corporate bond rating index has now remained below BBB+ for 9 consecutive years.

This is the longest period of sub-BBB+ rating since 1980. This prolonged decline in bond quality points to the risk that a future downturn may result in higher default rates than in previous credit cycles…

An economic downturn may also increase the rate of downgrades in the BBB rated corporate bond segment, which has undergone extraordinary growth in recent years. Issuers that downgrade from the BBB rating scale to non-investment grade, the so-called “fallen angels”, have to face an amplified increase in borrowing costs, due to a sudden loss of a major investor base.

Since there are regulatory restrictions on the holdings of non-investment grade bonds by important categories of institutional investors and many institutional investors follow rating based investment mandates or procedures, the non-investment grade market has a smaller investor pool and is associated with lower levels of liquidity.

In addition to the elevated borrowing costs that individual fallen angels will face, the downgrade of a large amount of investment grade bonds may be hard to absorb by the non-investment grade market, causing volatility and spreads to rise. In 2017, only 2.8% of BBB rated corporate issuers were downgraded to non-investment grade. But the rate of downgrading may be expected to increase during crisis times. In 2009 for example, 7.5% of corporate issuers rated BBB at the beginning of the year had been downgraded to non-investment grade by the end of the year. Considering that the current stock of BBB rated bonds amounts to USD 3.6 trillion, this would be the equivalent of USD 274 billion worth of non-financial corporate bonds migrating to the non-investment grade market within a year. If financial companies are included, the number would rise to nearly USD 500 billion…

Considering the size and maturity profile of the current outstanding stock of corporate bonds, corporations in both advanced and emerging markets are facing record levels of repayment requirements in the coming years. As of December 2018, companies in advanced economies need to pay or refinance USD 2.9 trillion within 3 years and their counterparts in emerging economies USD 1.3 trillion. At the 1-, 2- and 3-year horizons, advanced and emerging market companies have the highest corporate bond repayments since 2000. Notably, for emerging market companies, the amount due within the next 3 years has reached a record of 47% of the total outstanding amount; almost double the percentage in 2008.”

Two new papers have brought more clarity to the causal relationships between population ageing and key economic outcomes

SURPRISE
In 2016, researchers from RAND predicted that due to population ageing, US GDP growth would slow by 1.2% in this decade, and 0.6% in the next, based on their finding that “a 10% increase in the fraction of the population ages 60+ decreases the growth rate of GDP per capita by 5.5%.

Two-thirds of the reduction is due to slower growth in the labor productivity of workers across the age distribution, while one-third arises from slower labor force growth” (“The Effect of Population Ageing, the Labor Force, and Productivity” by Maestas et al).

Last September, in “Aging and the Productivity Puzzle”, Ozimek et al provided further evidence of the link between workforce ageing and productivity decline. They find that, “Based on the state-industry and worker-level models, the elasticity of productivity growth with respect to the share of the workforce over 65 years old, ranges from approximately 1% to 3%. Given this, the aging of the workforce has reduced productivity by between 3% and 9%, equal to between 0.25% and 0.7% per annum. For context, nonfarm business productivity growth during the current nearly 10-year long economic expansion has been close to 1% per annum.

This is a full percentage point below the 2% per annum growth in productivity growth experienced in the post-World War II period up until this expansion. Our results suggest, that between one-fourth and almost three-fourths of the productivity slowdown in this expansion is due to the aging workforce.

Even more important, our results suggest that productivity growth will continue to be significantly constrained in the coming more than a decade, as the share of the workforce that is 65 and older will continue to increase at a rate similar to that in the past decade.”

Regarding the causal process behind these results, the authors note that while their “work can offer no definitive conclusions as to the mechanisms causing aging to weigh on productivity, a plausible theory for which we have shown suggestive evidence is that older workers may resist productivity-improving technologies.” From our perspective, this is a key argument in favor of accelerated development of lifetime learning programs that facilitate older workers’ adoption of new technologies.”

Finally, in “The Impact of Population Ageing on Monetary Policy”, Bielecki et al conclude that, “Low fertility rates and increasing life expectancy substantially lower the natural rate of interest [via their negative impact on potential economic growth]. As a consequence, central banks are more likely to hit the lower bound constraint on the nominal interest rate and face long periods of low inflation.”

On 20th anniversary of the Euro, both the FT and Economist are pessimistic about its future

In “The Euro Enters Its Third Decade in Need of Reform” the Economist concludes that, “If Europe’s single currency is to survive a global slowdown or another crisis, it will require another remodeling that politicians seem unwilling or unable to press through…Political differences between the north and south mean that three institutional flaws remain unresolved. Private-sector risk sharing through banks and capital markets is insufficient, the doom loop connecting banks and sovereigns [via the former’s large exposure to sovereign bonds] has not been fully severed, and there is no avenue for fiscal stimulus.”

In “Challenging Times Lie Ahead for the Eurozone”, the Financial Times’ Editorial Board notes that “the question of how the Eurozone would deal with another full-blown crisis has not yet received a proper answer…Challenging times lies ahead as economic growth slows, notably in countries such as Italy where debt levels are already too high.”

In separate 15Jan19 column, however, the FT’s Martin Wolf argues that “the Eurozone is doomed to succeed” because breaking it up “would be hugely traumatic, financially and economically.”

What is unarguable, however, is that the Eurozone’s response to the global financial crisis has sharply reduced the currency’s international role, as described in a new paper by Maggiori et al (“The Rise of the dollar and the Fall of the Euro as International Currencies”).

This month saw further coverage of rising fears about the level of debt in the global economy, and the pain and uncertainty that the future could bring if an economic downturn triggers widespread debt restructurings.

