Economy Evidence File

Jun19: New Economic Information: Indicators and Surprises
Why Is This Information Valuable?
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.

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.
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

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.
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.”
May19: New Economic Information: Indicators and Surprises
Why Is This Information Valuable?
“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
“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.”
Apr19: New Economic Information: Indicators and Surprises
Why Is This Information Valuable?
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
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
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
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.
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.
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.
Mar19: New Economic Information: Indicators and Surprises
Why Is This Information Valuable?
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
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
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
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
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
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.”
Feb19: New Economic Information: Indicators and Surprises
Why Is This Information Valuable?
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.”
“The basic income experiment 2017–2018 in Finland, Preliminary Findings by the Ministry of Social Affairs and Health
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
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
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
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
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.”
Jan19: New Economic Information: Indicators and Surprises
Why Is This Information Valuable?
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
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.
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.
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.”
Dec18: New Economic Information: Indicators and Surprises
Why Is This Information Valuable?
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

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

“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

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

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

“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.”
Nov18: New Economic Information: Indicators and Surprises
Why Is This Information Valuable?
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

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

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

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.”
Oct18: New Economic Information: Indicators and Surprises
Why Is This Information Valuable?
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
“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.
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

“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.”
Sep18: New Economic Information: Indicators and Surprises
Why Is This Information Valuable?

A Template for Understanding Big Debt Crises” by Ray Dalio.

Following Bridgewater’s deep dive into “Populism: The Phenomenon”, it’s Chair has published this equally exhaustive guide to debt crises. As a veteran of many of the ones described (e.g., the LDC crisis in the 1980s), I found it a very impressive work.

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.