Sunday, October 20, 2019

Uncertainty Creates Its Own Reality

Uncertainty Creates Its Own Reality 

William Rapp 
Director, Leir Center For Financial Bubble Research 

On a macro-economic level, we exist in a circular cash flow economy. When the economy is growing this leads to greater employment, which means there are more wages to be spent. Increased spending puts pressure on supply that leads to more investment and employment and thus more wages to be spent. It may also lead to increased borrowing and depending on the central bank higher interest rates to slow the economy and moderate inflationary pressures. Any fiscal stimulus can add to this circular cash-flow process by increasing employment directly or indirectly through increased purchases plus through tax cuts that increase after tax income. 

But currently this circular flow of cash seems to be slowing despite lower interest rates and a big fiscal stimulus from massive tax cuts. Why? One obvious reason is the uncertainty surrounding the current environment due to the US trade and tariff wars with not just China but Japan, Canada, and the EU as well. When business executives or consumers face an uncertain economic environment, they naturally become less certain, less optimistic and more cautious. They then postpone major decisions until more information is available. 

Check declining auto sales; reduced consumer confidence [Michigan Index]; fewer job offerings [“US employers advertised 7.1 million available jobs in August, down 1.7% from July's figure of 7.2 million, the Labor Department said. August was the third consecutive month of declining job openings”]; declining new hires per month, factories operating below capacity; low interest rates; low inflation; continued wage stagnation, slowing GDP growth domestically and globally. 

However, it is not just the trade and tariff wars. As Engels explained in the 19th Century the Marginal Propensity to consume out of additional income declines with higher income and wealth. It may even approach zero for the super-rich. Thus, the large US tax cut that increased after tax income for the wealthy or corporations that then mostly used the funds for higher dividends or stock buybacks did little to stimulate the economy’s circular cash flow. 

There was never any real capital constraint on businesses in terms of investment. Before the tax cut capital was readily available in abundance at ultra-low rates. Indeed, one might view the rise of the unicorns or the recovery of Greek credit as confirming this view. Since the fiscal stimulus was not spent continued slow growth and low inflation were then inevitable. Add the uncertainty of trade wars and slower growth in other countries and a more cautious economic environment has arrived.

This is not a static situation, though. The greater caution that results in fewer new hires and less investment means slower growth in the cash flow running through the economy. This leads to more caution and slower growth or even stagnation and then recession. This is how uncertainty can create its own negative reality just as confidence and optimism can create a more positive outcome. Those latter factors, though, currently seem in short supply. 

Confirming Colin Clark

The U.S. business cycles that ended in the last three recessions involved progressively greater and more troubling risk-taking behavior. Each ended with worse financial fallout and a longer period of recession and weak recovery. Much has been written about the bubbles leading up to the commercial real estate deflation in the late 1980s and early 1990s, the crash of the tech stocks and the ensuing bear market of 2000-2002, and the deflation of home real estate and the debacle in mortgage-backed derivatives in 2006 through 2011. Yet analyses of the bubbles’ causes invariably omit a critical point.
The evolution of the economy’s aggregate financial structure has, over decades, altered the playing field for financial decision makers throughout the economy, increasingly skewing their available options toward higher risks, lower returns, or both. 
This paper presents two facts that help explain economic and financial performance in recent decades and offers insights into the current business cycle, the 2020s, and beyond.
  1. Private sector balance sheets grew faster than income over many decades; thus, aggregate debt grew faster than aggregate income, and aggregate assets grew faster than aggregate income.
  2. This disproportionate balance sheet expansion changed financial parameters in the economy, mathematically making financial activity increasingly hazardous and compelling riskier behavior.
The first of these statements is an empirical observation, easily documented. The second is the result of direct logical deduction. Together, they have several consequences:
  • From the mid-1980s on—the era of the Big Balance Sheet Economy—financial decision makers have had to choose between progressively lower returns and higher risk.
  • Too much private sector debt relative to income has adverse consequences, of course, but so does an excessive total value of private sector assets relative to income. An extreme value of aggregate assets relative to income means meager yields and operating returns on assets, distorted financial decisions, and an economy vulnerable to asset price deflation.
  • Each successive business cycle in the Big Balance Sheet Economy era has started with proportionately larger balance sheets and has involved more reckless balance sheet expansion leading to even bigger balance sheets and a worse financial crisis.
  • Each successive crisis, with more bloated balance sheets to stabilize, was more difficult to resolve and therefore required the government to engineer dramatic new lows in interest rates, heavy fiscal stimulus, and other measures to stabilize economic conditions. The measures eventually overcame recession and chronic weakness, but in doing so they necessarily caused further expansion of balance sheets relative to income.
  • During the 2000s, either the housing bubble or some other set of highly speculative, excessively risky, and destabilizing activities was virtually inevitable.
  • Increasingly unsound risk taking has been occurring again in the 2010s.
  • The present cycle is almost certain to end badly. Although there are signs that balance sheet ratios are undergoing an extended, secular topping process, they remain extreme and will produce serious financial instability during the next recession.
  • There is no nice, neat solution to the Big Balance Sheet Economy dilemma, no blueprint for a politically acceptable resolution. The task of preserving prosperity while shrinking assets-to-income and debt-to-income ratios is, if not outright paradoxical, at least plagued by conflicting forces.
  • Government policy cannot prevent serious consequences when the Big Balance Sheet Economy corrects, but it can moderate them and help households, businesses, and the financial system cope with them. However, these tasks would be difficult, politically tricky, and prone to cause some backtracking on balance sheet correction even if policymakers fully understood the economic problem.
  • Although the outlook is fraught with uncertainties, individuals and organizations can benefit by taking steps to prepare for, endure, and in some cases capitalize on some of the developments ahead.
The U.S. economy continues to face a bubble-or-nothing outlook. Participants in the economy and markets will keep increasing their financial risk until the expansion breaks down, and the bigger the balance sheets are relative to income, the more severe the breakdown is likely to be.