In a speech on “Debt Dynamics”, given on 23Jan19, Ben Broadbent, Deputy Governor of the Bank of England, began by noting the results of a Bank research paper that found that rapid expansion of private sector credit was a better predictor of the severity of subsequent recessions than the level of credit (see, “Down in the Slumps: The Role of Credit in Five Decades of Recessions”, by Bridges et al).

In light of that observation, it is interesting to look at private sector credit growth in major countries between 2000 and 2017, using the IMF’s new Global Debt Database (the most comprehensive debt database ever constructed).

As a percent of GDP, the highest growth was found in China (96%, from 111% of GDP to 207%); Canada (84%), and France (61%).

Far smaller increases were recorded in Italy (39%), the UK (38%), the USA (20%), Germany (minus 23%), and Japan (minus 29%).

Broadbent also pointed to the rapid growth in leveraged loans as a particularly worrisome development. As the Financial Times noted, “the so-called ‘leveraged loan’ market, where credit is typically extended to lowly rated companies…has exploded since the financial crisis, doubling in size of the past decade to $1.2 trillion.” The FT observed that the growth of the leveraged loan market “has eviscerated traditional investor protections and made looser lending standards common…which could amplify the next downturn” (“The Debt Machine: Are Risks Piling Up in Leveraged Loans?”)

Along the same line, multiple observers have called attention to the disturbing fact that many of these leveraged loans are ending up in “collateralized loan obligation” vehicles (CLO), which use the same structure as the collateralized debt obligation vehicles that became infamous during the 2008 global financial crisis.

Finally, when the next recession arrives, the financial distress in bond and loan (i.e., credit) markets will likely be rapidly amplified by a number of factors. First, increasing amounts of high yield bonds and CLO tranches that are held in retail investment vehicles, like mutual and exchange traded funds, which investors could rapidly try to exit at the first sign of trouble. Second, higher capital requirements on banks has reduced the level of liquidity in bond markets. Both of these could accelerate the fall in the price of debt instruments, and the rise in their yields.

Third, due to more complex corporate capital structures, weaker bond and loan covenants, and a much more litigious approach by the parties involved, workouts and restructurings of distressed leveraged loans and high yield bonds could take much longer than before, which will further increase uncertainty in financial markets and the real economy (on the latter, see, “Bankruptcy Hardball” by Ellias and Stark, and “Investors in Debt Laden Companies Face Messy Workouts” by Sujeet Indap in the 22Jan19 Financial Times.

This month a growing number of observers have warned that the next recession is likely closer than most people expect, and nations are generally unprepared for it.

Larry Summers noted that “The critical challenge for monetary and fiscal policy will be to maintain sufficient demand amid immense geopolitical uncertainty, increasing protectionism, high accumulated debt levels and structural and demographic factors leading to increased private saving and reduced private investment” (“We Must Prepare Now for the Likelihood of a Recession”, Financial Times 7Jan19).

In the FT, Martin Wolf warned that, “[policy] room for a response to a recession would be limited by historical standards, especially in monetary policy” and that the political “transformation of the global environment creates the risk that it would be impossible to mount a coordinated and effective response to a severe global economic slowdown.” He concludes on a pessimistic note: “Unfortunately, no simple mechanisms for reducing these sources of fragility now exist. These are deeply ingrained, and given recent political developments, are more likely to get worse than better” (“Why the World Economy Feels So Fragile”, Financial Times, 8Jan19).

In early January, the US Federal Reserve signaled a slowdown in the pace of its planned interest rate increases in 2019

SURPRISE
According to the released minutes from the Fed’s December meeting, the main reason for this move was increasing signs of a slowing global economy (e.g., weakness in Europe and China). This is likely to reduce macro uncertainty – at least temporarily.

According to the released minutes from the Fed’s December meeting, the main reason for this move was increasing signs of a slowing global economy (e.g., weakness in Europe and China). This is likely to reduce macro uncertainty – at least temporarily.

SURPRISE
This important column notes how slowing population growth in many emerging markets will, in the absence of substantial productivity gains, slow their economic growth rates.

“According to UN projections, the old age dependency ratio in EMs (65+ over the working age population) will rise from about 10 per cent at present to more than 22 per cent by 2050; the comparable increase in mature markets is from 28 per cent to 45 per cent…the growth advantage of more than 4 percentage points that EMs enjoyed over mature markets in the 2000-2010 period has narrowed to about 2 percentage points and will probably disappear in the long run…

“This potential growth slowdown puts the recent increase in EM debt in a more worrisome light…the current EM debt burden will make it more difficult to fund and build up pension assets to provide for future retirees…This will put pressure on public pay-as-you-go pension systems in EM countries, especially if government deficits and debt cannot be brought under control…failure to adequately provision for future retirees can create social tension, not conducive to growth…

“In conclusion, the case for global investors especially pension funds to diversify into EM assets (younger population, higher growth and potentially superior return) is still reasonable for the foreseeable future. However, in the long run, this case depends critically on whether policymakers in EMs can implement appropriate policies to tackle the structural problems mentioned above, to improve productivity and foster inclusive growth. In this race, some countries will do better than others. Hence, the key in EM investing is to be selective in picking country and stock exposures — and not treating EMs as a homogeneous bloc.”

A new paper, “Unicorns, Cheshire Cats, and the New Dilemmas of Entrepreneurial Finance?”, by Kenney and Zysmann, provides insight into the interaction of technological changes, and increased access to capital for startups, has changed the competitive dynamics in many sectors of the economy, and produced more underlying deflationary pressure on prices.

SURPRISE
The “increased availability of open source software, digital platforms, and cloud computing has facilitated a proliferation of startups seeking to disrupt incumbent firms in a wide variety of business sectors…[This has been accompanied by] growth in the number of private funding sources that now include crowd-funding websites, angels, accelerators, micro-venture capitalists, traditional venture capitalists, and lately even mutual, sovereign wealth, and private equity funds – all willing to advance capital to young unlisted firms. The result has been the massive growth in the number of venture capital-backed private firms termed “unicorns” that have market capitalizations of over $1 billion…The ease of new firm formation and the enormous amount of capital available has resulted in to a situation within which new firms can afford to run massive losses for long periods in an effort to dislodge incumbents…

This has produced “remarkable turmoil in many formerly stable industrial sectors, as the new entrants fueled by capital investments undercut incumbents on price. Because the new firms intending to disrupt existing firms are venture capital-finance, they can afford to operate at a loss with the goal of eventually triumphing. Existing firms competing with the disruptors must be profitable to survive, while the disruptors need only keep their investors. The ultimate result is that those firms with access to capital are likely survive and displace earlier firms and thereby change their respective industrial ecosystems.”

“The Late Cycle Lament: The Dual Economy, Minsky Moments, and Other Concerns”, by James Montier of GMO

For many years, I have long regarded James Montier as one of the world’s most insightful macro analysts. Hence, I take what he has written in his latest note with more than a grain of salt.

I strongly agree with his opening observation: “Overoptimism and overconfidence are two well-known psychological traits of our species. They are particularly dangerous in the late stages of an economic cycle where these terrible twins result in investors overestimating return and underestimating risk – a potentially lethal combination of errors.”

I also strongly endorse his conclusions, which agree with our own view: “The corporate bid is really a massive debt for equity swap, with firms issuing massive amounts of corporate bonds (very low quality debt at that), and effectively leveraging themselves up. This creates a systemic vulnerability, and is potentially a Minsky Moment in the making. The listed sector has been at the vanguard (or perhaps better described as the forlorn hope) of this movement…

“All of this occurs against a backdrop of an extremely expensive U.S. equity market, which is increasingly looking like Wile. E. Coyote – the hapless adversary of Roadrunner – having run off the edge of a cliff only to realise the ground is no longer below his feet.

Tragically, it seems valuation is doomed to suffer Cassandra’s curse at a time when telling the truth is never believed.”

“Risk is Building in the Housing Market” by Fisher and Pinto from AEI

“If the economy were to experience a downturn or worse in the next few years, home prices, which have boomed over the last six years, will surely realize a price correction and foreclosure rates will increase dramatically. This will be a surprise to many who say that this time is different and that a lack of supply will sustain prices. However, house prices adjusted for inflation are growing almost exactly as fast six years into the current price boom as over the same period in the last boom. Real prices are currently increasing around 4.2% per year through the middle of 2018 compared to 4.3% annually through the third quarter of 2003. That equates to about a 27% cumulative run up in real prices over six years.”

The reason this is concerning is that, in nominal terms, recent house price appreciation is far outstripping wage gains for most Americans. When house prices run way above longer run trends in wages, the gap between wage growth and house price growth constitutes territory ripe for a price correction. That gap does not exist in every major metropolitan area, but it exists in most.”

“The Housing Boom is Already Gigantic. How Long Can It Last?” by Robert Shiller

“We are, once again, experiencing one of the greatest housing booms in United States history. How long this will last and where it is heading next are impossible to know now. But it is time to take notice: My data shows that this is the United States’ third biggest housing boom in the modern era… It can’t go on forever, of course. But when it will end isn’t knowable. The data can’t tell us when prices will level off, or whether they will plunge catastrophically. All we do know is that prices have been roaring higher at a speed rarely seen in American history.”

“Demography, unemployment, and automation: Challenges in creating decent jobs until 2030” by David Bloom, Mathew McKenna, Klaus Prettner

SURPRISE

The conclusion of this analysis suggests that pressures on developed nations from increased economic migration will increase in the years ahead (and that is before taking climate change-induced increases in migration into account). “Based on growth in the working age population, labour force participation rates, and unemployment, about three quarters of a billion jobs will need to be created in 2010–2030. The challenges of technological progress as represented by automation further raise the number of jobs required."

"A large proportion of the jobs that are needed will have to be created in low to low-middle income countries, which often lack a strong tradition of decent work, compounding the job creation challenge… sub-Saharan Africa faces an especially daunting task in creating jobs due to its still growing population, as does South Asia. In fact, these two regions represent about half of the global job creation needs.”

“Testing the Resilience of Europe’s Inclusive Growth Model”, by Bughin et al from the McKinsey Global Institute

SURPRISE

“Although inequality across Europe has grown only moderately since the early 2000s, social divergence between and within some European countries has increased. Citizens’ trust of national and European Union (EU) institutions has fallen. Six global megatrends [ageing demographics; digital technology, automation, and artificial intelligence (AI); increased global competition; migration; climate change and pollution; and shifting geopolitics.] could widen income inequality and social divergence further to 2030, putting Europe’s inclusive growth model under even more strain…

In a simulated “denial” scenario, in which the EU and European countries do not respond to the megatrends (and roll back current policies), a social contract centred on inclusive growth would seem elusive, as Europe would face prolonged economic stagnation, rising inequality, and growth in welfare costs outstripping gross income growth….

One of the EU’s most pressing challenges—even in the [optimistic] scenario—could be rising inequality. Particularly digitisation and AI, but also global competition, could amplify skills premiums and put pressure on wages of routine jobs, superstar effects among firms and cities could continue, and both ageing and migration could further increase the wedge between top and bottom-income households.

What’s more, consensus forecasts project that Europe’s South is likely to diverge from, rather than reconverge with, Europe’s North, and a shift in global competition to digital may create yet more headwinds in Europe’s economically weaker geographies, threatening EU cohesion…

The EU is likely to be able to preserve the essence of its social contract only by delivering effective policies in response to the megatrends to restore social convergence in the EU, and by adjusting the parameters of its social contract.”

“Economic Piety is a Crisis for Workers” by Oren Cass

Writing in the Atlantic Monthly (a left of center publication), Cass (from the right of center Manhattan Institute) proposes that government should focus on production and labor market health rather than consumption and GDP growth for its own sake. This is a particularly well-written and cogent policy prescription that presents a cogent alternative to the current status quo

“Wiping the Slate Clean: Is it Time to Consider Debt Forgiveness?” by Gillian Tett in the Financial Times, 12Dec18

“As a veteran of the LDC debt crisis, Tett’s article hit very close to home for me. Ostensibly, it is a review of Michael Hudson’s excellent new book on debt forgiveness throughout history: “…And Forgive Them Their Debts: Lending, Foreclosure, and Redemption from Bronze Age Finance to the Jubilee Year.” However, Tett uses the review to raise what I believe to be a central issue confronting us today. Tett notes that, “Mesopotamian scribes knew that debt tends to grow much faster than the economy as a whole, creating inequality and social tensions.” She goes on to note how debt jubilees (forgiveness) “created a safety valve whenever debt exploded to a point that inequality was creating crushing tensions and harming productivity.” Tett then notes that “if you look at the economic history of the past century, it is a story of ever-expanding global debt: so much so that as a proportion of GDP, debt now stands at a record high of 217 percent, up from 117 percent in 2008.”

As I have seen over and over again in my career as a banker and turnaround specialist, there are only four ways to deal with excessive debt: (1) shrinking spending in other areas to pay it off – i.e., severe austerity; (2) growing your way out of it; (3) default – e.g., via bankruptcy, maturity extension, or outright; or outright forgiveness, or (4) converting it into another asset – e.g., cash via the seizure and sale of collateral, or equity in the debtor company. We have seen that mass austerity is politically infeasible, and growing your way out of it is extremely challenging (when the obstacles to faster growth are large and durable). That leaves default and conversion as, to some extent, unavoidable options.

Tett concludes with this observation: “Is rising debt destined to be a permanent feature of our 21st-century economy? Or will that debt eventually spark hyperinflation, selective defaults — or a social explosion in some countries? Is there, in other words, any way for nations to create 21st-century safety valves to cope with the fact that most countries are unlikely to “grow” their way out of debt? The answer is unclear.” But as we look at the future, the answer remains central.

“Time Scales and Economic Cycles”, by Bernard, et al, and “Measuring Financial Cycle Time” by Filardo, et al

SURPRISE

These papers provide an excellent overview of different economic and financial cycles that occur over longer time frames than the familiar business cycle, as well as the causal processes that underlie them and indicators that can be used to track them.

“New Data on Global Debt”, IMF Blog

SURPRISE

The IMF has unveiled a major upgrade to its global debt database, which now includes a wider range of instruments and countries, and covers a longer time period. In their blog post, the IMF highlights some findings from the new data: “Global debt has reached an all-time high of $184 trillion in nominal terms, the equivalent of 225 percent of GDP in 2017. On average, the world’s debt now exceeds $86,000 in per capita terms, which is more than 2ó times the average income per-capita.”

“Of the global total of $184 trillion in debt at the end of 2017, close to two-thirds is nonfinancial private debt and the remainder is public debt.” “The private sector’s debt has tripled since 1950. This makes it the driving force behind global debt.” “As we close the first decade after the global financial crisis, the legacy of excessive debt still looms large.”

“The Dire Effects of a Lack of Fiscal and Monetary Coordination” by Bianchi and Melosi

SURPRISE

“What happens if the government’s fiscal willingness to stabilize a large stock of debt is waning, while the central bank is adamant about preventing a rise in inflation? The large-scale imbalance brings about inflationary pressures, triggering a vicious spiral of higher inflation, monetary tightening, output contraction, and further debt accumulation. Furthermore, the mere possibility of this institutional conflict represents a drag on the economy.”

“The Changing Nature of Work” World Bank World Development Report, 2019

“Machines are coming to take our jobs” has been a concern for hundreds of years — at least since the industrialization of weaving in the early 18th century, which raised productivity and also fears that thousands of workers would be thrown out on the streets. Innovation and technological progress have caused disruption, but they have created more prosperity than they have destroyed.”

“Yet today, we are riding a new wave of uncertainty as the pace of innovation continues to accelerate and technology affects every part of our lives…The days of staying in one job, or with one company, for decades are waning. In the gig economy, workers will likely have many gigs over the course of their careers, which means they will have to be lifelong learners…That is why this Report emphasizes the primacy of human capital in meeting a challenge that, by its very definition, resists simple and prescriptive solutions…”

“This study unveils our new Human Capital Index, which measures the consequences of neglecting investments in human capital in terms of the lost productivity of the next generation of workers…”

“Three types of skills are increasingly important in labor markets: advanced cognitive skills such as complex problem-solving, socio-behavioral skills such as teamwork, and skill combinations that are predictive of adaptability such as reasoning and self-efficacy. Building these skills requires strong human capital foundations and lifelong learning.”

“An Assessment of McKinsey’s Forecast for Artificial Intelligence” by Jeffrey Funk

SURPRISE

Many analyses have recently been published on the potential impact of advancing artificial intelligence technologies on productivity and economic growth. Virtually all of them have forecast that the impact is likely to be large, and generate significant disruption, including job losses and rapid changes in corporate and potentially even national economic competitiveness.

Funk’s analysis is a necessary and timely counterpoint to these reports. He looks behind the conclusions of a recent McKinsey report, seeking to understand how much of an impact AI will have, in specific industries, by when, and, critically, why.

Funk takes a micro/activity-based approach, asking of those where AI seems likely to have the largest impact, how important they are to total costs and the value created for customers in different sectors. He also examines how much more room there is for substantial improvements in these areas, given past improvements and current improvement trajectories.

His conclusion is that because these micro questions are often not addressed, either at all or in sufficient detail in recent reports on AI’s potential economic impact, considerable uncertainty surrounds their optimistic conclusions.

“Start-Ups Aren't Cool Anymore”, by Stephen Harrison in The Atlantic

“Research suggests entrepreneurial activity has declined among millennials. The share of people under 30 who own a business has fallen to almost a quarter-century low.”

“The Global Effects of Global Risk and Uncertainty” by Bonciani and Ricci from the European Central Bank

The authors identify a factor that explains about 40% of the variation in the price of about 1,000 risky assets in 36 countries. They argue that it represents changes in global uncertainty and risk aversion, and find (as did previous papers that primarily focused on the US) that uncertainty shocks have severe and long-lasting consequences for economic growth and asset returns.

“Global Uncertainty is Rising, and That is a Bad Omen for Growth” by Ahir, Bloom, and Furceri.

The authors present a new text-based quarterly “World Uncertainty Index” (WUI) and report five key findings:

(1) Global uncertainty has increases significantly since 2012.

(2) Uncertainty spikes are more synchronised in advanced economies than in emerging and low income countries.

(3) Uncertainty is higher in emerging and low income economies than in advanced economies.

(4) There is an inverted U-shaped relationship between uncertainty and democracy (uncertainty peaks at the midpoint between the evolution from autocracy to democracy).

(5) Increases in the WUI foreshadow significant declines in output.

“The Monopolization of America” by David Leonhardt in The New York Times, 25Nov18

Leonhardt makes a point in the NYT that Rana Foroohar has frequently made in the FT, about the negative economic consequences of the growing power of a limited number of companies that increasingly dominate their respective industries.

For an excellent recent example of this, see the new report, “Provider Consolidation Drives up US Healthcare Costs”, by the Center for American Progress.

We should never forget that in the first decade of the 20th century, president Theodore Roosevelt made trustbusting a populist crusade.

Leonhardt notes that, a century ago, Louis Brandeis, the Supreme Court justice and anti‑monopoly crusader said, “’We may have democracy, or we may have wealth concentrated in the hands of a few, but we can’t have both’…In one industry after another, big companies have become more dominant over the past 15 years, new data show...

“The new corporate behemoths have been very good for their executives and largest shareholders — and bad for almost everyone else. Sooner or later, the companies tend to raise prices. They hold down wages, because where else are workers going to go? They use their resources to sway government policy…”

“Many of our economic ills — like income stagnation and a decline in entrepreneurship — stem partly from corporate gigantism. So what are we going to do about it? It’s time for another political movement…The beginnings of this movement are now visible”

Similar points were also raised in a recent article in The Economist, “Western Governments Need a Plan for Reinstating Effective Competition.”

“The Rise of Zombie Firms: Causes and Consequences” by Banerjee and Hoffman from the Bank for International Settlements

“The rising number of so-called zombie firms, defined as firms that are unable to cover debt servicing costs from current profits over an extended period, has attracted increasing attention in both academic and policy circles. Using firm-level data on listed firms in 14 advanced economies, we document a ratcheting-up in the prevalence of zombies since the late 1980s.”

“Our analysis suggests that this increase is linked to reduced financial pressure, which in turn seems to reflect in part the effects of lower interest rates. We further find that zombies weigh on economic performance because they are less productive and because their presence lowers investment in and employment at more productive firms.”

On the latter point, see also, “The Walking Dead? Zombie Firms and Productivity Performance in OECD Countries” by McGowan et al.

We expect that a key contributor to the persistence of the Deflation Regime will be extensive corporate debt defaults (which will involve either write-downs or debt/equity conversions). Elimination of zombie firms and redeployment of the resources that have been tied up in them could contribute to a beneficial increase in productivity growth, particularly if it is accompanied by reforms (e.g., in education and lifetime learning) that lead to substantial improvements in the quality of human capital.

“More Slack than Meets the Eye? Recent Wage Dynamics in Advanced Economies” by Hong et al from the IMF

SURPRISE

This recent paper from the IMF Research Department finds that deflationary forces at work in the world economy may have been significantly underestimated.

“Nominal wage growth in most advanced economies remains markedly lower than it was before the Great Recession of 2008–09. This paper finds that the bulk of the wage slowdown is accounted for by labor market slack, inflation expectations, and trend productivity growth. In particular, there appears to be greater slack than meets the eye.”

“The Deficit Reductions Necessary to Meet Various Targets for Federal Debt”, by the US Congressional Budget Office

This is a very sobering report that highlights the great challenge the US faces with respect to controlling the growth of federal government debt.

“CBO analyzed the primary deficit reductions necessary to meet three different debt targets over four different time frames. The three targets are federal debt equaling 41 percent of GDP (the average over the past 50 years), 78 percent of GDP (the current amount), and 100 percent of GDP. The four time frames begin in 2019 and extend to 2033, 2038, 2044, and 2048. (In CBO’s extended baseline, debt held by the public grows to 152 percent of GDP in 2048.)

“What Economists Don’t Know About Manufacturing”, by Bonvillian and Singer in The American Interest

SURPRISE

This analysis highlights the overlooked and critical connection between manufacturing expertise and productivity growth.

“The decline of manufacturing really is as disastrous as common sense suggests…the delinking of innovation from production has put the United States increasingly at a competitive disadvantage…”

“U.S. industry has allowed its historic production leadership to slip, endangering its innovative capacity—again, because production cannot really be delinked from innovation—in important areas of technology…”

“The argument that manufacturing jobs are economically equivalent to services jobs was and remains simply wrong. Manufacturing jobs have the highest job multiplier effect; that is, they lead to more jobs throughout the economy than do jobs in other sectors. Manufacturing is also an innovation driver, so it is critical to U.S. research and development and follow-on technological innovation—and therefore to growth…”

“The beginning of wisdom when it comes to understanding advanced manufacturing is the simple but somehow elusive point that not all industries are created equal in generating growth. Regrettably, mainstream economists have typically been unable to differentiate between the potential of different sectors.”

“The Dollar Can Defend Its Global Reserve Role Against the EU and China”, by Megan Greene in the Financial Times, 7Nov18

“While the euro accounted for the second largest share of global central bank reserves by mid-2018, its share was only around one-third that of the dollar. It will be difficult for investors to put their trust in the euro as long as there are doubts about the Eurozone’s survival, most recently prompted by the Italian government flouting fiscal rules…”

“For all the talk of an insurgent China, its currency is hardly poised to take over. The Renminbi accounted for a paltry 1.84 per cent of global central bank reserves in mid-2018. This could change as the Belt and Road Initiative expands — it would be easier for all countries in the project to use the same currency. But the Renminbi has a long way to go. It is not freely floating, monetary policy is unpredictable and China’s economy and financial system are not open.”

“Fragile New Economy: The Rise of Intangible Capital and Financial Instability” by Ye Li

The rising amount of intangible assets on corporate balance sheets that can’t be pledged as loan collateral has led to higher corporate prudential savings. However, this has also caused banks to bid up the prices of (and lower the yields on) risky assets in which they invest these funds (e.g., BB rated bonds). This is creating a hidden source of rising risk in the global financial system.

“The Secular Decline in US Employment Over the Past Two Decades” by Abraham and Kearney

“Labor demand factors – notably import competition from China and the rise of industrial robots – emerge as the key drivers of employment decline. Some labor supply and institutional factors (increased disability benefits, higher state minimum wages, and increased incarceration rates) also have contributed to the decline, but to a lesser extent.”

The first conclusion echoes one reached by David Autor and his colleagues in their 2016 paper, “The China Shock: Learning from Labor Market Adjustment to Large Changes in Trade.”

These are significant findings that will further reinforce both rising conflict between China and western nations, as well as debates over appropriate domestic policies to address employment declines.

“Superstars: The Dynamics of Firms, Sectors, and Cities Leading the Global Economy” by Manyika et al, McKinsey Global Institute

SUPRRISE.
“We define superstar to mean a firm, sector, or city that has a substantially greater share of income than peers and is pulling away from those peers over time… Superstars exist not only among firms but among sectors and cities as well, although we find the trend most evident among cities and firms…

“Relative to their peers, superstars share several common characteristics. In addition to capturing a greater share of income and pulling away from their peers, superstars exhibit relatively higher levels of digitization… For firms, we analyze nearly 6,000 of the world’s largest public and private firms, each with annual revenues greater than $1 billion, that together make up 65 percent of global corporate pretax earnings. In this group, economic profit is distributed along a power curve, with the top 10 percent of firms capturing 80 percent of economic profit among companies with annual revenues greater than $1 billion.

“We label companies in this top 10 percent as superstar firms. The middle 80 percent of firms record near-zero economic profit in aggregate, while the bottom 10 percent destroys as much value as the top 10 percent creates. The top 1 percent by economic profit, the highest economic-value creating firms in our sample, account for 36 percent of all economic profit for companies with annual revenues greater than $1 billion…

“Over the past 20 years, the gap has widened between superstar firms and median firms, and also between the bottom 10 percent and median firms. Today’s superstar firms have 1.6 times more economic profit on average than superstar firms 20 years ago…Today’s bottom-decile firms have 1.5 times more economic loss on average than their counterparts 20 years ago, with one-fifth of them (a growing share) unable to generate enough pretax earnings to sustain interest payments on their debt.”

This analysis shows the extreme economic pressures on many business models today, which has implications for both future income inequality (which is exacerbated by the gap between superstar and other firms) and future growth in the real median wage. Both of these have additional implications for potentially intensifying social and political conflict.

In its latest extended Z.1 Release – Financial Accounts of the United States – the US Federal Reserve has substantially revised upward its estimate of the size of US public sector pension deficits, based on the use of an estimate of pension funds’ future retirement benefit obligations and the use of an appropriate discount rate, which is much lower than that used by most public sector (but not private sector) defined benefit pension funds.

SURPRISE.
Unfunded public sector pension liabilities are a major source of “hidden” public sector debt. Ultimately, they can only be reduced through either much higher investment earnings (which are unlikely in a highly indebted global economy characterized by declining birthrates and stagnant productivity growth), or increased employer pension contributions (which means either cuts in other program spending and/or higher taxes to support retirement benefits for public sector employees which are often much better than those realized by their private sector peers).

This is a highly significant move, as it signals that the Fed will no longer silently conspire with state and local politicians to, in effect, hide the true size of public pension debt, that will likely one day force either significant benefit cuts for public employees, and/or significant spending cuts and/or tax increases.

This will have further implications for the future ability of state and local borrowers in the United States to access credit markets to fund infrastructure investments.

IMF World Economic Outlook, October 2018 edition

The latest WEO’s conclusions are in line with our forecast conclusions.

“Growing debt is creating increased financial vulnerabilities in world economy…the possibility of unpleasant surprises outweighs the likelihood of unforeseen good news… With shrinking excess capacity and mounting downside risks, many countries need to rebuild fiscal buffers and strengthen their resilience to an environment in which financial conditions could tighten suddenly and sharply.”

“Beyond the next couple of years, as output gaps close and monetary policy settings continue to normalize, growth in most advanced economies is expected to decline to potential rates—well below the averages reached before the global financial crisis of a decade ago. Slower expansion in working-age populations and projected lackluster productivity gains are the prime drivers of lower medium-term growth rates.”

“Special Report on World Economy” in The Economist

The Economist’s conclusions are consistent with our own and those in the WEO.

The world is “woefully unprepared” for the next recession…” Handling a bout of economic weakness used to be simple: the central bank would cut short-term interest rates until conditions improved. But in the aftermath of the global financial crisis rates around the world fell to zero, and the weak recovery that followed kept them pinned there.”

“Even the Fed, which has chalked up the most post-crisis rate increases, will almost certainly enter the next recession with a historically small amount of room to cut rates. In a downturn, central banks are likely to turn almost immediately to other tools used after the 2007-08 crisis, such as [quantitative easing]. But such tools are politically harder to deploy, and their stimulative effects are less certain…”

“Fiscal stimulus could pick up the slack, but mobilising government budgets to aid the economy will also prove a tall order. Across advanced economies the average government debt load has risen above 100% of GDP, up more than 30 percentage points from 2007. Debt in emerging markets has risen as well, from an average of roughly 35% of GDP to over 50%. Plans for large-scale fiscal stimulus were politically difficult to enact during the financial crisis, and will be harder still the next time around.”

“In Europe, any debate about government borrowing threatens to revive the disastrous political showdowns of the euro-area debt crisis. In the end politics may prove the greatest stumbling block to managing a new global downturn…Most advanced economies now have viable populist or nationalist parties, waiting to capitalise on the first sign of renewed economic distress. Many emerging markets have regressed as well. Nationalism and strongman tactics are in the ascendant.”

“Power in China is worryingly concentrated in the hands of one man, Xi Jinping. Thanks to Mr. Trump’s trade war, relations between America and China have become openly hostile.”

“In 2007 financial markets were primed for a massive crisis, but governments were able to draw heavily on their monetary, fiscal and diplomatic resources to prevent that crisis from destroying the global economy. Today the financial dominoes are not set up quite so precariously, but in many ways the broader economic and political environment is far more forbidding.”

Italy’s new leaders and budget could be setting up a renewed Eurozone crisis.

Because of its size, Italy potentially represents a much bigger problem for the Eurozone than previous crises in Greece, Ireland, and Portugal. Politically, Germany is also less willing to support Eurozone today than it was in previous crises. A crisis in Italy could thus could lead to a significant restructuring of the Eurozone – for example, the departure from the Euro of northern European nations with stronger currencies, which would allow the Euro to significantly depreciate, and thus restore the competitiveness of southern tier economies without forcing even more painful austerity and domestic restructuring of labor and produce markets.

“Global Trends in Interest Rates” by Del Negro et al from the Federal Reserve Bank of NY

SURPRISE.

“Four main results emerge from our empirical analysis. First, the estimated trend in the world real interest rate is stable around values a bit below 2 percent through the 1940s. It rises gradually after World War II, to a peak close to 2.5 percent around 1980, but it has been declining ever since, dipping to about 0.5 percent in 2016, the last available year of data” …

“The exact level of this trend is surrounded by substantial uncertainty, but the drop over the last few decades is precisely estimated. A decline of this magnitude is unprecedented in our sample. It did not even occur during the Great Depression in the 1930s.

“Second, the trend in the world interest rate since the late 1970s essentially coincides with that of the U.S. In other words, the U.S. trend is the global trend over the past four decades. In fact, this has been increasingly the case for almost all other countries in our sample: idiosyncratic trends have been vanishing since the late 1970s. This convergence in cross-country interest rates is arguably the result of growing integration in international asset markets.”

“Third, the trend decline in the world real interest rate over the last few decades is driven to a significant extent by a growing imbalance between the global demand for safety and liquidity and its supply. This contribution is especially concentrated in the period since the mid-1990s, supporting the view that the Asian financial crisis of 1997 and the Russian default in 1998, with the ensuing collapse of LTCM, were key turning points in the emergence of global imbalances.”

“Fourth, a global decline in the growth rate of per-capita consumption, possibly linked to demographic shifts, is a further notable factor pushing global real rates lower.”

“An important implication of these findings is that the persistent macroeconomic headwinds emanating from the financial crisis, including the effects of the extraordinary policies that were put in place to combat it, are far from being the only cause of the low-interest-rate environment.

“Longer-standing secular forces connected with a decline in economic growth since the early 1980s also appear to be crucial culprits, even though these trends might have been exacerbated by the crisis.

“The global nature of the drivers of low interest rates limits the extent to which national policies can address the problem.”

The Rise of Corporate Debt Must Be Managed” FT Editorial 31Oct18

A substantial amount of BB and BBB rated debt is now held in short-term vehicles (mutual and exchange traded funds) with high redemptions likely in the next economic downturn, which in turn would force fire sales and a sharp increase in rates. This would cause financial distress for many borrowers. As the FT’s Robin Wigglesworth wrote back in December 2017, “The Corporate Debt Boom Will Come to a Nasty End”

“The Student Loan Debt Crisis is About to Get Worse” by Griffin et al, Bloomberg 17Oct18

“Student loans have seen almost 157 percent in cumulative growth over the last 11 years. By comparison, auto loan debt has grown 52 percent while mortgage and credit-card debt actually fell by about 1 percent…there’s a whopping $1.5 trillion in student loans out there (through the second quarter of 2018), marking the second-largest consumer debt segment in the country after mortgages…More than 1 in 10 borrowers is at least 90 days delinquent, while mortgages and auto loans have a 1.1 percent and 4 percent delinquency rate, respectively…

Student debt has delayed household formation and led to a decline in homeownership. Sixteen percent of young workers aged 25 to 35 lived with their parents in 2017, up 4 percent from 10 years prior.”

The growing and as yet unresolved student loan problem in the US reminds us of Herbert Stein’s famous quote: “If something cannot go on forever, it will stop.”

Dalio is clearly trying to prepare policymakers and investors for when the stock of outstanding debt reaches a critical “Minsky” threshold.

Claudio Borio is the head of the Monetary and Economic Department at the Bank for International Settlements. For years, he worked there with Bill White, who presciently anticipated the crisis of 2008.

In a 23Sep18 speech, Borio said that, “On the financial side, things look rather fragile. Markets in advanced economies are still overstretched and financial conditions still too easy. Above all, there is too much debt around: in relation to GDP, globally, overall (private and public) debt is now considerably higher than pre-crisis. Ironically, too much debt was at the heart of the crisis, and now we have more of it - although, fortunately, banks have reduced their leverage thanks to financial reform. With interest rates still unusually low and central banks' balance sheets still bloated as never before, there is little left in the medicine chest to nurse the patient back to health or care for him in case of a relapse. Moreover, the political and social backlash against globalisation and multilateralism adds to the fever. Policymakers and market participants should brace themselves…”

Indicator that, like Dalio, Borio and the BIS believe that the global macro system is approaching a critical debt accumulation threshold.

Federal Reserve Bank of Boston Conference on “The Consequences of Long Spells of Low Interest Rates”. Presentations highlighted the continuing reach for higher yields; increased defined benefit pension plan underfunding due to low liability discount rates and investment earnings; and changing institutional structure in financial markets (e.g., growth of credit hedge funds) have created new sources of system risk. Do we have sufficient policy tools to buffer impact of next crisis? Greater likelihood that zero lower interest rate bound will be reached in future, and limit effectiveness of monetary policy (like Abe’s experience in Japan). Also highlighted limited state/local fiscal policy buffers. Final observatioin was impact of low rates on the ability of retirees to obtain sufficient income (e.g., via annuities).

Clearly, the US Federal Reserve system is concerned about the accumulation of negative consequences of the extreme monetary stimulation that avoided a severe downturn after 2008. Perhaps more important is their worries about the lack of sufficient monetary and fiscal policy “firepower” when the next downturn (which could be accompanied by a severe debt crisis) occurs. As in Japan, that places more emphasis than ever on structural policy reforms, which are too often blocked by political gridlock.

“A Failure of Responsibility” by Levin and Capretta (AEI)

“As Debt Rises, the Government Will Soon Spend More on Interest Than on the Military”, by Nelson Schwartz, NYT

“Avoiding [Sovereign] Debt Traps”, by Padoan et all, OECD Journal

“Paying Off Government Debt” by Bryan Taylor (the options are austerity, growth, inflation, and/or default)

All of these highlight growing concern with ballooning US federal deficits and the underlying growth of entitlement spending (e.g., Medicare, Medicaid, Social Security) which is being financed via debt issuance, which, even with a relatively strong economy, is still causing a rise in the ratio of government debt to GDP.

New Federal Reserve Board research paper: “Measuring Aggregate Housing Wealth: New Insights From an Automated Valuation Model” by Gallin et al. Housing recovery hasn’t been as strong as repeat sales indexes suggest; also, metrics based on owner valuation estimates understate extent of housing value destruction.

Combine this with IMF research finding common monetary policies by leading central banks have led to a sharp increase in global synchronization of housing prices, which has exacerbated the potential negative impact of a global fall in housing prices.

“Crashed: How a Decade of Financial Crises Changed the World” by Adam Tooze, and his Foreign Affairs arcticle, “The Forgotten History of the Financial Crisis” , “Ten years later, there is little consensus about the meaning of 2008
and its aftermath”… “How will a multipolar world that has moved beyond the transatlantic cooperation structures of the last century cope with the next crisis?”

Will wholesale funding markets hold up in the next crisis? The US Dollar has become an even more dominant currency since 2008, while foreign borrowing in USD has sharply risen. Fed swap lines could again be critical to prevent implosion of banking system in the next crisis – but with frayed political relations, will they work? E.g., At peak of Eurozone crisis, the Fed reopened swap lines. While European banks have disengaged from global financial system, emerging markets have increased theirs – including China’s shadow banking system.

The China - US trade war intensified in September. So far this only involves tariffs, but the potential for China retaliating by disrupting US companies’ supply chains remains.

Such a move could quickly trigger a financial panic in anticipation of a global recession of unknown severity. The US reaction to this is also another area of critical uncertainty.

In France, President Macron’s proposed structural reforms are running into growing political opposition. But they are key to increased growth in France and, through the power of example, across the Eurozone. In turn, higher growth creates the possibility for reducing class conflict and the attraction of extreme political views, as well as relaxing the currently difficult tradeoff between social and defence spending.

As noted above, given the limited monetary and fiscal “firepower” that will be available to policymakers in the next economic downturn (and financial crisis), structural reform will be a far more important policy lever than in the past for restoring economic growth. Yet there is great uncertainty about the willingness and ability of political systems in many countries to enact it

New Pew analysis shows US public pension fund’s shift to alternatives (hedge funds and private equity) is not paying off in higher net returns and improving funding ratios (pension assets as a percent of the present value of liabilities).

Also, “Lehman’s Legacy is a Global Pensions Mess” by John Authers in the Financial Times

The building public pension fund crisis, not just in the US but in other countries as well, is a classic “grey swan” – a future crisis that everyone can see, but nobody does anything about until it explodes. The essential problem is that due to a combination of higher promised benefits and longer lifetimes, public pension fund liabilities have continued to grow. To some extent, their true size has been disguised by the use of higher discount rates than private sector companies are allowed to use. Plan sponsors had hoped that shifting assets into risker investments would offset a significant percentage of this liability growth. As Pew found, this generally hasn’t worked. This leaves public sector plan sponsors and governments with an unpalatable choice between cutting government spending in other areas, raising taxes, or cutting retiree benefits. This choice will become exponentially harder in the context of a protracted economic downturn and extended low investment returns.